Directors face hidden dangers in insolvency Twilight Zone

25th March 2020 | Leigh Head | Corporate and Commercial, Business

UK businesses are in an extended period of uncertainty, and corporate insolvencies are at their highest since 2014, according to the Insolvency Service. The impacts are most visible on the high street where news of established brands going under is... Read more

UK businesses are in an extended period of uncertainty, and corporate insolvencies are at their highest since 2014, according to the Insolvency Service. The impacts are most visible on the high street where news of established brands going under is a regular occurrence.  This is, unfortunately, only going to be accelerated by Covid-19 and the current marketplace we are all in, despite the Government’s best attempts and financial stimulus packages.

Directors of limited companies take comfort in the fact that their liability is just that – limited. But many do not realise that they can incur personal liability in the period when their business is hurtling towards insolvency – the so-called twilight zone.

The dangers lie in the seven general duties of directors in the Companies Act 2006. These are to:

1. act within your powers
2. promote the success of the company for the benefit of its members as a whole
3. exercise independent judgment
4. exercise reasonable care, skill and diligence
5. avoid conflicts of interest
6. declare your interest in any proposed or existing transactions or arrangements with the company; and
7. not accept benefits from third parties.

These duties are important in insolvency proceedings, such as liquidation or administration, because breaches of those duties can enable insolvency practitioners to pursue an offending director for a greater recovery for the company’s creditors.

Many directors do not realise that their duties to a company change during, and as the company approaches, insolvency. This shifts the focus away from protecting the shareholders’ interests towards the creditors’ interests. The danger is that it is not clear when this twilight zone begins.

Considering the testing time that we are in, it is now more imperative than ever that businesses carefully document their decision-making processes through minutes of board meetings (also considering the impact of daily briefings from Number 10 and supporting expert advice from the company’s accountants and legal advisors); updated cash flow forecasts supplemented by the Government-backed loan and/or other stimulus support over a reasonable period; as well as any cash flow models or plans to return to profitability when ‘normal’ trading returns.  All of this information may well justify the continuation of trade and assist any directors facing potential action from insolvency practitioners.

There are three risks that all directors need to be aware of and consider carefully – these are wrongful trading, fraudulent trading, and misfeasance

Wrongful trading

The liquidator or administrator has the power to pursue a director (including statutory director,  de facto director, or a shadow director) for wrongful trading a. Those who exercise control over the company are at risk even if they are not formally appointed at Companies House, so it is not necessarily a defence to argue that a person exercising such control was not a statutory director.

To prove wrongful trading, it must be shown that at some point before the start of formal insolvency proceedings, the director knew or ought to have known that there was no reasonable prospect of avoiding an insolvent liquidation or administration; and that they failed to take every step to minimise further losses to creditors.

Indicators that a director should be aware of a company’s impending insolvency could include:

• company accounts showing liabilities exceeding assets
• proceedings against the company for unpaid sums
• failure to meet sales or cash flow targets or forecasts
• banks calling in or refusing to extend overdrafts
• suppliers refusing to make deliveries or provide services until outstanding invoices are settled.

The court has a wide discretion to determine the extent of a director’s liability when they are found guilty of wrongful trading, which is usually in the form of a financial contribution order. Where the court orders a contribution against a director, it also has discretion to disqualify that director, potentially for 15 years.

Fraudulent trading

Fraudulent trading imposes liability where a company suffers loss caused by continuation of the business with the intent to defraud. The key difference between wrongful and fraudulent trading, therefore, is that liability requires intent to defraud creditors.

Dishonesty involving moral blame must be proved. Dishonesty is assessed on a subjective basis and only what the director knew or believed is relevant. There is therefore a higher standard of proof than for wrongful trading.

A director found liable for fraudulent trading can be ordered to make a financial contribution, which should compensate for the loss caused to the creditors. The court can also disqualify the director. Additionally, a person who is knowingly party to fraudulent trading can receive criminal sanctions, regardless of whether the company is being wound up. These sanctions can include imprisonment of up to 10 years; a fine; or both.

Misfeasance

Misfeasance is a much broader offence and reflects the common law principle that a company can claim against its directors for breach of duty. It is, some say, a “catch-all” provision.

Misfeasance covers the whole spectrum of directors’ duties and therefore includes:

• misapplication of any money or assets of the company
• breach of statutory duty such as unlawful loans to a director or entering into transactions at an undervalue
• breach of the duty of skill and care.

A director found guilty of misfeasance must pay damages to compensate the creditors as a whole, and not any one particular creditor.

As is our continuing guidance during this difficult time the first step is not to make a snap decision. The Government has already committed significant resource to assist businesses during this period, most of which has already started or is likely to be in force during early April.It is highly likely that there will be more assistance to come.

In the face of the economic downturn, the need for directors to understand their duties – and how to fulfill their obligations and minimise potential liabilities – is increasingly important.  However, it is possible that the Government may take action to relax the Insolvency Laws in view of the Coronavirus pandemic.

To find out more, click here to contact Leigh Head.