These are extremely difficult times to be running a business. We are still in the midst of a pandemic, the costs of importing goods are rising, the cost of energy is exponentially increasing and many lifelines or support mechanisms provided during the height of the pandemic have been taken away. It is fair to say that some businesses are feeling the strain.
But what if the strain becomes too much? Directors need to understand their duties and responsibilities when a company is in distress (or even before).
What duties do directors have?
As a rule, a director's duty is owed to the company and its shareholders. The Companies Act 2006 has codified the main ‘general' duties of any director, namely to:
- Always act within their powers.
- Act in the best interests and promote the success of the company.
- Exercise independent judgement.
- Use reasonable care, skill and diligence.
- Avoid conflicts of interest.
- Not to accept benefits from third parties.
- Declare any interest in a proposed transaction.
But how do these duties change when directors become aware that a company is facing financial difficulty? Set out below are a few key points a director should consider when a business is feeling the strain (these are not exhaustive).
Who are duties owed to?
When a company is or is about to become insolvent, a director's duty is primarily to act in the best interests of the company's creditors. This duty applies to the creditors as a whole i.e. the duty is owed to all creditors equally.
The Court of Appeal recently confirmed that this shift in duties occurs not only on insolvency but a period prior to insolvency if the directors knew, or ought to have known that insolvency was a probability. It is crucial therefore that directors think carefully about how they manage a company's assets when it is on the brink of insolvency.
When insolvency is on the horizon, directors must act in a way which does not worsen the creditors' situation. Directors cannot dispose of any of the company's assets or make any payments to shareholders if provisions for the interests of the creditors have not been made.
Many directors fall into the trap of believing that they may be able to trade their way out of financial difficulties. However, if a director continues to run the business and in doing so incurs liabilities when they know (or ought to have known) that there was no reasonable prospect of avoiding insolvency, then they run the risk of ‘wrongful trading' where their actions have left the company worse off. To avoid this, directors need to be able to establish that they have taken every reasonable step to minimise the potential loss to the company's creditors.
Directors may be held personally liable for the company's debts from the point they knew the company was insolvent and may also face disqualification, fines or even imprisonment.
Transactions at an undervalue
Directors should also be aware of the risks of disposing of assets of the company for significantly less than their market value when the company was insolvent or became insolvent as a result. The insolvency legislation concerning transactions at an undervalue can apply as far back as two years for certain transactions. Falling foul of these provisions could lead to these transactions being set aside or reversed.
Care should also be taken in relation to payments or a transfer of assets which might constitute a preference in favour of one creditor over another. A director's duty to the company's creditors relates to the creditors as a whole and therefore creditors must be treated equally. If it can be proved that the directors, in entering into a particular transaction, were influenced by a desire to produce the preferential effect to a creditor the transaction may be set aside. This can apply to transactions which took place up to two years prior to insolvency.
An action can also be brought against a director for misfeasance or for a breach of a director's duty to the company. The offence of misfeasance includes amongst other things, improper payments of dividends and unauthorised loans or payments. A guilty director may be ordered to restore or account to the company for any money or property personally.
The obligations on directors when a company is facing insolvency are significant. A director of a company in financial hardship cannot simply resign and wash their hands of their responsibilities, as the above duties will apply at the time an individual was a director regardless of whether they still are. Directors must take positive steps to resolve the situation and taking professional advice at the earliest possible stage is strongly advised, even if it ultimately puts the company in the hands of an insolvency practitioner. Failure to take proper advice at the right time may result in personal liability for the directors.
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.