As the economic outlook remains uncertain, businesses of all sizes and their boards are experiencing mounting pressure from various sources. In particular, directors of companies in financial difficulty face a number of challenges. Primarily, they must decide what they can do to keep the company in business without running the risk of committing an offence or incurring personal liability, and at what stage they must stop trading.
This article outlines some key issues and strategies that directors should consider when times are tough.
What are my duties?
The Companies Act 2006 codified directors’ duties to clarify what is expected of directors and provides a single reference source setting out their duties. It is well established that directors are required to consider the interests of creditors of the company when the company is insolvent or approaching insolvency.
Consequently, as a company heads towards potential insolvency, directors should be aware that their duty to the members of the company to promote its success may need to be modified with a view to minimising the loss to the company’s creditors. Some of the most difficult decisions may need to be taken when the company is on the verge of insolvency; the so-called ‘twilight zone’, which begins when the company starts to encounter financial difficulties, such as cash flow problems and pressure from lenders in relation to banking facilities.
The directors’ conduct during this period will come under particular scrutiny. The duty to promote the company’s long-term success for the benefit of its members may in such a case potentially conflict with a director’s duty to the company’s creditors in the short-term.
Choosing whether or not to follow a particular survival plan when it is uncertain if that plan will turn the company around or lead to an insolvent winding up will be difficult. This is a particular dilemma for directors of companies which have strong management and a sound business model but are suffering from an unexpected or sudden downturn in business. Once a company is in the ‘twilight zone’ it is essential that directors err on the side of caution and direct their paramount concerns to the interests of the creditors.
To read more about directors’ duties and responsibilities, click here.
What are the risks?
In addition to any liability that may be incurred by a director for breach of duty under the Companies Act 2006, there are a number of potential legal remedies that are available against directors. However, these will generally only be invoked after the company has gone into insolvent liquidation (where the realisations from the assets of the company are insufficient to cover the liabilities of the company and the expenses of the winding up).
These include (among others):
- Wrongful trading: the most commonly used remedy to impose a personal liability on directors of an insolvent company is pursuing a director for wrongful trading under the Insolvency Act 1986.A director may be found liable for wrongful trading if it is established that, at a time before the company went into insolvent liquidation, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. There is no requirement for dishonesty by the director. Their actions will be judged on the basis of what a reasonable director would have done in the circumstances with the same knowledge, skill and experience as the particular director in question.If a director is found liable for wrongful trading the result can be very costly. Such a director (including one who has since resigned) may be required to make a personal contribution to the assets of the insolvent company. A prudent director should therefore make sure they are able to demonstrate that they took every step possible to minimise potential losses to the company’s creditors.
- Fraudulent trading: directors can be liable for fraudulent trading if they were knowingly party to carrying on the business of a company with the intent to defraud creditors. Fraudulent trading is a criminal offence. The burden of proof is high and there has to be actual dishonesty.
- Disqualification order: an order can be made against a director (including a former director) of an insolvent company disqualifying them from being a director or being in any way concerned or involved in the promotion, formation or management of a company, if their conduct makes them unfit to be concerned in the management of a company.
What should directors do?
Directors will continually need to consider if there is a reasonable prospect of the company avoiding going into insolvent liquidation. The board will therefore need to remain well advised and have available to it reliable financial information to closely monitor the company’s financial position. In particular:
- As soon as directors become aware of any financial difficulties, they should raise concerns with the board and seek trusted legal and financial advice (including from an insolvency practitioner).
- Prepare and keep under review realistic financial estimates of what would be realised in respect of the company’s assets were it to go into liquidation.
- Carefully document all meetings, conversations and advice, particularly with professional advisers and creditors. Board meetings should be held on a regular basis, and the more precarious the state of the company the more frequent the board meetings should be. Any decisions made during board meetings and the basis for those decisions should be fully documented, including dissenting views. Should the worst happen, then at least the directors will have the paperwork to support their actions.
- Ensure that all possible action is taken to minimise losses to creditors and that the interests of creditors are fully considered prior to any proposed transaction. Equally, directors should not enter into any transactions that prefer one creditor (or class of creditor) above others. It is a director’s duty to protect all the company’s creditors equally in an insolvency situation. This does not necessarily mean ceasing to trade immediately, but each spending decision will need to be carefully analysed.
- Directors must have clear, realistic plans in place to avoid insolvency if they decide to continue to trade. As well as investigating and considering additional funding routes, directors should ensure that they are monitoring the company’s compliance with financial covenants in existing lending arrangements to prevent facilities being called in.
- Above all, do not resign to avoid the problem! Ordinarily, a director who resigns is not taking ‘every step’ to protect the interests of the company’s creditors. Neither will resignation absolve a director from liability for conduct while they were in office.