UK: Illegal Loans To Directors: Inactivity And Lack Of Specific Knowledge No Defence

A director who knew that his company operated a loan account in favour of another director in breach of section 330 Companies Act 1985 has been held jointly and severally liable to repay all sums loaned after he became aware of the existence of the loan account, even though he did not know the details of the individual loans. In addition, because the director had failed, on becoming aware of the existence of the loan account, to take steps to recover sums that had previously been loaned, he was in breach of his duty to the company and consequently liable to pay the company the difference between what could have been recovered from the other director at the time such steps should have been taken, and what could be recovered now.

The case is a reminder that every director is legally responsible for statutory accounts that are approved by the board while he is a director, even if he does not personally sign the accounts or even attend the board meeting at which approval is given. If the accounts clearly reveal practices or transactions that are illegal, such as loans to other directors, or if a director becomes aware of such things at any time, he must make further enquiries and take all reasonable steps to rectify the position as soon as possible. Failure to do so could mean that the director himself will be personally liable to make good any loss that the company suffers.

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A director who knew that his company operated a loan account in favour of another director in breach of section 330 Companies Act 1985 has been held jointly and severally liable to repay all sums loaned after he became aware of the existence of the loan account, even though he did not know the details of the individual loans. In addition, because the director had failed, on becoming aware of the existence of the loan account, to take steps to recover sums that had previously been loaned, he was in breach of his duty to the company and consequently liable to pay the company the difference between what could have been recovered from the other director at the time such steps should have been taken, and what could be recovered now.

The case is a reminder that every director is legally responsible for statutory accounts that are approved by the board while he is a director, even if he does not personally sign the accounts or even attend the board meeting at which approval is given. If the accounts clearly reveal practices or transactions that are illegal, such as loans to other directors, or if a director becomes aware of such things at any time, he must make further enquiries and take all reasonable steps to rectify the position as soon as possible. Failure to do so could mean that the director himself will be personally liable to make good any loss that the company suffers.

A father and son were the owner-managers of a pharmaceutical distribution company called Unigreg Limited. The father, Avo Krikorian, owned 68% of the shares, and his son, Krikor Krikorian, owned 30%. The balance was controlled by a family trust. Krikor acted as the company’s managing director, sharing day to day control with the financial controller and general manager (who were not directors). His father, who was more than 70 years old, had more of a ‘consultancy’ role, but remained a board director.

Over a period of several years, the company loaned a total of around £2.3 million to its two directors, the vast majority to the son, Krikor, in clear breach of section 330 Companies Act 1985 (the Act). Under this section and related sections of the Act, it is a criminal offence for a director to authorise or permit his company to lend money to a director of the company or its holding company, other than in certain limited circumstances; a director who benefits from such a loan is liable to repay it; and any director who authorises such a loan is jointly and severally liable with the borrower to indemnify the company for any loss it suffers (e.g. as a result of the loan not being repaid in full).

The company’s statutory accounts for the for the 17 months ending 31 December 1997 (the 1997 accounts) noted that some £870,000 had been lent to Krikor in breach of section 330, and accordingly the auditors qualified their report. The 1998 accounts contained a similar disclosure and auditors’ qualification.

Both directors claimed that they thought the loans would be capable of being repaid either by their selling their shares or by the company selling some of its assets and distributing the profits to its shareholders. However, when the company went into administration in June 2002, Krikor was unable to repay the £2.2 million he owed. The administrator brought proceedings against both directors to recover the shortfall in the company’s assets, on the grounds of:

• breach of section 330; and

• misfeasance under section 212 Insolvency Act 1986 – i.e. that by approving the loans, or allowing them to be made, the directors had breached their duty to the company.

Both directors admitted liability for the amount due on their own loan account, but because the son, who owed the bulk of the money, was unable to pay, the critical issue was the extent to which his father should be liable for amounts owed by his son.

Section 341(5) effectively provides a defence to a director if he can show that, at the time the illegal loan was entered into, "he did not know the relevant circumstances constituting the breach" of section 330. The father claimed that he had not attended any board meetings which had considered the statutory accounts, and that he did not know about his son’s substantial drawings until February 2001, when he was told of the position by one of the company’s advisers, at which point he tried to get the loans repaid.

The Court of Appeal upheld the order for summary judgment against the father that had been made by the High Court, but reached a different conclusion on the amount of liability.

Although the father had not signed the statutory accounts for the periods ending 31 December 1997, 1998 or 1999, there was clear evidence that he had attended a telephone board meeting on 27 July 1999 to approve the 1997 accounts (which included the qualified auditors’ report by PWC).

Under section 233 of the Act (which imposes criminal liability on directors who approve accounts that do not comply with the Act), every director of a company at the time accounts are approved is taken to be a party to their approval unless he can show that he took all reasonable steps to prevent their being approved. No such steps had been taken. Although section 233 was not strictly relevant, the Court of Appeal considered that it illustrated Parliament’s intention that "a director cannot escape responsibility for the accounts of a company of which he is a director at the time when they were approved by mere inactivity". Even if the father had not known of the loans made to his son until February 2001 (which on the evidence was doubtful), in July 1999 he had been a member of the board that had approved the 1997 accounts, which contained a clear reference to illegal loans. He was therefore taken to have become aware of those loans when the accounts were approved on 27 July 1999.

Whilst the father may not have had actual knowledge of each individual loan made to his son at the time it was made, from 27 July 1999 at the latest he had been aware that a practice had arisen and was continuing. In the Court of Appeal’s view:

Having become aware of the practice, the father had taken no steps (or only very cursory steps) to cause the company to call in the outstanding loans. This was despite the fact that the loans were expressed to be repayable on demand, and that through his shareholding the father controlled the company.

As a result:

• Under section 341(2)(b) of the Act, the father was jointly and severally liable with his son to indemnify the company for all amounts loaned to the son after 27 July 1999 (some £560,000 at least); and

• Under section 212 Insolvency Act 1986, the father was liable for misfeasance in having breached his duty to the company by failing "to take the steps which (plainly) were open to him to cause the company to call in the indebtedness outstanding at 27 July 1999". The amount due from the father would be the difference between what the company could recover now (apparently nil) and the amount it could have recovered if it had called in the loans immediately after 27 July 1999 (perhaps as much as £870,000).

Separate proceedings brought by the Insolvency Service of the DTI culminated in January 2005 in both Avo and Krikor Krikorian being disqualified from acting as directors of any UK company for eight years. One of the main grounds for disqualification was that they caused or allowed Unigreg to enter into transactions to the detriment of creditors and in breach of the Act by permitting dividends to be paid, and loans and remuneration to be drawn by themselves, during the period from late 1997 to 18 July 2001.

This case is a reminder that:

• Every director is legally responsible for statutory accounts that are approved by the board while he is a director, even if he does not personally sign the accounts or even attend the board meeting at which approval is given. If a director believes that the accounts do not comply with the Act, or otherwise contain an irregularity, he must speak up and take all the steps he reasonably can to ensure that the error or irregularity is sorted out. He should ensure that his concerns and any follow-up steps are minuted.

• Every director will be taken to have knowledge of the contents of accounts for which he is legally responsible. If they clearly reveal practices or transactions that are illegal, such as loans to other directors, or if a director becomes aware of such things at any time, he must make further enquiries and take all reasonable steps to rectify the position as soon as possible – even if the irregularities occurred before he joined the board. Failure to do so could mean that the director himself will be personally liable to make good any loss that the company suffers. It is unlikely to be a defence to show that he did not himself know the precise details of the illegal activities.

For further information, refer to: Neville (as administrator of Unigreg Ltd) and another v Krikorian and others [2006] EWCA Civ 943

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 11/09/2006.