This article addresses recent decisions by Italian courts that deal with the new and complex matter of directors’ liability when executing their duty to set up an adequate organizational, administrative, and accounting structure for a company. These judgments were rendered in civil proceedings filed against directors for violation, inter alia, of the new obligation introduced in 2019 with the amendment of the second paragraph of section 2086 of the Italian Civil Code (the “ICC”). The introduction of this specific duty forced judges and legal scholars to consider whether and how directors can be held liable for failing to comply and whether the business judgment rule is applicable to these kinds of management choices.
1. The new provisions of section 2086 of the ICC
Legislative Decree No. 14 of January 12, 2019 (“Crisis and Insolvency Code,” hereafter “CIC”) and the later Legislative Decree No. 147 of October 26, 2020 introduced new provisions regarding the organizational structure of companies. Notably, section 375 of the CIC added a new second paragraph to section 2086 of the ICC, introducing a business owner’s legal obligation to establish “an organizational, administrative, and accounting structure adequate to the nature and size of the business, including in view of timely detection of a company crisis and the loss of its status as a going concern, and to act without delay in such cases, implementing the appropriate legal tools to overcome the crisis and recover the status of a going concern.”
This article is addressed to business owners, but it applies to directors as well, as provided by sections 2380-bis, 2381, and 2475 of the ICC.
This provision, incorporated into Italian Insolvency Law reform, is the result of a new approach to company crisis based on preventive measures and alert mechanisms. It is worth noting that in crafting this law the Italian legislature forged an explicit connection between corporate governance and insolvency law, focusing on management rules as fundamental tools for handling corporate crisis in a timely manner.
The obligation set forth by the amended section 2086 is not wholly new. In fact, section 2381 of the ICC, under paragraphs 3 and 5, provides a similar duty for Joint Stock Companies (Società per azioni, “S.p.A.”). The difference is that the new section 2086 applies to any kind of company under Italian law and its obligations apply to all members of the board of directors; moreover, the duty is explicitly connected to corporate crisis detection and management. More specifically, a company’s directors must equip it with a structure that is adequate to its nature and size so that it is functional in the case of a potential crisis.
The question Italian Courts have dealt with is whether directors may be held liable for breaching this specific obligation. The business judgement rule, in fact, protects the directors of companies that have not achieved their business goals, if they have made business decisions correctly and diligently via rational and cautious measures. But does this rule protect directors in the case of organizational decisions they must make under section 2086 ICC?
The outcome of the judgements we selected is positive: Italian local courts and the Supreme Court state that the business judgment rule applies to directors’ decisions concerning company organization, as provided by section 2086 ICC. Naturally, this does not mean that such decisions can never be challenged from a legal point of view: the organizational structure implemented by directors may make them liable if an ex ante evaluation shows (i) it was not adequate to detect company crisis or the loss of status as a going concern, or (ii) the board operated via unreasonable or manifestly irrational measures. The same applies to a director failing to provide a specific organizational structure or failing to take action once a crisis becomes evident.
2. Directors’ liability in defining the organizational, administrative, and accounting structures of the company: The decisions of the Supreme Court and of the Court of Milan
The decision issued by the Supreme Court on September 28, 2020 (no. 20398/20) concerns a proceeding between the Italian Tax Agency, as plaintiff, and a company (the defendant) for non-payment of taxes. Notably, the defendant claimed that the company was unable to pay its taxes due to a condition of force majeure, which left it cashless, thus excluding the defendant’s liability. The Supreme Court decided that this was not a case of force majeure, since as soon as the company detected a situation of ongoing illiquidity immediate action should have been triggered to limit the crisis and avoid deterioration of the company’s financial situation. In other words, the directors had not implemented all due measures to prevent escalation toward insolvency (which eventually occurred: the company went bankrupt during the proceedings) and, consequently, did not fulfill their obligation. The Supreme Court therefore refused to justify non-payment because the adverse economic situation that affected the company as a result of the directors’ conduct could not be deemed an extraordinary and unforeseen issue.
Another decision regarding directors’ liability in establishing company organizational, administrative, and accounting structures was issued by the Court of Milan on October 18, 2019. This was in response to two urgency proceedings filed by two companies against the sole director of both of them. The companies reported many irregularities committed by the director, including the fact that she allegedly had not fulfilled her organizational and management duties, pursuant to section 2086 ICC. The court stated that the sole director had not taken appropriate and timely action to protect the companies from a dramatic financial crisis, thus impairing their status as going concerns; in light of this, the court ordered the immediate revocation of the director and appointed a judicial administrator in her place.
3. The business judgment rule and the directors’ organizational choices: The decisions of the Court of Rome
The business judgment rule is a principle developed in American corporate law that in recent decades has been consistently applied by Italian courts in disputes regarding directors’ liability. This rule states that directors cannot be held liable for damages caused by their business decisions provided that two conditions are met: (i) the decision-making process was carried out with adequate diligence and the different possible solutions were assessed in order to choose the best one and (ii) those decisions were made on the necessary rational basis. If these two requirements are met, directors cannot be held liable for their unsuccessful business decisions. The aim is to grant directors the freedom to make business decisions, some of which are necessarily risky, without constantly being afraid of the possible consequences, including their own legal liability.
In order to explore whether this rule applies to organizational choices made pursuant to section 2086, we shall consider two decisions of the Court of Rome, issued respectively on April 8 and September 15, 2020. Both admit applicability of the rule and clarify when directors can be held liable for breaching the abovementioned provision.
Both judges acknowledged that under section 2086 ICC directors must make organizational choices in establishing an appropriate structure for a company. These are management decisions, too, and therefore benefit from the freedom granted via application of the business judgment rule.
More specifically, in the decision issued on September 15, 2020, the judge clarified that whenever the directors’ obligation provided by section 2086 is invoked with regard to damages or losses suffered by the company:
a) directors shall be held liable if they did not establish any organizational structure and, consequently, were not able to detect the early signs of a potential crisis;
b) directors shall not be held liable if they established an adequate organizational structure and detected the forthcoming crisis due to their alert mechanisms and then took appropriate measures to handle the situation.
Here the criteria for determining whether the directors can be held liable or not regards the adequacy and rationality of their choices, from the perspective of ex-ante oversight. These choices should be appropriate to the nature and size of the business and for early detection of signs of crisis. If those requirements were met, directors are not responsible, regardless of potential consequent damages or losses suffered by the company.
It is useful to look at how the two judges carried out their oversight of the specific management conduct in question.
In the first decision, the court looked at massive hiring of a large number of employees when the company was still in its early stages and not yet operating. This choice led to a huge increase in costs for the company and, according to the judge, was not consonant with the directors’ obligation to manage the company’s financial resources appropriately and establish an organizational structure appropriate to the nature and size of the company. Here the criterion of adequacy was clearly not met.
In the second decision, the judge posited that the directors had not taken timely and appropriate action to overcome the crisis. In particular, the directors approved a business plan that included listing the company on the stock exchange and issuing bonds to raise money. However, this plan was abandoned without explanation. In addition, the judge deemed the directors’ decision to sell a company branch in exchange for 30% of the buyer’s company shares poorly suited to the adverse economic conditions.
These decisions show that while judicial oversight should be limited to the diligence and rationality of the choices made, it can turn into in-depth scrutiny of the merits of those choices as well.
In conclusion, all four judicial decisions analyzed are very significant, since they are the first cases in which Italian courts have dealt with the new obligation provided by amended section 2086. While we await more decisions on this topic, the assessments of these judges can serve as a useful guide for directors. These decisions show that section 2086 ICC requires directors to ensure that their companies are equipped with appropriate sets of internal rules that allow prompt detection of any developing crisis.