This is the second article in a series of articles looking at insolvency in the construction industry. This article focuses on directors' duties generally, how those duties are impacted by insolvency, the types of claims that can be made against directors where their companies become insolvent, and what steps can be taken to reduce the risk of being exposed to such claims.
The issue of insolvency in the construction industry has become very real following the lifting of the temporary pandemic protections, rising costs of operation and borrowing, global supply chain issues, economic uncertainty and interest rate rises. Red Flag Alert has expressed concern that more than one hundred building firms will enter a formal insolvency proceeding every week in 2023. Given this potential exposure, it is vital that directors understand the fiduciary duties they owe their companies.
Who are Directors?
For the purposes of the Companies Act 2006 (the "CA2006") and the Insolvency Act 1986 (the "IA1986"), the word "director" covers "any person occupying the position of director, by whatever name called". The definition includes de jure directors (directors that have been formally appointed as such), de facto directors (people who assume responsibility to act as a director although they have never been formally appointed) and shadow director (people in accordance with whose directions or instructions the directors of the company are accustomed to act).
Directors' Duties and Insolvency
Like all directors, directors of construction companies owe fiduciary duties to their companies and are trustees of company assets. Directors who breach their duties or who deal with assets without reference to their companies face personal claims for all associated losses. When a company becomes insolvent, the duty to act in the best interest of the company is supplanted by a duty to act in the best interests of the company's creditors, and the directors must take all reasonable steps to protect the financial interests of the company's creditors, if they want to escape personal liability.
What Duties do Directors Owe?
The CA2006 sets out the general common law and equitable duties of directors. A breach of any of these duties will potentially give rise to a claim by the Company (or derivatively, its shareholders) against the errant director personally. The duties are as follows:
- To act within their powers. Directors must familiarise themselves with, understand and act in accordance with the company's memorandum and articles of association to ensure that they do not act beyond the scope of their authority.
- To promote the success of the company. This means that directors must remain mindful of the consequences of their decisions, the interests of their employees, the need to support business relationships with suppliers and customers and other third parties, the impact of the company's operations on the community and the environment, the company's reputation for high standards of business conduct and the need to act fairly to all members of the company.
- To exercise independent judgment. Directors must not allow other people to control their powers as a director. It is perfectly fine for directors to accept advice, but it is for the directors to use their own independent judgment to make final decisions.
- To exercise reasonable care, skill and diligence. Directors must perform their functions and exercise their powers to the best of their ability and the more qualified and experienced they are, the greater the standard expected of them will be. This means that they must use any relevant knowledge, skill or experience they have, including professional experience.
- To avoid conflicts of interest. Directors must avoid situations where their loyalties might be divided, including with their families and other personal or business interests. If there is a conflict or potential conflict of interest, the director must tell his or her fellow directors about it and follow the process set out in the company's articles of association. This duty also applies after directors resign from office when they must not take advantage of any property, information or opportunity that they became aware of as a director.
- Not to accept benefits from third parties. Directors must not accept benefits from third parties without the knowledge and approval of their fellow directors.
- To declare any interest in a proposed transaction or arrangement with the company. Directors are under a positive obligation to tell their fellow directors and shareholders if they will or might benefit from any transaction their companies enter into.
These general duties are supplemented by numerous other duties which, similarly, expose directors to the prospect of personal liability both under the CA2006 and the IA1986 and under a wide variety of other laws and regulations, such environmental and health and safety legislation.
How are Directors Exposed in Insolvency?
Directors of companies that are facing financial difficulties and which go into insolvent liquidation and insolvent administration face potential claims and may face criminal liability. The rest of this article briefly considers the principal claims that are made against directors and identifies various further offences under the IA1986. As relevant, directors should take professional advice as soon as possible to protect themselves, their companies, the company's shareholders and the company's creditors:
- Wrongful Trading. If a liquidator or administrator is appointed over a company, the liquidator or administrator is bound to review the actions that the directors took before they were appointed. If it appears that a director knew or ought to have concluded at some point before the commencement of the liquidation or administration that there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the liquidator or administrator can seek an order requiring a director to contribute towards the assets of the company for the benefit of its creditors.
- Fraudulent Trading. If, during the currency of a liquidation or administration, it appears that any business of the company has been carried on with the intent to defraud creditors, or for any other fraudulent purpose, the liquidator or administrator can seek a court order requiring any person who was knowingly party to the fraudulent business contribute to the company's assets. Fraudulent trading is also a criminal offence.
- Misfeasance or Breach of Fiduciary Duty. If, in the course of winding up, it appears that a current or former director has misapplied or retained, or become accountable for any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty, the court may order the director to repay, restore or account for the money or property with interest or contribute to the company's assets by way of compensation.
- Reviewable Transactions. Creditor pressure on an insolvent company may lead directors to cause their companies to take steps to alleviate the company's trading problems, which amount to reviewable transactions thereby exposing the directors to claw back claims if the company goes into liquidation or administration. Such transactions may include, for example: (a) granting security to an unsecured creditor supplier in respect of debts incurred for goods previously delivered; (b) acceding to new supply terms from an existing supplier on more onerous terms; (c) granting new security to an existing lender in respect of the same debt; (d) paying preferred unsecured creditors ahead of other unsecured creditors; (e) the making of severance payments to senior employees or directors; (f) causing the company to repay a debt that has previously been guaranteed by a director; and (g) making a gift of company assets.
- Director Disqualification. A disqualification order must be made against a director of a company that goes into liquidation or administration if that person's conduct as a director makes him or her unfit to be concerned in the management of a company (including where the director in question has been found liable for fraudulent or wrongful trading). If a director is disqualified from acting, he may not be a director of any company or in any way, directly or indirectly, be concerned or take part in the promotion, formation or management of a company for a period specified in the disqualification order without the Court's permission The minimum disqualification period is two years and the maximum is fifteen years.
Additional Fraud and Misconduct Offences under the IA1986
There are various further offences under the IA1986, which give rise to criminal liability and need to be taken extremely seriously. These include the following:
- Fraud in Anticipation of Winding Up.
- Transactions in Fraud of Creditors.
- Misconduct in the Court of Winding Up.
- Falsification of the Company's Books.
- Material Omissions from Statement Relating to the Company's Affairs.
- False Representation to Creditors.
How can Directors Protect Themselves?
- Board meetings. If the company is in financial difficulties the directors should call regular full board meetings and ensure that all commercial decisions are recorded in full in the company's minutes. It is also important that the directors reach their commercial decisions independently based on current financial and legal information available to them.
- Current financial information. To be best placed to exercise their commercial judgment and to ensure that the directors discharge the fiduciary duties that they owe their companies, they must ensure that they are working with current financial information. The directors should not wait for an external event (such as the issue of a winding up petition) to alert them to the company's possible insolvency. In this way directors can make sure they are monitoring compliance with financial covenants in contracts with third parties, including lenders.
- Take advice. As soon as a director becomes at all concerned that there may be no reasonable prospect of avoiding insolvent liquidation or insolvent administration, he or she should raise this with the board with a view to taking immediate, independent legal or financial advice from an appropriately qualified professional. At this point directors should be taking every possible step to minimise any potential loss to creditors. If they fail to take such steps they could find themselves being sued personally for creditor losses. It is clear from decided cases of the English Courts that any claim by directors that their knowledge, skill and experience was "hopelessly inadequate", will not protect them from liability for wrongful trading.
- Cease trading. Liability for wrongful trading cannot arise unless the company continues to trade whilst insolvent. It follows that ceasing to trade before this time reduces the risk of liability being established, particularly where the directors take steps to minimise creditor losses. This can give rise to tensions between creditors (who want the company to continue to trade) and directors (who want to avoid liability) and will require careful management. Borrowing money from secured creditors on normal commercial terms to enable the company to continue to trade should have no effect on the company's net asset position and should, therefore, have no direct impact on wrongful trading considerations. A company can simply cease to trade but unless the company is solvent and can pay off its debts (including actual, contingent and prospective debts), in order to protect themselves, the directors should cause the company to implement a formal insolvency procedure.
- Resignation. Directors cannot avoid liability by resigning and the Courts are likely to see resignation as a director's abrogation of responsibility. However, where a director forms the view that there is no reasonable prospect of the company avoiding insolvent liquidation or administration but is unable to persuade the board to that view, this may justify resignation. In these circumstances the director should seek independent advice, have his or her concerns noted in board minutes and communicate these concerns to the board in writing.
Issues surrounding directors and insolvency are complicated. The above provides only a broad outline of a number of the principal issues that directors should have in mind if their companies are insolvent or they form the view that their companies may become insolvent. Directors are strongly encouraged to take timely advice from appropriately qualified professionals to minimise the chances of civil, criminal and/or director disqualification proceedings being taken against them. As appropriate, please feel free to reach out to your usual Spencer West contact for more information and advice.
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.