Directors always operate under their overriding fiduciary duty to act honestly and in good faith and their duty to exercise skill, diligence and care. However, specific duties and potential liabilities arise in the context of any possible insolvency. In particular, whenever questions arise about the solvency of a company, it is necessary to ensure that the company does not:
- Unfairly incur new debts and obligations which it will not be able to meet; or
- Engage in transactions which further prejudice its ability to meet its obligations.
As under the old Act, the court can impose personal liability on directors, officers and others for continuing to trade fraudulently or in reckless disregard of whether the company is able to meet its liabilities. The Act also prohibits specified transactions where a company does not satisfy various prescribed solvency tests. Directors who authorize any such transaction are exposed to personal liability. They therefore need to be able to:
- Recognize those transactions which are prohibited unless the relevant solvency test is met;
- Ensure that the appropriate solvency test is properly applied; and
- Take all available steps to minimize their own exposure to personal liability.
Unless the company can pass the relevant solvency test, the Act prohibits certain transactions. These are:
a) Making a payment to purchase, redeem or otherwise acquire the company's own shares;
b) Reducing the stated capital, except for the purpose of declaring its stated capital to be reduced by an amount that is not represented by realizable assets;
c) Paying a dividend;
d) Providing financial assistance (including loans and guarantees):
e) Paying to a shareholder any sum ordered in an action commenced to remedy "oppression".
- to a shareholder, director, officer or employee of the company or any associated company or to any associate of such person, or
- to anyone for the purpose of, or in connection with, the purchase of shares of the company or an affiliated company; and
Each of the solvency tests is in two parts. For example to pass the solvency test prescribed for the payment of a dividend, the company must be able, after the payment of the dividend, to meet its liabilities when they become due; and the realizable value of its assets must exceed the aggregate of its liabilities and stated capital. The first limb of each of the solvency tests is the same. However, the second varies depending upon which of the transactions is being considered. Directors need information to avoid trading while insolvent and to apply the entire range of solvency tests imposed by the Act. They should:
- See that the company's books are kept in accordance with modern accounting standards;
- Ensure that they are kept informed of the company's financial situation by an officer of the company on whom they can reasonably rely;
- Identify the key factors which could lead to insolvency; and
- Ensure that they are informed as soon as possible about changes which have occurred, or may occur, in relation to those key factors.
If a director believes that the company may be, or may become, insolvent he should also:
- Check that all steps have been taken to protect the directors by obtaining appropriate indemnities and insurance cover;
- Take immediate steps to get the information and professional advice necessary to decide whether to continue trading;
- Ensure that no specified transaction is approved unless the company passes the appropriate solvency test;
- Consider whether or not to resign, weighing the risks associated with resignation against the benefits;
- Bear in mind that he can protect himself from liability by relying in good faith on the company's financial statements represented to him by a company officer and on a report of a professional (including an attorney, accountant and appraiser); and
- Consider whether a USA can be used to protect the directors from liability.
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.