The following is a broad overview of the duties and liabilities of directors when their company is in financial difficulties. It is a general guide only and there will be variations according to the specific laws in each jurisdiction.
The directors of companies in financial difficulty face a number of challenges and difficult decisions. What can they do to keep the company in business without the risk of incurring a personal liability? At what stage should they decide to cease trading? If they do decide to cease trading which insolvency route should they take? Given the issues involved, as soon as the directors are aware that the company is in financial difficulties, they should seek specialist advice.
This briefing complements our other publications on corporate restructuring and the sale or purchase of distressed assets.
What is a director’s primary responsibility if a company is in financial difficulties?
Generally, when a company is solvent, the primary responsibility of its directors is to act in good faith in the best interests of the company and this duty is generally construed as a duty to act in the best interest of the shareholders. Directors also have responsibilities to employees and others with whom they deal. However, if the company is insolvent (or likely to become insolvent) then they may also owe duties to the creditors.
These duties are owed by all directors, non-executive as well as executive. Indeed, the fact that some directors may have been appointed to protect the interests of a particular shareholder does not absolve them from their general fiduciary duty to act in the interests of the creditors if the company is insolvent or close to insolvency.
Generally there are two broad tests of insolvency. A company is typically insolvent if either:
- its liabilities (including its contingent and prospective liabilities) exceed its assets (the ‘balance sheet test’); or
- it is unable to meet its liabilities as they fall due (the ‘cash flow test’).
Even where a company is solvent, it is not safe for its directors to ignore the interests of creditors if there is a significant risk that the company will become insolvent. In such a case, the directors must balance the interests of shareholders and creditors, depending on the effect which their actions will have on each class of interested parties.
What are the risks for directors?
When a company gets into financial difficulties, there are two main risks that directors face:
- potential liability for wrongful trading; and
- potential liability for breach of fiduciary duty.
- In addition, directors need to be aware of a number of other risks, including:
- the possibility of disqualification as a director;
- potential liability for fraudulent trading (including any criminal liability);
- the particular responsibilities of boards of listed companies; and
- any disclosure requirements.
What is wrongful trading?
The consideration which should be uppermost in the minds of directors of a company in financial difficulties is whether, and if so when, the company should cease trading as a director may be made personally liable for all or part of the company’s debts in an insolvent liquidation if:
- he knew or ought reasonably to have known that there was no reasonable prospect that the company would avoid insolvent liquidation; and
- he nevertheless allowed the company to continue trading.
What is the nature of a director’s fiduciary duty?
A director’s fiduciary duty includes a duty of confidentiality, a duty not to act in conflict with the company and a duty not to profit from his position (without declaring his interest). If, in the course of a winding up, it appears that a director has misapplied or retained any money or property of the company or been guilty of misfeasance or breach of fiduciary, then a court may order the director to repay the money or property in question. This also applies to any officer of the company who has been involved in the formation or management of the company. The definition of "director" includes any person occupying the position of director, by whatever name.
In many jurisdictions liquidators are obliged to report to the court on the conduct of directors in the run up to insolvency and this may lead to an order disqualifying a person from being a director of a company. In very serious cases it may lead to a custodial sentence. In considering whether or not a person is unfit, courts will consider a range of issues such as any breach of duty by the director and the extent to which he is responsible for transactions which can be set aside (such as transactions at an undervalue or preferences).
There are also penalties for directors who act fraudulently. In addition to the general law of fraud, there are often particular statutory provisions which impose liability on directors who are knowingly parties to the company carrying on business with intent to defraud its creditors.
There are particular requirements for listed and other public companies. Generally, directors of a public company have a duty to convene a shareholders meeting if the net assets of the company fall to half or less of its called-up share capital. Of more practical importance, where the company is listed on a stock exchange, its directors will have to ensure that it continues to comply with its obligations under any disclosure rules and other legislation. There is clearly potential for a conflict here between the requirement to keep the market informed and the commercial necessity not to disclose information which might harm the company. In practice, this is an issue which needs to be kept under constant review by the directors of a listed company in financial difficulties.
What is the position for Non-Executive directors?
When a company gets into financial difficulties, the position of a non-executive director is the same as that of executive directors. Potential liability for wrongful trading and for breach of fiduciary duty needs to be monitored carefully, and the other issues described in this note need to be reviewed. All directors need to be involved in considering these matters.
Record, record, record! Directors can sometimes feel that they are living day-to-day juggling creditors and chasing debtors. Regular reviews, board meetings and less formal meetings should be (and most likely will be) held by directors and they should record their views as to why the company can continue to trade. This evidence will help liquidators in the future to consider the conduct of the directors if indeed insolvency occurs.
- All directors (executive and non-executive) owe the same duties to creditors. Each director should actively pursue information about the company.
- Contractual obligations. Directors should consider the ramifications of financial difficulties. Loan agreements would typically require the company to inform lenders of the difficulties (even if insolvency proceedings are not commenced).