Limited liability is not complete protection for directors and they must carefully consider their actions and, indeed, failures to act in order to avoid “piercing the corporate veil”. Directors may be ordered to contribute to the assets of the company even where they have not acted dishonestly.
Wrongful trading is often called “trading whilst insolvent” but this is only half the story. Directors may find themselves personally liable for wrongful trading where, at some point in time, they should have concluded that the company would not be able to avoid insolvent liquidation but continued to trade. In those circumstances the director may be ordered, by the court, to contribute to the assets of the company for the benefit of its creditors.
A director will be able to raise a defence to such a claim if he took every step to minimise losses to creditors that he ought to have taken.
The acts and omissions of the director are considered both subjectively and objectively. The court will take into account the facts and matters that a reasonably diligent director ought to have known or been able to ascertain and steps that he ought to have taken. The fictional “reasonably diligent person” will be taken to have the general knowledge, skill and experience expected of a person carrying out the same functions as the director and the general knowledge, skill and experience that the director actually had. Ignorance is not a defence.
This is not the only pitfall that a director of an insolvent company may face.
The Court has wide powers to order that a director should make a contribution to a company’s assets where a director has misapplied, retained or become accountable for company property or has been guilty of any misfeasance or breach of any fiduciary or other duty.
Duties of directors have been developed through common law over many years and were codified by the Companies Act 2006. Directors and the board must remember that a company is a separate legal entity of which they are merely employees and custodians but their role and position of trust means that they must achieve high standard of responsibility and duty of care and act in good faith at all times.
Directors’ duties are to:
- promote the success of the company;
- exercise reasonable care, skill and diligence;
- exercise independent judgment;
- avoid conflicts of interest.
Ordinarily these duties are owed to the company and its shareholders but directors of insolvent companies owe these duties to the creditors. A failure to observe these duties may lead to personal liability. Each legislative provision that a director may fall foul of cannot be considered in isolation. Any act or omission could lead to claims under a number of statutory provisions or common law and support an application by the Secretary of State for a director to be disqualified from acting as such.
Misapplication of company property may also lead to a clawback from the recipient, whether that is a director or third party, where assets are transferred less than their market value.
Directors should avoid paying any creditors, including themselves, in priority to other creditors since such payments may be clawed back if they are a “preference” made (or deemed to have been made) with a view to putting the recipients in a better position on insolvency than they would otherwise have been.
Transferring assets and preferring creditors would also be circumstances that would support an application by the secretary of state to disqualify a director from acting as such in the future.
What should directors do when their company may be insolvent?
- ensure that up to date and accurate management information is available and monitor the company’s finances and cash flow on a regular, at least monthly, basis and more regularly if the financial situation worsens;
- prepare cash flow statements so that they can anticipate the times when the company may not be able to pay creditors and plan for them e.g. through communication and negotiation with creditors;
- if insolvency cannot be avoided, consider whether the company can continue to trade. This should only be considered an option if the board determines that insolvent liquidation is not inevitable and creditors will not be prejudiced e.g. a continued period of trading will improve the company’s fortunes or a cost cutting exercise and/or turnaround strategy will return the company to solvency. Directors should record their decision to continue to trade and the reasons for them in the form of board minutes and a review of the decision should take place regularly;
- take professional advice and have that advice recorded in writing;
- consider whether to continue to take a salary at the level currently awarded or at all and reduce or suspend remuneration is necessary. Directors should be aware that HMRC and the Secretary of State will take a dim view of directors who effectively “bank roll” their company with “credit” from HMRC unless an agreement has been reached, particularly in circumstances where funds that could have been used to pay HMRC have instead been used to pay the directors;
- treat all creditors fairly and equally. New supplies should not be ordered unless they can be paid for nor should new contracts be entered into unless they can be performed;
- avoid transferring assets of the company away from it, including intangible assets such as intellectual property, without taking advice and ensuring that full market value is paid;
- consider whether to invoke an insolvency process, such as a liquidation or administration or seek a formal arrangement with creditors through a Company Voluntary Arrangement.
Resigning as a director will not absolve a director from liability. Further non-directors may be liable as if they were a director where their behaviour, in controlling the affairs of the company and the actions of the board, is akin to that of a director such that they may be considered to be “shadow directors”.