Rebecca Ferguson Head of Capital Markets
Advice for company directors navigating the zone of insolvency
It is important for directors to understand the full scope of their duties if their company is in financial distress and continuing to trade in the zone of insolvency. This is in order to ensure that they avoid facing personal liabilities for the losses suffered by creditors in these difficult times. This is a complex area for directors and it is important that they have appropriate legal and financial advice to ensure that they address the relevant considerations when reaching their decisions around continuing to trade whilst in the zone of insolvency.
Please see our updates on specific consideration for directors in light of trading difficulties arising out of the impact of COVID-19 at 'Directors' Duties in light of COVID-19' and 'COVID-19: Governance'.
What are the duties of directors in the zone of insolvency?
In general terms, directors have a duty to act with reasonable care, skill and diligence and a duty to act in good faith and in a way that is most likely to promote the success of the company for the benefit of its shareholders. In fulfilling their duties, directors must consider the long term context of their decisions, fostering business relationships with suppliers, customers and others, the interests of employees, the impact of their company on the local community and the environment, and generally maintaining the high standards and reputation of their company.
In the zone of insolvency, that is when the company is nearing a point at which it is likely to be unable to pay its debt as they fall due, then the directors’ duties shift to ensuring they act with the best interests of their creditors rather than their shareholders in mind. This means that directors of distressed companies may need to consider pursuing more conservative strategies which focus on minimising losses to creditors.
What is wrongful trading?
Wrongful trading is a statutory liability that arises if a director knew, or ought to have known, that there was no reasonable prospect of their company avoiding insolvent liquidation and they continue to trade incurring further losses for creditors. In these circumstances directors can be held personally liable for the losses faced by creditors resulting from trading in this interim period. Directors found liable for wrongful trading can be made to make a contribution to the company’s assets to cover these losses. It is important to note that liability only arises once a company has entered into insolvent liquidation. As such, an insolvent company may continue to trade provided that there is a reasonable prospect of avoiding insolvent liquidation - a light at the end of the tunnel.
The test for whether a director should have known of the inevitable insolvency is a two-fold test with an objective and subjective component
- would a reasonably experienced and diligent person in the same position as the particular director in question have known or ascertained the position and
- should that director, with his or her genuine level of skill and experience, have known or ascertained the situation?
If, for example, a director is a creative director with very little expectation in their role that they would be responsible for the finances of the company and very little financial background then they are much less likely to be held liable than a CFO whose day-to-day role is to scrutinize the financial position of the company and who has a strong financial background.
How is the quantum of the liability calculated in wrongful trading?
If the insolvency officer decides to bring a case against a director for wrongful trading and is successful in this then the court will try to ascertain the net increase in liabilities between the point at which the director should have known that there was no prospect of avoiding insolvency and the point at which the company ceased trading. If there has been no increase in the company’s liabilities over this period then it follows that the court will make no order against the director.
Is there any way a director can mitigate his or her liability?
A defence to a wrongful trading claim can be established on the basis that the directors took every possible step with a view to reducing the loss to the company’s creditors. If they have done this and there is still a further loss to the company’s creditors then they will not be found liable. The court will expect directors to take appropriate professional advice as to the steps that should be taken which will include regular and comprehensive board meetings with detailed minutes to include, amongst other matters:
- carefully considering all commercial decisions which they take;
- ensuring they remain abreast of the company’s financial situation and are reviewing appropriate financial forecasts such as a 13 week cash flow forecast;
- carefully considering whether additional credit should be taken and whether this will enable the company to recover;
- making every effort to increase income and reduce expenditure of the company, if necessary this may involve redundancies and terminating service agreements;
- maximising the value of the company’s assets and if necessary realising those assets;
- if appropriate negotiating better terms for the repayment of financial and trade debts so that the company can continue to trade and work its way out of difficulty;
- considering a likely contingency valuation which sets out the realisable value for creditors in an insolvency process
Ultimately however, if directors cannot see any light at the end of the tunnel, they will be expected to cease trading at the optimal time. This should not be too early because this could be detrimental to some creditors, and should certainly not be too late. This can be a difficult balance to weigh up.
Directors should ensure that a formal written record of all decisions and their involvement and factors taken into account in those decisions is kept.
In these situations there is always the possibility that not all directors will agree with the decisions are being taken. In this situation the best course of action for a director who finds him/herself out of line with the majority is to resign. In such case the views of the dissenting director and the rationale for his/her resignation should also be carefully minuted. The resignation of one or more directors when the company is in the insolvency zone does not mean however that such directors are immune from an action for wrongful trading nor that there will be no consequence for them in the long term. They remain responsible for the collective decisions of the directors up to the point at which they resign.
What should directors consider before incurring new credit whilst insolvent?
Accepting credit on standard commercial terms is unlikely to have a significant effect on the company’s balance sheet. The company will borrow a certain amount in exchange for a promise to pay the same amount back, plus some interest. However directors should bear in mind the following considerations:
- whether liabilities which are incurred in reliance of additional funding might remain unpaid and therefore contribute to the balance sheet insolvency of the company;
- what the repayment terms of the credit are;
- whether any constraints are placed upon the funds forcing the company to, for example favour one creditor over another or to accept extortionate repayment terms (see reviewable transactions below);
- whether the company is likely to be able to steer out of its present difficulties with the help of the credit, if it is not then directors should make the decision to cease trading.
What is insolvency?
A company is insolvent if it is deemed to be unable to pay its debts and there are two main tests which the court will use to decide whether a company is insolvent:
- Cash Flow Insolvency – this is when a company is unable to pay its debts as they fall due, and therefore has not got the liquid assets available to continue trading in the short term; or
- Balance Sheet Insolvency – this is when a company’s assets are less than its liabilities taking into account its contingent and prospective liabilities.
For the purposes of wrongful trading directors are only at risk of liability if the company is insolvent from a balance sheet perspective. Nevertheless, cash flow insolvency is a relevant factor to consider as a creditor may petition for a company to be wound up on the basis of cash flow insolvency. In which case the company may become balance sheet insolvent as a result of the revaluing of its assets in an insolvency process.
Who exactly counts as a director?
The duties of directors, and especially in the context of insolvency, does not simply apply to those formally appointed as directors under the articles of the company, although of course in most situations formally appointed directors are the most likely to be scrutinised.
The law will also look at the actions of de facto directors, that is those who despite not being formally appointed as directors assist in company decision making and hold themselves out as directors.
Shadow directors also owe the same duties as formal directors. Shadow directors are those who although not formally appointed as directors and not engaging with stakeholders on behalf of the company influence board decisions with their instructions and directions.
Other common sources of liability for directors of insolvent companies
If a director is found to have intended to defraud creditors then directors can be liable for fraudulent trading. The primary difference between fraudulent trading and wrongful trading is that fraudulent trading requires genuine intent to reduce the assets available for creditors, and dishonesty in doing so, from the director(s).
Directors should be wary of making personal guarantees to creditors, and if they think it necessary to do so should take thorough professional advice, if their company does become insolvent then creditors will turn to the director, personally to honour the guarantee.
A director can also be liable for misfeasance if they have misapplied or otherwise retained for themselves money which should otherwise be property of the company or its creditors then the Court will order the director to repay that with interest and compensation.
Directors of distressed companies can find themselves under intense pressure to try and please creditors and do all they can to ease the burden on themselves and on the company. Transactions which impact upon the return to the general body of unsecured creditors need to be avoided as directors could end up with personal liability if these transactions are challenged and unwound in an insolvency process. Such transactions include transactions at an undervalue, preferences, granting security for no new value, and obtaining credit on extortionate terms.
Are there any potential further consequences of being a director of an insolvent company?
Company directors will no doubt be concerned about the reputational consequences of being a director of a company which goes into insolvent liquidation. There are various potential consequences. On an insolvent liquidation the liquidator is obliged to make a report to of the Insolvency Service on the conduct of the directors of an insolvent company. An adverse report may trigger disqualification proceedings although in our experience these are still relatively rare. If a director is found to have acted improperly or neglected their duties, then directors may be disqualified from holding any directorships or being involved in any other way in forming, marketing or running a company in the UK for up to 15 years.
Public company directors are obliged to publicly disclose details of any company of which they have been a director at the time of or within the 12 months preceding an insolvency event.
Companies House will also record all liquidations and give details of directors who have been involved in the management of those companies which can cause reputational issues.
If a person has been a director of a company which has gone into insolvent liquidation within a period of 12 months, that person may not, without leave of the court or unless they fall within certain exceptions prescribed by statute, be a (shadow) director of a company with a name the same as the liquidated company or so similar as to suggest an association or in any way, directly or indirectly, concerned or take part in its promotion, formation or management or the carrying on of its business for a period of 5 years from the date of liquidation.
Regulated business considerations
A director of a regulated business may face further challenges. If the company’s business is regulated by for example the FCA, the Institute of Chartered Accountants or the SRA the general duties of the directors to the company and to the Regulator may clash and the director may face personal disciplinary action from the Regulator, a loss of personal livelihood or qualification as well as action by the insolvency officer. In these circumstances specialist advice should be taken at the earliest possible opportunity.
Navigating the zone of insolvency is a challenging task for directors. It is important for directors to engage professional legal and financial advisers as soon as possible once they become aware of solvency issues. Professional advisers are able to provide invaluable support in steering the company through its difficulties and ensuring that the directors are adequately protected should an insolvency process be required. Our team stands ready to help so please contact us if you require assistance.