Acting in the interests of the Creditors when insolvent
Whose interests prevail when cash flow issues are on the horizon?
One of the core duties (of directors is a general duty to act in the best interests of the company (members) as a whole; but when insolvency is on the horizon, that shifts to a duty to act in the best interests of the company’s creditors as a whole. Breaching of that duty can lead to personal liability of the director, as well disqualification from acting as a director and a potential criminal offence.
While Directors & Officers (“D&O”) insurance can assist with obtaining legal advice on, and defending such claims, if they arise (and I’d always suggest directors have a suitable D&O policy in place), prevention is always better than cure. D&O insurance does not always cover a director's personal liability if they are found guilty / liable.
So, when insolvency threatens, what are the key points directors should bear in mind?
- Being a ‘non-executive’ or ‘nominee’ director, does not get you off the hook. The duty still applies to you.
- The shift in focus of the duty from members to creditors as a whole. This can mean carefully balancing competing interests.
- Misfeasance: An administrator / liquidator can sue the directors personally if they have breached any of their duties and pursue them for the losses arising. You can read more about this here (add in link to the misfeasance article).
- Transactions at an undervalue: This is where the company transfers / disposes of assets for significantly less than they are worth. The Court can set such a transaction aside if it happened within 2 years prior to the company's liquidation and the company was insolvent at the time (or became so as a result). You can read more about this here (add in link to the paying creditors while insolvent article).
- Preferences: A preference happens when a payment out / transaction puts a creditor (or guarantor of the company’s debts) in a better position on insolvent liquidation than if the transaction had not happened, and the company's directors were influenced by a desire to do so when allowing the transaction. If the transaction happens within 6 months prior to the liquidation (2 years if the company and creditor are deemed ‘connected’. You can read more about this here (add in link to the paying creditors while insolvent article).
- Beware 'clever' schemes designed to shift assets: The insolvency act allows the Courts to unwind transactions that are designed to put the company's assets beyond the reach of its creditors. Numerous attempts at such schemes, some highly sophisticated and some less so, have been attempted and challenged (with varying successes and failures) across the years. The extent scope and risks of such schemes are a thesis of their own. It suffices to say that they are high risk, especially when insolvency is approaching, and may lead to misfeasance claims against the directors personally. Be wary of people offering magic solutions that sound too good to be true – they generally are.
- The risk of “wrongful trading”: A director of an insolvent company can be ordered to personally contribute if: i. they knew - or ought to have concluded - that there was no reasonable prospect that the company could avoid insolvent liquidation. ii. they failed to take every step with a view to minimising the potential loss to the company's creditors that they ought to have taken. This applies to a person who is, or was, a director of a company that goes into insolvent liquidation (you cannot avoid it by resigning). The obligation is to minimise the loss to creditors, and the appropriate action to do this will depend on the circumstances (sadly there’s no one size fits all list). You can read more about this here and in our Wrongful Trading article here (add in links to the paying creditors while insolvent & wrongful trading articles.
- Fraudulent trading: This occurs where someone is a knowing party to the carrying on of any business of the company with either the intent to defraud creditors (including potential creditors) of the company, or of any other person, or for any fraudulent purpose. In that case the person will be liable to a fraudulent trading claim against them (it’s not limited to directors), as well as guilty of a criminal offence.
Fraudulent trading can include a scenario where a director allows a company to obtain credit knowing that the company will not be able to repay the debt. Note however that, for a fraudulent trading claim to succeed there must be proof of dishonesty.
The Court may relieve a director (wholly or in part) from liability arising from breach of duty if it is satisfied that they acted honestly and reasonably. (this does not apply to wrongful trading).
Directors should be careful and regularly monitor their company’s financial situation. Where insolvency threatens (whether cash flow or balance sheet insolvency) they should carefully evaluate the situation and risks (with the assistance of professional advisers), record the subsequent decisions taken as well as why (I cannot emphasise this enough) in regular board minutes. Taking proper professional advice at an early stage is key. The earlier you take it, the more likely you'll have options.
For further information on this topic, please contact Frank Bouette, or you can give us a call on 0345 070 6000.