This article first appeared in the January 2011 issue of Financier Worldwide magazine. ©2011 Financier Worldwide. Permission to reproduce the article has been granted by the publisher.
This article explores how the duties owed by directors of a UK incorporated company can shift when financial difficulties arise and the personal risks for directors who fail to respond to that change.
Directors' duties
Under the Companies Act 2006, a director's primary duty is to act in the way that he or she considers, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole. The Act goes on, however, to say that this duty is subject to any '...enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company'.
While a company is trading solvently, it is presumed that in generating profits for the benefit of its shareholders, the company will also generate sufficient funds to pay its creditors.
The interests of shareholders and creditors diverge sharply when a company's solvency is in doubt, however. In these circumstances, there is a risk that the company is effectively spending creditors' money that will never be repaid.
The courts have recognised this by establishing that, when a company's continued solvency is in doubt (sometimes referred to as the 'twilight period'), the interests of the company's shareholders fall into the background and a director's primary duty is to manage the company in the interests of the company's creditors. A company is generally thought to enter the 'twilight period' at the time that it first starts to encounter financial difficulties, such as cash flow problems or the withdrawal or restriction of credit by suppliers or lenders.
The shift of focus from shareholders' to creditors' interests becomes even starker once it appears that the company cannot avoid insolvency; from this point on, the law requires directors to take every step to minimise the potential loss to the company's creditors (which may include ceasing to trade).
Who is a director?
It is sometimes assumed that non-executive directors owe lesser duties than their executive counterparts. This is not the case; non-executive directors share the same duties and are subject to the same liabilities as executive directors in an insolvency scenario.
It is likewise incorrect to assume that directors must be formally appointed to owe duties or incur liabilities. In fact, the term 'director' is very widely defined in English insolvency legislation and includes any person occupying the position of a director, whatever their title and regardless of whether they have been formally appointed. Persons at risk of being found to be de facto directors include lender and investor representatives, former directors who continue to be actively involved in the company, and any other person who exercises real power within the company.
Even if a person is not a de facto director, they may be at risk of being a 'shadow director' if they exercise so much influence over the company's board that it simply acts in accordance with their directions or instructions. Some of the offences and sanctions which apply to directors under English insolvency legislation apply equally to shadow directors.
The consequences of getting it wrong
In the aftermath of an insolvency, directors' actions will be closely examined to determine whether they have properly discharged their obligations to the company and its creditors.
A director who has committed any breach of duty or other wrongdoing in relation to an insolvent company may be ordered to repay money to the company or contribute to the company's assets. A breach of duty would include approving the entry by the company into a transaction which is at an undervalue or a transaction which is intended to prefer a particular creditor over others.
Any director who knowingly allowed the business of the company to be carried on in a way intended to defraud creditors could be found guilty of fraudulent trading and required to contribute personally to the assets of the company. There will always be a risk of fraudulent trading if the directors of a company continue to incur credit when they have no good reason to think that funds will be available to pay the debt when due.
A director may also be required to contribute to the assets of a company that continued to trade after the director knew, or ought to have known, that there was no reasonable prospect of avoiding insolvency. This is known as wrongful trading. There is a defence available to directors who can show that they took every step to minimise the potential loss to the company's creditors as soon as they became aware that the company faced insolvency.
A director of an insolvent company could also be disqualified from being a director if the court considers him or her unfit to be involved in the management of a company. Disqualification orders can be made for a minimum period of two years and a maximum period of 15 years. There has recently been a significant rise in the number of director disqualification proceedings being issued by the Insolvency Service. In the year to 31 March 2010, 2167 disqualification proceedings were brought to ban company directors, an increase of 17 percent up from the 1852 proceedings launched in the previous year. There was also a 56 percent increase in proceedings against directors for making non commercial transactions while the company was insolvent (up to 388 from 249 in the previous year).
Directors of UK listed companies can also face sanctions for breaches of disclosure or other obligations under the Listing, Prospectus, Disclosure and Transparency Rules, and the Financial Services and Markets Act 2000. Misleading the market as to a company's financial condition can give rise to serious offences carrying criminal liability and unlimited fines.
Reducing the risks
Directors of a company in financial difficulties should consider the following steps to help avoid any subsequent personal liability. First, carefully monitor cashflow forecasts and compliance with financial covenants in arrangements with lenders; this will help flag-up financial problems early on. Second, as soon as it appears that the company may be facing future financial difficulties, raise the alarm with other board members and seek external, professional advice. Third, regularly review the financial position of the company at full board meetings and ensure that up to date financial information is available to all directors. When a group of companies is involved, ensure separate board meetings for each company are held and that directors consider only the interests of the relevant company at each meeting. Likewise, nominee directors a pointed to protect the interests of stakeholders in the company must ensure that they focus on the interests of the company and its creditors, rather than those of their appointors. Fourth, ensure comprehensive board minutes are produced, recording the detailed reasons for board decisions. Dissenting directors should make sure that their views are also recorded. Fifth, do not selectively pay certain creditors if funds are not available to pay all creditors. Sixth, do not incur further credit if there is no reasonable prospect of avoiding insolvency, and take all possible steps to minimise losses to creditors; this may include ceasing to trade. Finally, only resign as a last resort and ensure that any concerns are communicated in writing to the board on resignation.
Conclusion
Directors of companies approaching insolvency face a number of challenges and difficult decisions. To minimise the risk of personal liability, it is vital that they recognise the point at which their duties to creditors become paramount and that they do (and are seen to be doing) all that they can to discharge those duties. If the company ultimately fails, they will inevitably find their conduct being closely scrutinised by insolvency practitioners, creditors and other interested parties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
