Fraudulent trading
– court intervention and creditors’ protection
By Choong Kwai Fatt, PhD – Advocate and Solicitor, High Court of Malaya *
Introduction
Fair commercial dealings between parties are core essential elements in businesses. This is enshrined in the s 540 of Companies Act 2016 (CA 2016) which is also rooted in the then s 304 of Companies Act 1965. Directors who attempt to defraud the creditors through fraudulent trading, knowing that the company is at an insolvent level, would be held personally liable on the debts owed by the company.
Section 540 is a remedy provision specifically enacted to empower the Court to intervene and declare any person who is knowingly a party to a company conducting its business with the intent to defraud its creditors or for any fraudulent purpose to be personally liable, without any limitation of liability for all or any of the debts of the company.
Legislation
Section 540 governs fraudulent trading. The primary object of s 540 provides civil remedy to creditors. It allows the Court to lift the veil of incorporation, with a view to ultimately pin down personal accountabilities and lay down liabilities on the directing mind that is behind the corporate legal personality.
These fraudulent transactions carried out by the company are masterminded by either the shareholders or its directors. Section 540 would hold them to be personally liable for the fraudulent trading acts of the company, where the intention to default in the payment to its creditors or defraud its creditors by hiding behind a separate legal entity curtain from liabilities is found to be present in business transactions or dealings.
Sections 540(1) and (2) provide:
“Responsibility for fraudulent trading
(1) If in the course of the winding up of a company or in any proceedings against a company it appears that any business of the company has been carried on with intent to defraud the creditors of the company or creditors of any other person or for any fraudulent purpose, the Court on the application of the liquidator or any creditor or contributory of the company, may, if the Court thinks proper so to do, declare that any person who was knowingly a party to the carrying on of the business in that manner shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the Court directs.
(2) Where a person has been convicted of an offence under sub-s 539(3) in relation to the contracting of such a debt as is referred to in that section, the Court on the application of the liquidator or any creditor or contributory of the company may, if the Court thinks proper so to do, declare that the person shall be personally responsible without any limitation of liability for the payment of the whole or any part of that debt.”
Section 540 is not and never an insolvency provision. It can be operated both outside insolvency proceeding and where there were no insolvency proceedings. In Tang Eng Iron Works Co Ltd v Ting Ling Kiew & Anor [1990] 2 MLJ 440, the Court held that s 304 of the then CA 1965 (para materia with s 540) can be used when the company is in ‘the course of winding up or in any proceedings against the company’.
Section 540 is invoked by the application of the creditors (including liquidators) to the Court in civil suits, putting up evidence to demonstrate that the company is being used by the dominated shareholders or directors to defraud the creditors. These transacted business activities are carried out with the intention to defraud or for fraudulent purposes.
The Court would evaluate the factual matrix, the submission of both parties, their assertions and the various explanations or defence addressed in Court. Once the wilful defraud intention is established, s 540(1) read with (2) empowers the Court to hold the perpetrators, be they directors or shareholders, to be personally responsible and liable to the debts owed to the creditors due to the fraudulent trading acts.
Exclusion of company
The accountability on the fraudulent action to defraud any creditor would be restricted to individual directors or shareholders. It cannot extend to include a company. In addition to that, s 540(1) read together with s 540(3) & (4) further justify and support that it only applies to real persons who would be named as defendants in the suit, i.e., the directors or the shareholders that engineered the business activity or those top management persons in receipt of proceeds of the fraudulent trading.
A company does not fall within the definition of any person in s 540(1). Although it has the legal capacity to sue, a company being sued and owning property does not have a human mind and knowledge to formulate any intention to defraud creditors. The penal offences in s 540(5) further supports this interpretation that it is only individual human beings who can have any defraud intention and be held on imprisonment. Section 540(5) provides:
“Where any business of a company is carried on with the intent or for the purpose mentioned in sub-s (1), every person who was knowingly a party to the carrying on of the business with that intent or purpose, commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding ten years or to a fine not exceeding one million ringgit or to both.”
In Zamzam Arabic Food Holding Sdn Bhd & Anor v Johanjana Corporation Sdn Bhd [2022] 5 MLJ 302, the Court of Appeal held that ‘any person’ in s 540(1) only applies to a real person, namely a director or a shareholder who had engineered the company to conduct its business with intent to defraud its creditors. The natural, ordinary reading of s 540(1) shows that any offence or wrongdoing is only intended against an individual person, a director, a managing director or a shareholder and not against a corporation or a company. Hadhariah Syed Ismail JCA succinctly opined on p 314:
“… The underlying purpose of s 540(1) is to impose a personal responsibility and liability on the director and/or the person who controls the company and not the company itself for carrying on the business of the company with intent to defraud a creditor. The wording in s 540(1) is plain and unambiguous. The word ‘person’ in s 540(1) in its ordinary and natural meaning meant ‘a real person’. He could be a director, managing director or person in control of the company. Therefore, to give effect to s 540(1), the court must apply the ordinary meaning of ‘person’ and not the meaning assigned to it by the plaintiff.”
The Court of Appeal then concluded with the final remark where Hadhariah Syed Ismail JCA held on p 316:
“We hold that the word ‘person’ in s 540(1) of the CA 2016 does not include a company.”
Intention to defraud
The invocation of s 540(1) requires an ‘intention’ to defraud to be present. The ‘intent to defraud’ would mean an aim to deprive creditors of an economic advantage or inflict upon them some economic losses. An intention to defraud with dishonesty is sufficient. It is neither a necessity nor a requirement to establish fraud or that the creditors were in fact defrauded. Intention includes an inference drawn by its own factual matrix.
In Aneka Melor Sdn Bhd v Seri Sabco (M) Sdn Bhd & Anor [2015] MLJU 2247, the Court of Appeal acknowledged the phrase ‘with intent to defraud’ requires the element of dishonesty in the form of incurring company debts by thoses in charge when either they know that the creditors will not be repaid or there is a substantial and unreasonable risk that they will not be rapid. Essential and pivot evidence need to be adduced to Court to establish facts pinpointing that the directors / shareholders had carried out the business with intent to defraud creditors or for fraudulent purpose.
Where a company in financial difficulties or in debts accumulating but continue to invite suppliers to provide goods or services despite the directors have knowledge that the company had no reasonable prospect of paying these creditors would be crystalisation of ‘the intent to defraud’. The Court of Appeal approved this factual matrix to be within the ambit of ‘fraudulent trading’.
The ‘intention’ to defraud needs to be established. Essentially, it is a matter of making a finding of facts or inferences legitimately drawn from those facts taken together as a whole, pointing that the business of the company has been conducted with intent to defraud the creditors of the company or for any fraudulent purpose. Where debts have been cumulatively piling up and within the domain of the directors’ conscious knowledge that these creditors have reasonable prospects of no payment would be the high point to put s 540(1) in motion.
Accounting evidence at the material time of entering into an agreement to purchase plant and machinery, stock in trade, and incur expenses on projects in which cash flow forecast of 6-12 months showing cash flow deficits in honouring existing debts due would be a strong inference as an intention to defraud or venture into fraudulent trading.
In this post Covid era, the creditors who are in doubt of the company’s capacity and ability to honour the contract consideration should take a prudent approach to make enquiries to the company secretary to provide information on the company relating to:
(a) the date of incorporation;
(b) its principal business activity;
(c) the financial statement from the last lodgement to SSM for review and examination of its financial position,
before proceeding to sign the agreement of supplies or services.
Cash flow forecast of 6-12 months from the company director may also be needed if the sum of contract of supplies is substantial.
The failure to make early enquiries from the existing company secretary or obtain relevant financial data from the company director to assess the financial standing of the company before venturing into an agreement may at times be fatal in later application of s 540(1).
In Lai Fee & Anor v Wong Yu Vee & Ors [2022] MLJU 1082, the Court of Appeal accepted the findings of the High Court that the appellant consciously knew that the company, Centennial Asia Sdn Bhd (‘centennial’), being a newly incorporated company without any assets and business, yet proceeded with the contract for the sale of a timber logging concession for a consideration of RM7 million. As such, he could not now turn to complain that the respondent, directors of the new company had any intention to defraud the creditors by defaulting the balance sum of RM2.5 million. The appellant had in fact entered into the agreement voluntarily with a conscious mind relating to the financial position of ‘centennial’.
Kamaludin Md Said JCA highlighted the High Court findings with approval:
“[31] The learned HCJ was in fact satisfied that based on the evidence, the Respondents when acting for Centennial in the Agreement had not carried on Centennial’ business with the intention to defraud the Appellants as creditors. It is also a finding of fact that the Appellants were in fact aware and consciously knew about Centennial’s financing standing before they enter into the Agreement and knew that Centennial was only used as vehicle for the Respondents to obtain the right to do timber logging. The learned HCJ also found that the Appellants never raised any complaint, question or objection relating to Centennial’ financial standing. This according to the HCJ shows that the Appellant were never in doubt on the capability of Centennial to pay the purchase price. We agree with the Respondents’ submission that the Appellant had agreed to sign the Agreement with Centennial despite Centennial was only registered on 28.6.2012 and without any assets and business.”
Upon the evaluation of evidence in its entirety, the Court of Appeal affirmed the High Court’s decision that the respondents never had the intention to defraud the appellants when entering into the timber concession agreement. The non-payment of the balance sum of RM2.5 million was due to contract disputes and misrepresentation of the contract terms.
Separate legal entity
A company incorporated is encroached with the legal entity having the capacity to sue or is being sued. Creditors should not engage s 540(1) as a quick fix solution by taking the directors to task and be held personally liable for the company’s debt whenever payment is delay or not received. This amounts to an abuse of Court processes and an attempt to humiliate the directors should be avoided in business fair dealing.
In Lai Fee & Anor v Wong Yu Vee & Ors [2022] MLJU 1082, the Court of Appeal agreed with the High Court’s decision that the non-paying the balance of RM2.5 million was a company decision as there exist a misrepresentation on term of contract. The respondents discovered that a large area of the subject land purchased is a restricted area of which timber logging activities are prohibited. This resulted in the reduction of RM24 million from the RM80 million promised. The respondents believed that they would not gain any benefit or profit from the said agreement and made the decision not to pay the balance purchase price of RM2.5 million. The decision represents a business decision and not an intention to defraud the appellants. It remains a company’s debt and the respondent cannot be held liable for the company’s debt relying on the golden thread of separate legal personality.
Real life application
The operation of s 540 has a far-fetch effect as it could extend to include the ultimate shareholders or controller of the company. Beneficial ownership of the company is also included as the ‘person’ envisaged in s 540.
In Eastmont Sdn Bhd v Tay Keong Kok & Ors [2022] 1 LNS 456, the first and third defendants are the ultimate controllers of Dakota Engineering Sdn Bhd (Dakota) and Mega Planner Jaya Sdn Bhd (Mega). Both of the companies are related and closely connected despite not within a group of companies.
The plaintiff, Eastmont Sdn Bhd (Eastmont), a company involved in the building and construction business, was awarded a construction project to carry out substructure work for a 16-level serviced apartment for a sum of RM26 million from Mega. Upon completion of the project, Eastmont claimed an outstanding sum of RM12.6 million due from Mega on 10.6.2019 but was informed by Dakota, a Mega related company, that Mega had been wound up on 14.5.2019. Both Mega and Dakota occupied the same business address.
Dakota and Mega are related companies with common shareholders and directors. The defendants, in particularly Defendant 1 and 3, have jointly and severally conducted Mega’s business with the intent to defraud the creditors of the company for fraudulent purposes by orchestrating Dakota to wind up the company, Mega in order to avoid repaying the debts due by Mega to Eastmont. The defendants relied on the principle of separate legal entity, contending that they are not party or privy to the Letter of Award to Eastmont. There is no way that they are personally liable for Mega’s indebtedness to Eastmont.
The High Court vigilantly held that the corporate veil ought to be lifted as Mega has been set up for fraudulent purposes within the ambit of s 540. The defendants are aware of the debts owed by Mega to Eastmont, but have engineered its related company Dakota to institute proceedings to wind up Mega to avoid the payment.
In this regards, Rohana Abd Malek JC opined:
“[45] This Court noted that despite not holding the director’s position in Mega Planner, both Defendants 1 and 3 testified that Mega Planner had decided not to defend the claim initiated by Dakota as they find that there were no merits in defending the same. Based on this, I am inclined to agree with the learned counsel for Plaintiff to conclude that Defendant 1 and Defendant 3 are the ultimate controllers in Mega Planner. Otherwise, how would they know or have the power to give testimony that Mega Planner has decided there is no merit in defending the claim. Further, there is every possibility that Defendant 1 and Defendant 3 have actually planned for the winding up of Mega Planner.”
The Court further found that the purported debts owed by Mega are fictitious as these debts were not reflected in Dakota’s financial report. This was admitted by the first defendant during cross examination. The second defendant equally admitted that once the company is being wound up, it will not need to pay any debt to the creditors. The intention to defraud Eastmont was established by the corroboration evidence between Defendant 1 and 3.
The Court concluded that the defendant’s actions are dishonest and have every intention to frustrate or hinder the plaintiff’s claim against Mega and to further avoid liability to the plaintiff.
Rohana Abd Malek JC in her illuminating remarks:
“[62] Based on the foregoing, this Court concluded that both Defendants 1 and 3 are the mastermind and the controlling minds of Mega Planner and Dakota. Defendant 1 and Defendant 3 were the persons who awarded the Taman M Project on behalf of Mega Planner, to Plaintiff and ever since, Plaintiff has been following up the progress of the Project with Defendants 1 and 3. Furthermore, Plaintiff’s witness, PW 1, Mr. CLC, who had previously dealt with Dakota, has also dealt with Defendants 1 and 3 in their negotiations for a settlement with Dakota.”
The Court concluded that the winding up of Mega is a sham and represents a fraudulent action on the part of the defendants. The business of Mega has been conducted with the intent to defraud Eastmont and the defendants were parties in carrying out the fraudulent acts, being clearly aware of what they were doing.
Section 540 ought to be invoked to ensure the trite principles of the separate legal personality and limited liability are not wrongly taken advantage of. Defendants 1 and 3, in particular, are held liable although they are not directors of Mega. Both are the beneficial owners or ultimate controllers of Mega. Rohana Abd Malek JC in her final remarks concluded:
“[67] The facts also show that the business of Mega Planner and Dakota was carried out by the ultimate controllers, namely Defendant 1 and Defendant 3 and the other Defendants 2,4,5 and 6 were knowingly parties to the carrying on of the business in that manner. Defendants had jointly and severally taken advantage of their separate legal entity and s 540 of CA ought to be invoked to ensure the principle of the separate legal personality and limited liability are not wrongfully taken advantage of (see Aneka Melor Sdn Bhd v. Seri Sabco (M) Sdn Bhd & Anor Appeals [2015] MLJU 2247)
…
[70] Therefore, on the balance of probabilities, I find that evidence arising from the pleaded case is sufficient to impute liability on the Defendants. They are therefore, jointly and severally responsible personally, without any limit to liability, for the debts of Mega Planner to Plaintiff and are liable to pay to Plaintiff RM17,012,816.88 as special damages and/or any amount awarded by the Court (to be assessed) to Plaintiff.”
Company secretary as advisor
A company secretary plays a vital role to enlighten the senior management team, in particularly the company directors, on the danger of being personally liable for company debts in the event the company is incapable of meeting the obligation of debts yet continues to commit liabilities by entering the various business contracts.
Likewise, the company secretary equally needs to ring fence his company, calling the directors to embark on due diligence to exercise on to the current financial standings of the customer before embarking into contract signing, provision of services or supply of goods. The company secretary being an officer of the company, inevitably may compel to participate in the demanding and challenging business activities that continuous evolving by the rapid digitalization of e-economy, coupled with incessantly swift changes and developments, making the work of company secretary is all times challenging and demanding.
The company secretary must be technically competent with the conceptual framework and working mechanism of CA 2016. Being competent in offering advisory services in adding on the various administrative works urgently calls for the company secretary’s fees to be revisited and revised accordingly.
Conclusion
The incorporation of limited companies under CA 2016 is enshrined by a separate legal entity concept. However, business fair dealing, honesty and integrity must be always adhered to. The Court acting vigilantly on fair play will hold the directors to be jointly and severally liable in the event the company abuses its corporate legal personalities and uses them to defraud creditors or to avoid existing contractual obligations.
The fraudulent trading legislation in s 540(1), being specific and technical in nature, must be carefully understood for its scope and boundaries. It is only to be used in an exceptionally clear situation where the intention to defraud by the directors is vividly present. It should never be abused as an at-all-times weapon to be employed for all seasons to harass the directors to be personally liable, to disregard the repeated trite separate legal entity principle, and to allege fraudulent trading in every situation of non-payment from the company. These attempts are tantamount to an abuse of court processes.
* Dr Choong Kwai Fatt is an advocate and solicitor with special interest in tax and company law matters. He was an associate professor of tax of Faculty of Business, University of Malaya.
Note : The deliberation on “Fraudulent trading – court intervention and creditors’ protection ” is the writer’s own opinion and conclusion.
References:
- Company Law: Conceptual Framework, Real Life Applications, InfoWorld, 2021, 1st ed.
- MyCoID – Procedures, Mechanism and Real Life Applications, Choong Consultants Plt, 2021, 1st ed.
- Dr Choong on Companies Act 2016, Peng You Solutions Plt, 2020, 3rd ed.
- Dr Choong on Interpretation of Companies Act 2016 (2020, 1st ed.), Peng You Solutions Plt, 2020, 1st ed.
- Hallmark Legal Principles on Companies Act 2016, Choong Consultants Plt, 2019, 1st ed.
- Single Person Company, InfoWorld, 2018, 2nd ed.
- To order the books, please email to pengyou.solutions@gmail.com
