Directors’ duties and practical matters to consider in a potential insolvency

Matthew Akers

Matthew Akers

Partner

Alex Dawson

Alex Dawson

Solicitor

With the government withdrawing its COVID related support, and in the face of continued domestic and global economic uncertainty, many businesses that managed to survive the pandemic could experience yet more challenging times ahead.

With this in mind, and following a recent uptick of instructions focusing on directors’ conduct in the period leading up to potential insolvency, Matthew Akers and Alex Dawson provide a short refresher of directors’ duties and the practical steps that can be taken to mitigate the risk of personal liability.

What are they?

To recap, directors’ duties are principally set out in the Companies Act 2006 and include the duty to:

(i)     Act within powers (s. 171);
(ii)    Promote the success of the company (s. 172);
(iii)   Exercise independent judgement (s. 173);
(iv)   Exercise reasonable skill, care and diligence (s. 174); 
(v)    Avoid conflicts of interest (s. 175);
(vi)   Refuse third-party benefits, if likely to create a conflict (s. 176); and
(vii)   Declare an interest in proposed or existing transactions or arrangements (ss. 177 & 182).

It is worth noting that these general duties apply to all directors of a company including non-execs and potentially shadow directors.  Also, whilst these duties typically end once the director ceases to hold office, the duties: (i) to avoid conflicts of interest in respect of any opportunity they became aware of whilst a director; and (ii) not to accept benefits from third parties in respect of acts carried out whilst a director, continue to apply even after they cease to be a director.

What changes when the Company approaches insolvency?

Where a company is insolvent or on the verge of insolvency, a director’s duty shifts from acting in the best interests of the company and its shareholders to acting primarily in the best interests of its creditors.  This means taking steps to pay creditors in full and on time or, put another way, minimising any loss. 

But this is not a straightforward determination.  In practice, it may not be possible to identify a precise point in time when this duty crystallises, less still when a company becomes insolvent and should cease trading.  Directors must balance the desire to implement measures to keep the company going, on the one hand, whilst not continuing to trade unlawfully, on the other.  This is particularly difficult when the company is facing conflicting demands from suppliers, shareholders and creditors.

As such, tricky questions (and potentially disagreements) will arise at board level when a company encounters financial difficulties as to when the duties shift, how they should be discharged and when (if at all) insolvency procedures should be initiated.

Given the wide-ranging powers enjoyed by office holders and the potential for personal liability for directors (as set out below), we identify some general practical tips for directors to help mitigate the risks.

Practical steps for Directors to help protect themselves

  • In broad terms, a company is insolvent if its financial position is such that any reasonable director would conclude that it has no reasonable prospect of avoiding insolvent liquidation. Directors must therefore exercise their own independent judgement based on the information available.
  • This means ensuring they have up to date financial information both from a balance sheet and working capital perspective. In particular, directors should be careful to monitor compliance with financial covenants contained in any arrangements with lenders and the impact of any cross-defaults on their lending arrangements.
  • Directors should hold regular board meetings and ensure that all commercial decisions are recorded in the company’s minutes. Discussions relating to matters such as additional borrowing, granting of security or entering into new supplier terms must be carefully considered and any decisions documented (see Reviewable Transactions below).  Where there are proposals to dispose of company’s assets, independent valuations should be undertaken. Generally speaking, distributions to shareholders or repayment of shareholders’ debts should be avoided (or at least carefully considered).
  • Directors should consider keeping major creditors informed about the company’s position.  Precisely what is communicated to creditors and when can be a difficult balance to strike given the potential impact on the business. That being said, cooperation and support from major creditors may assist the company’s ability to trade through difficult periods.
  • Directors should bear in mind potential conflicts of interest particularly if they hold more than one directorship within the company’s group. All decisions must be taken independently on the basis of advice provided to the company in question.
  • If a director reaches the conclusion that there is no reasonable prospect of the company avoiding an insolvent liquidation but fails to persuade the board, that director should ensure that his/her concerns are recorded in the company’s minutes.  He / she may also consider taking independent advice regarding their position and whether it is prudent to resign.
  • That said, resignation alone is unlikely to offer much, if any, protection (and may even be looked upon unfavourably by a court or office holder) and a director may still be liable for any wrongful trading that took place during their time in office.
  • The company may have taken out directors' and officers' insurance (D&O insurance). Directors should review the terms of any D&O insurance policy to determine what coverage applies and whether they have protection against certain claims. 
  • Finally, as soon as directors are aware that the company is in financial difficulty, they should seek external advice regarding its financial position and the potential options for an insolvency scenario. Depending on the circumstances, it may also be appropriate at this stage to seek legal advice. In general, the courts will look favourably on a board that has taken proper advice to minimise loss to creditors when assessing whether the directors have acted honestly, reasonably and sensibly.

What are the main offences and remedies available to an office holder?

  • Misfeasance or breach of fiduciary duty: broadly speaking, the court may examine the directors’ conduct and potentially make an order that he/she make a repayment or contribution to the company's assets.  This may arise from any misfeasance or breach of duty and can be pursued by an office holder, creditor or contributory.  Notably, this section also applies to any present or former officer of the company and any person who is or has been concerned, or has taken part, in the promotion, formation or management of the company.
  • Wrongful trading: a liquidator can seek a court declaration that a director make a contribution to the company’s assets where he/she ought to have concluded at some point before the commencement of the liquidation that there was no reasonable prospect that the company would avoid going into insolvent liquidation. As above, knowing precisely when that decision should be made is rarely straightforward and creditors may equally suffer damage where a decision to enter an insolvency process is made prematurely.
  • Fraudulent trading: where the company has been carried on with the intent to defraud creditors, or for any other fraudulent purpose, the liquidator can seek a court declaration that anyone who was knowingly party to the fraud make a contribution to the company's assets. Fraudulent trading is also a criminal offence under the Companies Act 2006. 
  • Director Disqualification: A person held liable for wrongful or fraudulent trading may also be the subject of a disqualification order under the Company Directors Disqualification Act 1986 (CDDA).  
  • Reviewable Transactions: a liquidator can seek a court order undoing the effect of certain transactions (for example, preferences and transactions at an undervalue) entered into by the company before the start of insolvency. It is easy to see how such transactions might be entered into under extreme commercial pressure in an attempt to ease the company’s day to day problems. Whilst any director involved in such transaction is not personally liable, their conduct and/or participation may be taken into account when ascertaining if that person is unfit to be concerned in the management of a company under the CDDA.

Conclusion

With yet more uncertain times ahead and the possibility of a spike in insolvencies following the government’s withdrawal of its support packages, the importance of directors monitoring the company’s financial position and taking early advice remains overwhelmingly important.  Whilst the conclusion might appear self-serving (!) it is nonetheless the safest course of action for directors seeking to navigate a company through a myriad of difficult issues whilst avoiding any personal liability themselves. 

 


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