Sources of Liability in Financial Distress

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This is the second of five articles in the Financial Distress series:

1. Stages of Financial Distress 
2. Sources of Liability in Financial Distress
3. Out-of-Court Restructuring Strategies
4. Voluntary Insolvency Proceedings
5. Do’s and Don'ts - Action Plan for Debtors in Financial Distress

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In the context of financial distress, Mexican companies and their directors and officers (D&Os) face various sources of potential liability. Understanding these risks is crucial for navigating the challenging waters of financial difficulty while avoiding legal pitfalls. This is an outline of some key areas of concern:

General Sources of Liability for Directors and Officers

The Mexican legal framework imposes specific liabilities on D&Os from the moment a company is found to be in general cessation of payment. These liabilities are modeled on the regime applicable to publicly traded companies, which can sometimes lead to punishable actions that may seem unrelated to solvency issues. Some key actions that can result in liability include:

• Voting at directors' meetings or making decisions about company assets with a conflict of interest
• Knowingly favoring certain shareholders to the detriment of others
• Obtaining undue economic benefits due to their position
• Generating or providing false information
• Altering or falsifying accounting records
• Destroying or modifying accounting systems or entries

Mitigants

D&Os are shielded from liability for good-faith decisions taken in compliance with statutory requirements, based on information from officers or external auditors, or when following legitimate shareholders' mandates.

Defective Accounting

The quality of a company's accounting practices is a critical area of potential liability. The Mexican Insolvency Law provides for criminal sanctions related to deliberate actions that cause or aggravate a company's cessation of payments, including the destruction, alteration, or hiding of books and records. Importantly, maintaining accounting records in a manner that obscures the true financial condition of the company can expose both the company and its D&Os to criminal liability.

Preferential Transactions

Entering into certain transactions during the period leading up to insolvency can be another source of liability. These "preferential transactions" may be set aside if the company enters insolvency proceedings, and engaging in them can also lead to personal liability for D&Os. The law defines several categories of transactions that may be considered preferential:

• Per se fraudulent transactions: Those entered into with the intent to defraud creditors
• Cases of constructive fraud: Transactions presumed to be fraudulent, such as gratuitous transactions or those with significantly unfavorable terms for the company
• Objective preferences: Transactions like granting additional collateral or changing payment methods
• Subjective preferences: Transactions with related parties made in bad faith

Payment of Taxes

Failing to meet tax obligations is another significant source of liability. Companies must continue making tax payments and other contributions, especially those resulting from withholdings from third parties. Failing to pay taxes withheld from third parties is considered a criminal offense in Mexico.

Implications and Mitigation Strategies

Understanding these sources of liability is crucial for companies navigating financial distress. To mitigate these risks, companies and their D&Os should:

• Maintain transparent and accurate accounting practices
• Avoid conflicts of interest in decision-making processes
• Refrain from entering into transactions that could be perceived as preferential, especially with related parties
• Ensure timely filing of tax returns and payment of taxes, particularly those withheld from third parties
• Seek professional legal and financial advice when making significant decisions during periods of financial stress

By being aware of these potential liabilities and taking proactive steps to avoid them, companies can navigate financial distress more safely and increase their chances of successful restructuring or recovery. However, the complexity of these issues often necessitates expert guidance to ensure full compliance with Mexican law and to protect the interests of both the company and its leadership.