The liquidator of Onslow Ditching Ltd (ODL), sought a declaration against two directors (on three grounds), seeking damages/fines or a contribution of assets from each director for:
- Misfeasance and breach of fiduciary duties by failing to act honestly in the best interests of the company and its creditors;
- Wrongful trading, for failing to act in the best interests of creditors when it was clear that insolvency of the company was unavoidable; and
- Failing to exercise their roles as directors with reasonable skill and care.
ODL was created as a special purpose vehicle by the two directors, Peter Frohlich and Godfrey Spanner, for the sole purpose of acquiring and developing a piece of land.
The liquidator argued that the venture was doomed from the early days: the directors treated a ‘casual conversation’ with the chairman of a development company, FCL, as if it were a quotation for business units, and it was on this loose and vague proposition that the construction costs and cashflow forecasts for the site were based. These were then presented to the bank in order to obtain financing to acquire the site and a further development loan.
Problems began to emerge once the site was acquired. The development facility from the bank was contingent on certain conditions, including there being a fixed-price contract in place with FCL to develop the site on a build-to-order basis based on pre-sales, rather than a speculative development of the whole site. This accorded with the initial intentions of the directors, who intended never to be exposed to more than two units unsold at any one time. In fact, there was no contract negotiated between ODL and FCL at this point, and negotiations and a Letter of Intent reflected the intention of the parties not to enter into a fixed-price contract at all.
The judge held that the initial approach to the bank, stating the existence of a fixed-price contract and the rolling development programme, as well as the costs estimates, overstated the position of ODL; it “did not accord with reality”, and “the confusion between aspiration and reality was apparent at many points during the course of the evidence”.
While there was no contract and so the conditions of the development facility could not be met, the directors still instructed FCL to commence development works under the Letter of Intent. The bank honoured some of the initial costs but, not being satisfied of compliance with the conditions, froze the rest of the amount and effectively starved the company of further funds.
The judge was careful to distinguish this point in time: had the directors properly acted then, the land could have been sold, paying off all the creditors and realising some profit. Instead, knowing that they could not fulfil the terms of the bank loan (but still informing the Bank that “all pre-requisites were in place”), and having no other credible source of funding (following an abortive take-over bid by another company) the directors instructed FCL to undertake further development works, which FCL duly did, accumulating more than £1m in fees and costs.
Upon realising that no payment would be forthcoming, FCL suspended work and took the matter to adjudication, where it was awarded £1.6m. The directors then placed ODL into administration, selling the land and repaying the site loan and the balance on the development facility (an aggregate of £1.42m), but leaving further significant liabilities owing to unsecured creditors, including FCL.
In terms of liability, the judge in the case was careful to distinguish between two points in time: 1) when the directors’ views of the company’s prospects were perhaps overly optimistic and not entirely realistic; and 2) when the insolvency of the company was a very real prospect which the directors did nothing to aid or avoid in their actions.
For breach of fiduciary duty, the judge noted that a director would have a ‘harder task’ to persuade a court that he honestly believed to be acting in the company’s interests, “if the act undertaken resulted in substantial detriment to the company”. The judge further cited the judgment in Gwyer v London Wharf (Limehouse) Ltd  EWHC 2748 (Ch) that, “where a company was insolvent, or of doubtful solvency, or on the verge of insolvency”, and it is the creditor’s money at risk, the directors, in exercising their duties, “must consider the interests of the creditors as paramount”, and that, in this context, the interests of the company “are in reality the interests of the existing creditors alone”.
By the time when it was clear the loan conditions could not be met, and with no alternative avenue for funding, the decision to authorise further development was irrational and based on “wilful blindness... a deliberate decision not to enquire or consider lest an unpalatable truth be exposed”. At this point, the judge held “the only honest thing to do was to stop the development”. Therefore, at the later point in time, the directors were in breach of fiduciary duty to the company and its creditors. The directors were further liable of wrongful trading as the company was clearly insolvent on a balance sheet basis, yet they used credit extended to it to trade when, but for their wilful blindness, they ought to have concluded that there was no realistic prospect of avoiding insolvent liquidation. On the question of reasonable skill and care, the judge held that a reasonably diligent director would have realised the ‘extremely short’ time horizon for the company, and acted accordingly, halting the development and selling the land to repay creditors, and failing to do so further constituted breach.
While the judge was careful to acknowledge the fact that “risk is an inherent part of economic activity”, in excusing liability at the earlier point in time, this did not stop the finding of liability once funding was clearly not to be provided.
Directors and Officers Liability Insurance Cover?
Directors and Officers (D&O) liability insurance cover is designed to protect a company’s directors and officers from a wide range of claims brought against them arising from their actions or decisions. A director of a company owes numerous duties which arise from the common law and statute. Claims may be brought by, amongst others, shareholders and creditors of the company, government and regulatory agencies, and liquidators.
From a D&O perspective most policies will pay for the costs of any regulatory investigations and may in certain circumstances pay for the defence costs of any court proceedings brought by the liquidator. In the event that the directors were found to have been at fault and fraudulently trading, then most D&O policies would require that those defence costs be paid back to the insurer.