Directors’ Duties and Insolvency

We previously looked at company voluntary arrangements (“CVAs”) off the back of BHS entering a CVA; however, with that company subsequently entering administration and facing liquidation, and the significant public scrutiny of the directors’ conduct in the lead-up to the company’s failure, our attention turns to directors’ duties and possible pitfalls when faced with insolvency.

Directors are under various duties as dictated by case law and statute; specifically ss.171-177 of the Companies Act 2006 codifies the following duties:

• to act within powers
• to promote the success of the company
• to exercise independent judgement
• to exercise reasonable care, skill and diligence
• to avoid conflicts of interest
• not to accept benefits from third parties
• to declare interest in proposed transactions

However, when faced with insolvency, the responsibilities and duties that fall on directors are expanded in order to ensure that creditor positions are protected. Failure to meet these obligations can result in severe repercussions for directors, and it is therefore important for directors to be armed with sufficient information and guidance.

Initially, directors should be aware of what constitutes formal insolvency. S.123 of the Insolvency Act 1986 (“IA86”) defines when a company is insolvent via two tests. The first is that a company is insolvent when it unable to pay its debts as and when they fall due, often shown by way of a Court judgement or statutory demand remaining unsatisfied after a set period; this is also known as the ‘cash flow test’.

The second test is where it can be shown to the satisfaction of the Court that the value of the company’s assets is less than the amount of its liabilities; this is also known as the ’balance sheet test’. In practice, however, there will be numerous practical indicators of financial difficulties that should not be ignored.

A liquidator or administrator must make a report to the Department of Business Innovation and Skills on the conduct of all directors who have served within the three years prior to the onset of insolvency. Depending on the content of this report, it is possible that directors may face disqualification proceedings under the Company Directors Disqualification Act 1986.

One of the most important potential offences of which directors should be aware is detailed in s.214 of IA86; that of ‘Wrongful Trading’. In simplified terms, if at some time prior to the commencement of administration or liquidation, a director of a company knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, and yet continued to trade, he may be guilty of Wrongful Trading.

If a director is convicted under this s.214, then the Court may declare that person to be liable to make such contribution to the company’s assets as the Court sees fit. This ‘piercing of the corporate veil’ of limited liability is a significant threat to directors who may well have had the best of intentions in continuing to trade. It is therefore important to ensure that directors take every possible step pre-emptively to negate any possible allegations of wrong-doing when faced with potential insolvency.

Practical steps to take when facing possible insolvency:

• Speak with your accountant
• Take advice from an insolvency practitioner
• Hold regular board meetings and keep minutes thereof detailing decision making processes
• Regularly review management accounts and monitor the company’s financial position on an ongoing basis
• Contemporaneously record the rationale behind any significant decisions
• Ensure that no assets are sold or transferred for less than market value
• Ensure that no one creditor is ‘preferred’ to other creditors, and that goods or services are not obtained by taking on further credit
• Do not use an overdrawn bank account
• Do not supply any good or services should on credit to any party who may have a potential claim against the company
• Ring-fence deposits taken from customers

Based on the complexity of the law in this area and the potential for director conduct to be challenged, it is imperative that directors seek professional advice at an early stage when faced with potential insolvency. If you have any queries about the content of this article or wish to receive further information about any insolvency query, please do get in touch with one of our experts who will be happy to assist.