Company in Distress: Insolvency Issues relating to Employees

Under Malaysia’s movement control restrictions and with COVID-19, companies are facing cash-flow issues and financial difficulties. With the employers facing such difficulties, the employees may also face salary cuts (for example, see this news report) or retrenchment. Companies may then slip closer towards financial distress and may have to pursue restructuring and insolvency options. This article sets out the insolvency issues relating to employees.

I set out the different scenarios where a company in distress may pursue a scheme of arrangement, apply for judicial management, end up placed in receivership or is compulsorily wound up. I touch on how these scenarios will affect the rights of employees.

#1: Scheme of Arrangement

Where a company undertakes a scheme of arrangement, the existing management continues to be in control of the company. Therefore, the relationship between the company and the employees would not be affected.

The company may apply for a restraining order to provide it with protection from legal proceedings. The grant of a restraining order requires a creditor-nominated director to be appointed to the board of directors. But it is unlikely that this director will take part in the day-to-day management of the company and the director would not be interacting closely with all employees.

Further, the grant of a restraining order will prevent disposition of the company’s property which is outside the ordinary course of business. So, payment of ongoing salaries and wages, being the ordinary course of business, would still allowed during the duration of a restraining order.

Finally, as mentioned, the restraining order is effectively a stay on all legal proceedings brought against the company. Therefore, if a former employee had filed judicial review or has an Industrial Court action against the company, those proceedings ought to be stayed.

#2: Judicial Management

Judicial management involves the court eventually granting an order and appointing a judicial manager (JM), being an insolvency practitioner, to take control of the company. This is to steady the company and to have the JM try to work out a proposal with the company’s creditors. There may be three phases affecting employees.

The first phase is where there is the initial filing of the judicial management application. The management of the company still stays in control but the company now enjoys a moratorium on legal proceedings. So, similar to the above restraining order, this would stay any employee-related legal proceedings as well.

The second phase is that there may be the appointment of an interim JM. An interim JM will take over the management of the company. Unless explicitly instructed by the interim JM, employees should not be taking instructions from the directors or management any further. Nonetheless, it is likely that the interim JM will work closely with existing management and to ensure the status quo of continuing the ordinary business.

The third phase is where the court grants the judicial management order and appoints the JM proper. The JM is an insolvency practitioner and would be from one of the accounting firms.

Critically, in relation to employment contracts, the default position is that the JM will now become personally liable for the contracts of the company entered into or adopted by the judicial manager (see section 416(1)(b) of the CA 2016). This would include employment contracts. But, the JM is not treated as adopting the contract within the first 30 days of the grant of the judicial management order (see section 416(3) of the CA 2016). This would mean that in the first 30 days of the grant of the order, the JM would have to assess which employment contracts the JM wants to continue or to adopt, and which ones to terminate.

Next, the JM will likely want to disclaim personal liability under the contracts, including the employment contracts. So, the JM will likely issue a blanket notice to employees that the JM will be disclaiming personal liability (see section 416(2) of the CA 2016).

Throughout the duration of the judicial management order, the company continues to enjoy the moratorium protection. The initial order will last for six months and the Court may extend the order for a maximum of a further six months.

#3: Receivership

A company may have taken out a loan and where the loan is secured through a debenture. In the case of a default in the loan, the debenture allows for the appointment of a receiver or receiver and manager over the company.

I will touch on the common situation where a receiver and manager (R&M) is appointed over all the assets and undertakings of the company. I make six points for this scenario.

First, the R&M would then primarily take over control of the company. The R&M would have to decide whether to continue on with the business of the company or not. While the R&M is appointed by the creditor (i.e  the debenture holder), the R&M is by law acting as the agent of the company.

Second, on the company’s employees. If the R&M were to continue the business, the R&M has to decide whether to retain all the employees or, more likely, to terminate some of their employment. The overriding aim of the R&M is to maximise the returns to repay the debt due to the debenture holder. So, the R&M has to try to maintain the cashflow to keep the company afloat.

Third, the employees who are terminated can make a claim against the company for their dismissal. But this will be an unsecured claim and the R&M will not be responsible for such an unsecured claim. The R&M will then likely have the directors take on the process on behalf of the company to defend such a claim or not.

Fourth, for the employees who are retained, they will now take instructions from the R&M. The R&M would have decided to continue with their services. Just like in any ordinary employment scenario, if the employees do not obey the instructions from senior management (here, the R&M), they may also be terminated.

Fifth, under the old Companies Act 1965, it may have been the case that by continuing with the contracts or services of the employee, the R&M would have taken on personal liability to pay out on these contracts. It was meant to provide some sort of security for the contracts that continued on. This position has been diluted down under the Companies Act 2016 (CA 2016). It would not have been fair for the R&M to take on personal liability for the debts or the obligations under the contracts when ordinarily, the directors themselves would not have taken on personal liability. So, the CA 2016 allows for various mechanisms for the R&M to not taken on this personal liability. The R&M would invariably ensure that these mechanisms are used.

Sixth, the R&M’s common exit strategy to maximise the repayment of the debt will be a sale of the charged assets of the company. That may include the work place, like the factory or the plantation that the employees work on. All of these assets are charged to the secured creditor and would be first used to repay the secured debt. Ordinarily, only the excess proceeds would be used to pay the unsecured creditors, and that would include any employees’ claims such as unpaid wages and the like. This may leave the employees with the risk of being paid very little, if at all.

Parliament then stepped by introducing the wording in section 31 of the Employment Act. This provision is to protect the Employment Act category of employees. In essence, based on the Perwaja Steel decision, the Employment Act protection trumps the ordinary position under the CA 2016. Where the R&M sells the place of employment and receives the proceeds, the R&M must first pay four consecutive months’ of wages to the Employment Act employees. Only then will the secured creditor receive the proceeds. The R&M will also have to pay the statutory benefits to these employees before releasing the sale proceeds to the secured creditor.

#4: Winding Up

The final situation is where the company is unable to pay its debts and faces the situation of a Court winding up petition.

First, once a winding up petition is filed in Court, the company should no longer be paying out any money. This is the effect of the void disposition provision (see section 472(1) of the CA 2016). Strictly speaking, the company must apply to the winding up court for a validation order to allow for payments out, especially for payments in the ordinary course of business like salaries. In practice, many companies still continue operate as normal despite the filing of the winding up petition. Banks also ordinarily would not freeze the bank accounts of the company as this has been frowned on by case law.

Second, there may be situations where the Court may appoint an interim liquidator over the company. This is an extreme measure and normally only justified if there is a real risk of dissipation of assets and a strong case for the winding up. The interim liquidator would be an insolvency practitioner and be from one of the accounting firms. The interim liquidator would take over the management powers of the company.

Third, if the winding up petition is allowed, the Court will make a winding up order and appoint the liquidator. English case law from the 19th century has established that the making of the winding up order serves as a notice of discharge of all the company’s employees (see for example, Chapman’s Case (1866) LR 1 Eq 316).

Fourth, the third point above is not easy to reconcile with the situation where the liquidator may choose to carry on the business of the company. The liquidator can choose to do so if the liquidators feels it is beneficial for the winding up, and can carry on the business for 180 days after the winding up order (see Part II Twelfth Schedule of the CA 2016). Longer than the 180 days and the liquidator will have to seek approval from the creditors or from the court.

Fifth, where former employees are bringing claims against the company in liquidation, a moratorium is imposed upon the grant of the winding up order. The case law is divided on whether an Industrial Court action would require leave from the winding up court. But it would appear prudent to seek leave from the winding up court. However, ultimately, any successful claim in the Industrial Court action would result in a claim for damages which would be an unsecured debt.

Sixth, the issue of priority of debts  owed to employees. The CA 2016 sets out a list of priority of debts that are to be paid before the unsecured debts are paid. First would be the costs and expenses of the winding up, including the liquidator’s fees. Second would be wages or salary up to the sum of RM15,000 for services rendered to the company within a period of four months before the winding up order. Third, would be amounts due for worker’s compensation. Fourth, remuneration for vacation leave. Fifth, amounts due for contributions payable during the 12 months by the company relating to social security and superannuation or provident funds.

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