Directors’ duties in distressed scenarios: When do you cross ‘that’ line?

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Directors’ duties in distressed scenarios: When do you cross ‘that’ line?

Directors’ duties in distressed scenarios: When do you cross ‘that’ line?

The Companies Act 2006 imposes various duties on directors.  In good times those duties are owed to the company for the benefit of shareholders as a whole, as a general rule. However, this clear cut position quickly changes in a distressed scenario.

Who do they owe their duties to?

When a company faces financial difficulties, creditors become the key stakeholders with the most to lose and the right to be repaid unlike shareholders whom may have lost all capital value. In that scenario, a director’s duty switches and a director must consider how their decisions will impact creditors, the value of the company and its assets if the company doesn’t or cannot trade its way out. In short, the duty becomes to act in the best interest of creditors as a whole.

Directors of companies in a distressed scenario must make decisions with reasonable care, skill and diligence based on their level of experience, their skills and the company’s state.  Those decisions might include whether it’s reasonably viable for the company to trade its way out; whether it can negotiate with creditors to allow it some breathing space to plan what it does; whether to pre-emptively restructure the debt via a CVA (or alternative); whether administration is required; or whether it’s terminal – and to shut the doors and liquidate.

When does that duty switch?

One of the key questions is when does a director’s duty change from being shareholder to creditor focused. This is particularly important given the long list of potential pitfalls that may land the directors with personal liability, including wrongful trading, fraudulent trading, breach of duty, and disqualification etc.  The recent Court of Appeal decision in BTI 2014 LLC v Sequana clarified this, when it stated the test is when the directors knew (or ought to have known) that the company had no reasonable prospect of avoiding insolvent liquidation. This is a subjective test of likeliness in all the circumstances, and can be a point in time before actual insolvency.

However, in practice things don’t always go from bad to worse - some companies have a slow predictable decline while others seem to collapse overnight. This conundrum was described in Re White & Osmond (Parkstone) Ltd (1960) 105 CLR  when the Court said:                   

…there is nothing wrong in the fact that directors incur credit at a time when, to their knowledge, the company is not able to meet all its liabilities as they fall due. What is manifestly wrong is if directors allow a company to incur credit at a time when the business is being carried on in such circumstances that it is clear that the company will never be able to satisfy its creditors

How do you know when that line arrives?

This leaves directors asking: “Are we there yet?”  The concern is not for those with reckless mal intent, but for those who attempt to save the farm, and genuinely believe they can, but may breach their duties doing so. Sadly there is no one size fits all guide, and the role of a director is sometimes an onerous one. The legal implications of Sequana are not ground breaking, but serve as a reminder that when a directors’ duty switches from shareholders to creditors must be assessed on a case to case basis – based on the facts at the time.

The key for directors is to ensure they take their company’s pulse regularly, are mindful of their duties (i.e. exercise reasonable skill, care and diligence) and document the reasons for their decisions. This evidence can be a life saver at a later date when the guns are out for you. In any event, directors of a distressed company must be aware that taking on further credit, whether by loans, trade terms, credit agreements, or simply delaying payments due to HMRC, can have personal legal consequences.

We will look at practical steps directors can take later in our series of articles on directors duties.

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This article was prepared by David Lim.