While a company is trading solvently, the duties of the directors are owed to the company for the benefit of present and future shareholders. However, once the company becomes insolvent, or there is doubt as to its solvency, the directors must also consider or act in the interests of the company’s creditors in order to minimise the potential loss to them.
A breach of these duties can lead to personal liability and possible disqualification from acting as a director or being involved in the promotion, formation or management of the company for a specified period. The directors must also consider whether the company’s liabilities, including contingent and prospective liabilities, exceed its assets.
A company’s statutory balance sheet should not be used alone to determine whether a company is “balance sheet insolvent” as it may omit some information, such as the company’s contingent liabilities. It is generally accepted that, for the purpose of this test, accounts should be prepared on a going concern basis, as it is likely that many companies would be balance sheet insolvent if the accounts were prepared on a break-up basis.
In order to assess the extent of the problem, the directors will, at the very least, need an up-to-date cash flow statement, whatever recent monthly or other management accounts are available and appropriate projections, such as of trading prospects, cash flow and financial covenant compliance. Any actual or potential breaches of covenant or events of default in relevant loan agreements should be brought to the immediate attention of the directors.
The full board of directors should meet as soon as possible after the preliminary assessment of the position. If any of the directors cannot attend in person, they should participate by telephone. The company’s lawyers should advise the board of the statutory and other duties of the directors in this situation, both in general terms and by application to the facts.
Directors are subject to a number of duties, many of which have been codified under the Companies Act 2006 (“CA 2006”). CA 2006 also preserves the common law duty to consider or act in the interests of the company’s creditors when a company is insolvent or of doubtful solvency, with a view to minimising losses.
Under section 212 of the Insolvency Act 1986 (“IA 1986”) if, in the course of a winding up, anyone who has been involved with the promotion, formation or management of the company is found to have misapplied, retained or become accountable for any money or other property of the company, or been guilty of misfeasance or breach of a fiduciary or other duty in relation to the company, a court may on an application by the official receiver, liquidator or a creditor compel him to:
(a) repay, restore or account for the money or property of the company with interest; or (b) contribute such sum to the company’s assets by way of compensation in respect of the
misfeasance or breach of fiduciary duty or other duty as the court thinks just.
A director can also incur personal liability following an application to the court by a liquidator for fraudulent trading (section 213 of the IA1986). The court can order that any person who was knowingly a party to carrying on the business of the company with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, is liable to make such contributions to the company’s assets as the court thinks proper.
Fraudulent trading is also a criminal offence which carries the risk of imprisonment, a fine or both. Fraudulent trading can arise when directors of a company allow it to incur debt when they know there is no good reason for thinking that funds will be available to repay the amount owed when it becomes due or shortly thereafter. Thus, directors have to be satisfied that services or goods supplied to the company can be paid for on the relevant due date.
Wrongful trading (section 214 of the IA1986) can lead to personal liability, although there have been few reported cases. The provision applies where a company has gone into insolvent liquidation and: (i) before the commencement of the winding up, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation; and (ii) thereafter the director failed to take every step with a view to minimising the potential loss to the company’s creditors.
The standard required as to what a director ought to know, the conclusions he ought to reach and steps he ought to take is that which would be known, reached or taken by a reasonably diligent person with the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as those of the director in relation to the company and with the general knowledge, skill and experience that the particular director has.
Apart from the risk of incurring personal liability, where a director or former director of an insolvent company is found to have engaged in conduct which makes him unfit to be concerned in the management of a company, he must be disqualified by court order or have a disqualification undertaking accepted by the Secretary of State under the Company Directors Disqualification Act 1986.
Where a Director is disqualified or provides an undertaking the Insolvency Service can apply to the court for a compensation order on behalf of the Secretary of State for Business, Energy & Industrial Strategy. The court can make a compensation order if the director is subject to a disqualification order or undertaking and their conduct has caused a quantifiable loss to one or more creditors of an insolvent company.
Directors are advised to take early legal advice as soon as they consider the company to be under pressure, where a dispute arises affecting income, or clients extend payments past agreed payment terms, or costs of projects start to outweigh incoming.