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Director and parent company liability

Liability

Under what circumstances can a director or parent company be held liable for a company’s insolvency?

Directors or shareholders are not strictly liable upon the insolvency of a company. However, as a company’s financial position worsens, directors must refocus their duties from the interests of existing shareholders to the company’s creditors. This transition is required before the point at which the company is unable to pay its debts. Where a company is of doubtful solvency, the directors must consider the creditors’ interests.

Once a company is unable to pay its debts, a number of ways in which directors could become liable for the company’s position begin to arise. In particular, directors can become liable for ‘wrongful trading’, which applies when the directors know, or ought reasonably to have concluded, that there is no reasonable prospect of avoiding an insolvent liquidation or administration. At this point, unless the directors place the company into an insolvency process, they must take every step that is available to them in order to minimise the potential loss to the company’s creditors. A director’s failure to comply with the wrongful trading test or with his or her duties (under the Companies Act 2006 or under common law) may lead to personal liability or disqualification as a director.

Subject to  rare exceptions (eg, fraud), a shareholder will not be liable for the debts of an insolvent subsidiary. However, it may become subject to some of the same liability regimes discussed above if it is acting as a shadow director (ie, if the directors of the subsidiary are accustomed to acting on its directions or instructions). 

Defences

What defences are available to a liable director or parent company?

Directors will not be liable for wrongful trading if they can show that they have taken every step that they ought to have taken with a view to minimising the potential loss to the company’s creditors. Whether this requires ceasing to trade and placing the company into an insolvency process depends on the circumstances; in some situations, it may be in the creditors’ interests for the company, despite being insolvent, to continue trading for a short period if other funding options are available to the company.

In practice, directors are likely to be given some protection against personal liability for non-fraudulent activity by their directors’ and officers’ liability insurance. However, directors should check the insurance terms carefully in order to avoid taking false comfort.

Due diligence

What due diligence should be conducted to limit liability?

Breach of directors’ duties or wrongful trading can lead to personal liability for directors, and even to disqualification and fines. 

A prudent director should thus obtain advice on these and other types of potential liability regimes (eg, breaches of duty caused by transactions which are voided) at an early stage if financial difficulties are anticipated, in order to develop strategies to mitigate these risks.

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