Argument (#7-8 July-August 2021)

The Liability Side of Corporate Governance

by Taras Dumych

Corporate governance is commonly associated with decision-making, directing, oversight and the representation of companies in public by company executives and board members. These roles are undoubtedly important elements of corporate governance. However, there is yet another side of corporate governance, which is arguably more robust than the above-referred privileges, but is no less important. This other side relates to liability, which arises from corporate governance.

This article analyzes the nature of corporate governance liability and addresses it from the point of view of those who are directly involved in corporate governance, as well as those who depend on it. In this regard the article focuses not just on Ukrainian laws, but also on the international legal framework and practices, as the latter, considering the internationalizing and globalizing of Ukrainian businesses, have become no less relevant and influential than Ukrainian law.

Sources of liability

Until recently, the mere terms of fiduciary duties or a fiduciary, being the bearer of fiduciary duties, had not been actively used in Ukrainian law. At the same time, the concept of fiduciary duties was not unfamiliar to Ukrainian law. The concept was originally developed through common law and received wide application and regulation across national laws. Furthermore, the concept has been framed and institutionalized at international level, particularly in the OECD Principles of Corporate Governance, first published in 1999 and then updated and reviewed in 2015.

The OECD Principles refer to two key elements of fiduciary duty: the duty of care and the duty of loyalty. The duty of care requires a fiduciary to act on a fully-informed basis, in good faith, with due diligence and care. The duty of loyalty relates to an obligation of equitable treatment of shareholders, managing and avoiding conflicts of interest and acting in the interest of shareholders.

When it comes to Ukrainian law, the Civil Code of Ukraine (the Civil Code), the Law of Ukraine On Joint Stock Companies (the JSC Law), the Law of Ukraine On Limited Liability and Additional Liability Companies (the LLC Law) and the Bankruptcy Procedures Code of Ukraine (the Bankruptcy Code) are the main bodies of law that set out the framework of fiduciary duties and the fundamentals behind corporate governance liability. The recent practice of the Supreme Court of Ukraine, which shall be discussed further below, is another useful source in which the practical substance of fiduciary duties is assessed.

Article 92 of the Civil Code sets up the following requirements for the acts of a person bearing fiduciary duties: acting in the interest of a company, acting in good faith, acting reasonably, and acting within the limits of authorities that one is subject to. In addition to these, the JSC Law and LLC Law provide for obligations of a fiduciary to act in accordance with the law and charter (article) of a company and to be liable for damages caused to a company as a result of a breach of the fiduciarys duties.

On 12 March 2020, the National Securities and Stock Market Commission of Ukraine approved The Core Code of Corporate Governance: Requirements and Recommendations (the Core Code). While this act does not have an effect of a binding body of law, it is the source of important corporate governance principles, including those related to fiduciary duties. Based on the Core Code, fiduciary duty can be defined as a duty to act responsibly, effectively, accountably and exclusively in the interest of the company and its shareholders.

In addition to the above conventional corporate governance-related sources, one should not rule out less conventional or less direct sources either. These may include employment regulations, as under Ukrainian law the executives of Ukrainian companies are often also company employees and, for this reason, may be subject to employment-related duties and liabilities. Finally, the Criminal Code of Ukraine is the source of liability for corporate governance-related breaches that qualify as criminal offences.

Who can bear liability?

The core of the question as to who bears liability in corporate governance lies in the answer to the question as to who qualifies as a fiduciary in corporate governance. In this regard, Ukrainian law operates with the term officer of the company [ ], which may include the following: a sole director, members of the management board, chairman of the supervisory board (board of directors), members of the supervisory board and members of the companys audit commission.

Such management and governance bodies and officers do not all always exist in companies. Often, one sees companies that are managed by sole directors only. As to supervisory boards, while they have started appearing more frequently in Ukrainian companies, whether owned by sole or multiple shareholders, however, unless regulatory required, establishing a supervisory board is the exception rather than the rule. Additionally, both JSC Law and LLC Law provide that other officers or members of other bodies, if such are provided for or established by the companies charters, may also qualify as companies officers.

Ukrainian law makes no specific differences as to the liability of executive officers, such as a sole director, a general director, or members of the management board and the liability of the members and chairman of the supervisory board. All of them qualify as company officers, thereby making them the subjects of corporate liability. For this reason, it is important that the charters and by-laws of companies are clear and detailed as to the competence and roles of executive officers and bodies on the one hand, and members of supervisory bodies on the other.

The charters and by-laws of companies are also important from the point of view of potential liability of other companies employees who may bear titles such as directors. Often one may see a marketing director, business development director or even an executive director. However, such titles do not necessarily mean that the respective individuals are involved in corporate governance or management, and thus should be subject to corporate governance liability. From the point of view of companies, as well as bearers of such titles, the documents of companies, as well as contracts with employees, should be clear as to whether their roles are in the sphere of corporate governance and management.

The ongoing reforms of Ukrainian corporate law and corporate governance have led to the appearance of corporate secretaries, as a new type of officers, particularly in Ukrainian public joint stock companies and companies with a state-owned shareholding. The JSC Law does not directly refer to a corporate secretary as an officer of the company. Thus, a corporate secretary should not be subject to corporate governance liability. One could argue that there is logic behind this, as a corporate secretary does not have governance and decision-making power, while the prime role of the corporate secretary is to facilitate and coordinate the activity of the companys management and governance bodies, particularly that of the supervisory board. Thus, unless the Charter of the company, its by-laws and terms of employment clearly and expressly provide otherwise, the corporate secretary should not be subject to corporate governance-related liability. At the same time, the corporate secretary may still be subject to liability for any potential breaches of ones duties and their consequences, as provided by general law.

Finally, one should consider the question of whether or not shareholders may be subject to corporate governance liability. Neither the JSC Law nor LLC Law list shareholders as officers of a company. Indeed, the mere fact of being a shareholder, unless one is also an executive or member of the supervisory board, should not lead to such a person falling within the category of a companys officer. Furthermore, under the general concept of company law, the liability of shareholders of joint stock companies and limited liability companies is limited to their shares or the amount of their capital contribution.

At the same time, the Bankruptcy Code provides for the concept of the so-called vicarious liability [ ] of, among others, shareholders of companies. According to this concept of the Bankruptcy Code, a shareholder whose actions or failure to act have led to the bankruptcy of the company, may be subject to vicarious liability, and that type of liability may reach the assets beyond the shares in the bankrupt company of such a shareholder. Importantly, the actions of the shareholder that may potentially trigger vicarious liability should be of a corporate governance nature, and not of some other nature which is not related to the companys governance and business operation.

Types of liability

The previous section has touched upon vicarious liability. In addition to shareholders, members of executive and supervisory bodies can also be subject to this type of liability, should it be proven that their actions or failure to act have led to bankruptcy of the company. In a nutshell, vicarious liability means that a person bearing it would need to compensate the creditors of bankrupt companies to the extent the assets of the companies do not cover the awarded losses of the creditors. Thus, vicarious liability can potentially be of significant nature.

Turning to the general rules of corporate governance-related liability, Ukrainian company law provides for an obligation of the companys officers to compensate for damages caused by a breach of duties of such officers. The Civil Code of Ukraine, as well as the LLC Law, provide that members of the collective management and governance bodies are subject to joint and several liability.

Under Article 26 of the LLC Law, officers of the company may be liable for the improper payment of dividends by the company. Should the distribution of dividends take place as a result of submitting misleading information regarding the financial health of the company, the officers that were responsible for this misleading information shall bear joint and several liability with the shareholders of the company for the repayment of the distributed dividends back to the company.

The above are examples of monetary liability by shareholders and officers of companies. In addition to monetary liability, the officers of a company may be subject to specific management and governance-related liability and consequences. Furthermore, as officers of the company are often the companys employees, their liability may also be of an employment nature. Particularly, in the case of breaches of their duties, the officers of the company may be subject to either temporary dismissal from holding an office or termination of office or employment. In this case, the practice of Ukrainian courts leans towards treating disputes related to the dismissal or termination of companys officers as corporate disputes, rather than as employment disputes.

Breaches by company officers of their corporate governance-related duties may also lead to liabilities arising out of administrative, tax, securities, banking and other regulations. Furthermore, if a breach by an officer qualifies as a criminal offence under the Criminal Code of Ukraine, an officer may also face criminal prosecution and liability.

Cross-border liability

While companies are always the subjects of a certain country or jurisdiction, in situations where the companies are a part of multinational groups, or they include foreign shareholders or officers, or have assets or businesses in more than one country, the nature of corporate governance liability in such companies may be of an international and cross-border nature. If companies meet at least one of such features, not just the companies and their officers may be exposed to cross-border liability, but also the companies shareholders can potentially face it too.

As mentioned above, the shareholders in joint stock companies and limited liability companies enjoy limited liability. However, there are instances when limited liability protection may not be effective, and it seems that corporate governance is the key trigger that can challenge limited liability. The situation when limited liability may be effectively challenged is called piercing the corporate veil. Even though the practice of piercing the corporate veil is not yet well established in Ukraine, probably except for the case of vicarious liability, it is well developed in many foreign jurisdictions, particularly those, which are often used for international corporate group structuring1.

Those situations where piercing the corporate veil may take place include instances where (i) there is no real separation between the company and its shareholders, (ii) when the company was an instrument for fraudulent actions or misrepresentations, or (iii) where certain corporate formalities were not followed in the company. The first and third instances are most closely related to corporate governance and deal with the shareholders role in it. Those measures that are discussed in the next section of this article can be employed to significantly diminish the risk of piercing the corporate veil.

As to a companys officers, if they are also shareholders in a company, they may be subject to piercing the corporate veil. Yet, if the officers are hired guns, the risk of cross-border liability may be triggered if the actions of the officers affect the rights and interest of the parties (such as shareholders, investors, lenders, etc.) in other countries, or certain transactions have significant nexus to other countries, or courts in other countries may decide that they have jurisdiction over the claims launched in these countries.

Considering the factor of piercing the corporate veil, careful due diligence of corporate governance-related matters and addressing them in transactional documents are important in M&A transactions, particularly in cross-border ones. It cannot be excluded that new shareholders and new management can inherit the legacy of corporate governance problems and find themselves in situations where they have to deal with something they were not responsible for.

Managing and controlling liability

Two interesting insights may be used in order to set a fundamental strategy for managing and controlling corporate governance-related liability. The first source, being the Corporate Directors Guidebook published by the American Bar Association, states that: Good faith and careful monitoring of management programs directed toward corporate legal compliance should provide substantial safeguards against any such personal liability [of companies officers].2

The other insight comes from decisions of the Great Chamber of the Supreme Court of Ukraine in two of its trial cases. Corporate governance matters, particularly breaches of fiduciary duties, were at the epicenter of these cases. In these cases, the Supreme Court has confirmed that the relations between a company and its officers are of a fiduciary nature. In the opinion of the Supreme Court, a breach of the officers fiduciary duties may consist of: (i) non-fulfilment of the officers duties, as provided for under the companys foundation documents,
(ii) exceeding the officers authorities, (iii) undue and bad faith fulfilment of the officers authorities by also breaching the limits of usual commercial risk, (iv) breaching the conflict of interests rules or driving decisions with a personal interest rationale, (v) making careless and wasteful financial decisions.3

The fist insight, as referred to above, proposes a basic strategy for managing and controlling liability, while the second insight provides examples of actions which, if allowed or committed, would definitely expose an officer or a governance or management body of a company, or its shareholder to corporate governance liability. The mere following of the first insight and not allowing the actions of the second insight, would already be an excellent strategy to manage and control corporate governance liability.

The place of supervisory boards in managing and controlling corporate liability may occupy a central role. It should be the supervisory board setting up the corporate governance framework which would, not only allow the management board or the executive directors to efficiently manage the company, but also take into account the interest of the companys shareholders and stakeholders in the course of that process. If the supervisory board sets the right framework and policies, not only will it crystallize the rules of the game for executives, and thus limit their exposure for corporate governance liability, but also limit the same exposure of the supervisory board. If no supervisory board is established within a company, it would be the task of the shareholders to ensure the existence of a proper framework and policies, while managing and controlling corporate governance liabilities are yet another argument in favor of establishing a supervisory board.

Additional measures, such as involvement of professional advisors in those areas where the supervisory board or management board lack expertise, or even procuring directors and officers (D&O) liability insurance, should be considered by companies and business owners. While these may mean additional costs for a company, doing so would help to boost the expertise of management and, in the case of D&O insurance, serve as a kind of security for both business owners and those responsible for the governance and management of their companies.

Conclusions

Being involved in corporate governance of a company is not just a privilege, but is also a duty towards many interested parties starting from the company itself and its shareholders, right up to the companys stakeholders, such as investors, counterparties, employees, and creditors, as well as state and local authorities. As the present article notes in analysis, the breaching of those duties may result in various liabilities which can be of monetary and non-monetary nature as well as domestic and cross-border. Proper structuring and compliance with the corporate governance framework will not only help those involved and responsible for corporate governance to not expose themselves to liabilities but, foremost, will also help them to keep and maintain their professional and personal reputation.

Taras Dumych is a partner at Wolf Theiss

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