Given the current pressure all businesses face dealing with the effect of Covid-19, it is important that directors understand what their duties are in respect of insolvent companies or companies that are at risk of heading towards insolvency.

In this blog we briefly remind directors what their duties are, the potential claims that could be brought against them in the event of insolvency and how they might arise.  To mitigate against these risks it is critically important that directors:

• have a business plan;
• meet and regularly review the ongoing financial position and progress of the business plan;
• review carefully any relevant transactions for which particular consideration should be given;
• keep and maintain regular minutes of all meetings and decisions taken (including the rationale for such decisions)
• take and follow professional advice from insolvency practitioners and lawyers and engage with their funders and
• are able to justify their continuing belief in the merits of continuing trading.

Directors Duties and Covid-19

As matters stand, what is set out below represents a snapshot of the law relating to directors duties but there is a huge raft of case law interpreting and applying the law and principles behind it. What is unclear is how the law may change, or be interpreted and applied differently, to take into account the impact of Covid-19. Given the potential catastrophic consequences of Covid-19, both personally and professionally, it would be no surprise for there to be some relaxing of the law to take into account the fact that we are currently experiencing unprecedented turmoil on a global scale. A relaxation of this nature would certainly be in keeping with recent announcements made by the UK government to mitigate the impact of Covid-19 but currently, the below, represents the law as it is today.

Directors’ Duties in Insolvency

Every director of a company owes individual statutory duties to that company. Generally and whilst the company trades solvently, the directors must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole.

If the company becomes insolvent, whilst these statutory duties are still owed legally to the company, they become subject to other interests to which the directors should have regard, such as those of the creditors of the company.

Who is a “Director”?

The law makes no distinction between executive and non-executive directors or shadow and de facto directors. All directors must exercise reasonable care, skill and diligence which is tested on an objective and subjective basis. This means the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may be reasonably expected of a person carrying out the functions carried out by a director (objective test) and the general knowledge, skill and experience of that particular director (subjective test).

When is a Company deemed to be Insolvent?

If a company cannot meet all its present and due payment obligations, the company is likely to be insolvent on a cash flow basis (i.e. it is unable to pay its debts when they fall due).

If the value of a company’s assets is less than the amount of its liabilities (taking into account its contingent and prospective liabilities) it is likely to be balance sheet insolvent.

Within these two tests of insolvency, there is much case law (recent and historic) beyond the scope of this note setting out exactly what must be taken into account.

Wrongful Trading: what happens if a company continues trading while it is technically insolvent?

If the directors of a company continue to trade in circumstances where they knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into administration or insolvent liquidation, then they may be liable for wrongful trading under section 214 of the Insolvency Act 1986 (“IA 1986”).

Whilst there is no statutory prohibition against a company trading whilst insolvent, there is a risk that the directors could be personally liable to contribute to the assets of a company if such trading increases the net deficiency to creditors.

In order to avoid liability for wrongful trading, the directors would need to show that either

(1) having regard to information available to them and the standards of skill and care expected of them, there was a reasonable prospect of avoiding administration insolvent liquidation and/or

(2) they took every step which they ought to have taken with a view to minimising the losses to creditors.

If the directors are found to be liable for wrongful trading, the starting point for the quantum of any damages award against them is the amount by which their decision to continue trading has increased the net deficiency to creditors.

Challengeable Transactions

Certain transactions that take place at a time when a company is insolvent, or if the company becomes insolvent as a result of the transaction, are open to challenge by an appointed insolvency practitioner if the company subsequently enters a formal insolvency procedure.

To the extent that directors are responsible for such transactions, they can be held personally liable for any loss suffered by the company as a result of the transaction as a potential misfeasance and under specific statutory provisions of IA 1986 (some of which are set out below).

Unlawful Dividends

A director who authorises the payment of a dividend that contravenes the provisions of the Companies Act 2006 may be in breach of their duties and may be personally liable to repay the company for any loss suffered, even if the director is not a shareholder. The recipient of the unlawful dividend may also be liable to repay any unlawful element of the dividend he/she received if they had knowledge it was unlawful.

Transactions at an Undervalue (s238 IA 1986)

A transaction will be at an undervalue (within the meaning of IA 1986) if:

1. it is a gift by the company or the company receives no consideration for it or
2. the value of the consideration received by the company (in money or money’s worth) is significantly less than the value of the consideration given by the company in the transaction.

Any such transactions taking place within two years of formal insolvency will be open to challenge, provided they took place at a time the company was insolvent or became insolvent as a result of the transaction. Insolvency is presumed if the transaction was with a “connected” person.

However, the transaction will not be capable of challenge if:

1. it was done in good faith for the purpose of carrying on the company’s business and
2. the directors had reasonable grounds for believing that it would benefit the company.

A “connected person” is a director, shadow director or associate of such director or shadow director or an associate of the company.

Preferences (s239 IA 1986)

A preference is given to a person where a company does anything which has the effect of putting that person in a better position than it would have been in if the transaction had not occurred and the company subsequently proceeds into insolvent liquidation or administration. A preference is open to challenge if the company proceeds into formal insolvency within 6 months of the transaction in question, if the creditor is not a connected party, and within 2 years of insolvency if the creditor is connected.

In order to be a preference, it must also be shown that the company was insolvent at the time the preference was given or became insolvent as a result of the transaction. Insolvency is presumed if the creditor is connected to the company (see above). Furthermore, it must be shown that the company was influenced by a desire to give the creditor the preference. A desire to prefer is presumed for preferences given to connected creditors but it can be rebutted by evidence.

Often, decisions have to be made on a daily basis during cashflow difficulties as to which creditors to pay. In such circumstances, the directors should consider the following:

1. is the payment necessary for the continued operation of the business, and therefore necessary to preserve the reasonable prospects of a going concern survival and payment in full to creditors, i.e. is the payment business critical? This may include payment to key suppliers of goods and/or services where such supplies are critical and cannot easily be resourced elsewhere at the speed and price required;
2. is the payment necessary to avert action being taken by the creditor which may prejudice the survival of the business? If payment is made under threat of winding up proceedings or other legal proceedings which the company cannot defend or afford to defend, or to avoid distraint on goods, it is unlikely to be considered a preference.

Directors’ Remuneration, Expenses and Employees

If the company is continuing to trade on the basis that the board holds a reasonable belief that the company will avoid insolvent liquidation or administration and pay all creditors in full, it would be unwise if, at the same time, significant arrears of expenses and remuneration are discharged when other unconnected creditors are not being paid.

However, directors under a contract of employment are employees and if they are a critical requirement to ensure the company is managed through a period of financial distress, ongoing payments of remuneration and expenses may well be justified to ensure the directors’ continued services to the company.

Employees will usually be a necessary part of continuing to operate the business so provided there is a reasonable belief that continued trading is in the best interests of creditors, payments of wages/salaries to key employees can usually be justified.

Other Offences under the IA 1986

The other main offences which will be investigated by the appointed insolvency practitioner in the event that the company proceeds into formal insolvency are:

• fraudulent trading (s213 IA 1986) – it is an offence to knowingly carry on the business of a company with intent to defraud creditors and any person who does so may be ordered by the Court to make such contributions to the company’s assets at it thinks fit and
• misfeasance or breach of fiduciary duty (s212 IA 1986) – it is an offence for a director of a company to have misapplied or retained or become accountable for any money or other property of the company or been guilty of an misfeasance or breach of fiduciary duty in relation to the company. If a misfeasance has taken place by a director the Court has the power to order him to repay, restore or account for the money or property together with interest or contribute to the company’s assets by way of compensation.

Directors Disqualification

Where a company proceeds into formal insolvency, the appointed insolvency practitioner has a duty to report to the Secretary of State on the conduct of each of the directors and former directors of the company. The Secretary of State must then decide whether to bring proceedings against the directors (or any of them) to disqualify them from acting as a director or in the promotion, formation or management of any company on the grounds of unfitness, for a period between 2 to 15 years.

If it is not possible to effect a solvent turnaround and/or disposal and a company proceeds into formal insolvency, the directors’ conduct as directors (particularly at the time of financial distress) will be subject to scrutiny.