Directors duties: what are they on insolvency, and how can a director avoid personal liability for breach?

Last updated: 12 May 2021

Estimated reading time: 9 minutes

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Directors of a solvent company owe their main duties to the company and the shareholders of the company. These are generally set out in the Companies Act legislation. However, when a company comes close to insolvency or becomes insolvent, then the duty changes so that the directors’ main concern must be to the company’s creditors instead.

In a complex legal landscape, understanding your obligations and liability as a director is a must. To help, we have assembled a set of answers to insolvencies most pertinent legal questions.

What Is Insolvency?

Insolvency is when a company is unable to meet its debts when they are due, or if the company is balance sheet insolvent. Once their duties change from company to creditors, directors must be particularly cautious, as breach of any of these duties can lead to personal liability in the event the company goes into formal insolvency. It can also lead to disqualification as a director. It is therefore vital that directors are aware of the risks they face, and how to avoid these.

Here we explain the duties that are on directors personally once a company starts to face financial difficulties. We also explain how a director can avoid breaching these duties.

Do all directors owe duties to creditors?

All directors, of whatever name or rank, owe duties equally. This includes non-executive directors, as well as non-registered directors who either hold themselves out as directors (de facto directors) or others who take a controlling hand in the company but are not registered (shadow directors).  Even directors who have resigned may be at risk for some transactions carried out before they resigned.

Insolvency legislation contains the majority of duties required and covers a number of areas of potential misconduct on the part of a director of a company, either prior to or while the company is insolvent. We set out below some of the most common areas that a director should be aware of.

What happens if you breach these duties?

If a company goes into a formal insolvency process, such as liquidation or administration, then the insolvency practitioner (IP) appointed over the company will investigate events and circumstances leading up to the company’s insolvency.  If it looks like directors of the company have acted incorrectly and to the detriment of the company’s creditors, then they can take action to claw back property disposed of improperly and restore the company’s position.

Who can bring a claim against you?

Traditionally a claim could only be brought by the IP responsible for the formal insolvency process, but over the past few years the law has changed so that certain claims can be assigned by the IP to a third party. This change has increased the risk of a claim being brought, because where an IP may not have had the financial means or the motivation to bring a personal claim against a director, a creditor may have better funding, and more motivation to bring a personal claim.

What is wrongful trading?

This is where the director knew or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent liquidation or insolvent administration, and they failed to take every step after this point to minimise the further potential loss to the company’s creditors.

If a director is guilty of this then they may have to repay the increase in creditor claims that arose between the time they should have stopped trading and instigated a formal insolvency process, and the time they actually did so. This can be financially very onerous

What is fraudulent trading?

Similar to wrongful trading, but the continued trading was carried on with the intent to defraud its creditors, or for any other fraudulent purpose. It involves an element of dishonesty.

Anyone found to have knowingly participated in the fraudulent activity can be asked to pay compensation into the company’s assets as the court thinks fit, and pay a sum by way of a penal measure. Fraudulent trading is both a criminal and a civil offence, so could potentially invoke criminal sanctions.

What is preference?

Preference proceedings can be taken when the company does something which has the effect of putting a creditor into a better position than he would have been had the preference not taken place, and the company was influenced by a desire to prefer that creditor over other creditors. For example, a director of an insolvent company can be accused of making preference payments to a creditor, at a time when other creditors may go unpaid.

‘Desire’ is presumed if the creditor in whose favour the preference was given was connected with the company at the time. A director will be connected with the company, for example.

 The preference must have occurred within the ‘relevant time’. In the case of a connected person, this is within two years of formal insolvency, or in the case of an unconnected person, within six months.

A preference claim might occur for example where directors see the writing on the wall and repay themselves or their family monies owed to them by the company before the company goes into an insolvency process. This money can be clawed back either from the recipient or the director. Another example may be where a favoured supplier who is earmarked to continue to supply in the director’s new venture is treated more favourably, to the detriment of other creditors. Legal advice should be taken before undertaking any transaction that could be considered a preference as this could be a costly mistake. Learn more about our insolvency and business recovery services.

What are transactions at undervalue?

A transaction at an undervalue claim is where the company has disposed of an asset for no value, or at a significant undervalue. The person in receipt of the asset therefore gets the benefit of the asset to the detriment of the body of creditors.

The transaction must have been made at any time within two years of a formal insolvency.  For the claim to succeed, the company must also have been unable to pay its debts at the time of the transaction, or the transaction caused this to happen.

If the person who received the benefit of the transaction was a connected person, it is presumed as a transaction at undervalue. This however is still rebuttable.

The court will usually try to look at ways to put the company back into the position it would have been in had the undervalue not occurred, therefore the value of the undervalue will be requested to go back to the company for the benefit of creditors.

What are transactions defrauding creditors?

This is a transaction at an undervalue entered into for the deliberate purpose of putting assets beyond the reach of a person making a claim against the company (now or in the future). For example, if a legal claim is being brought against the company that is likely to succeed, a director might remove assets from the company in order to avoid having to pay the claim. This might involve repaying loans quickly, or moving money into a parent or subsidiary. The court can make any order that it sees fit to restore the situation.

What is misfeasance?

Misfeasance covers a multitude of ‘wrongdoing’ and is often brought along with one of the other claims listed above. It will often be used for breaches of general directors’ duties set out in companies legislation, and can include failure to file accounts or other such duties. 

If found guilty of misfeasance the court has wide discretion to order repayment of money or property with interest, and can also order compensation to be paid. 

What practical steps can a director take to protect creditors?

There are ways to avoid personal liability as a director, even in difficult times. If in doubt, take professional advice sooner rather than later. Below are some measures you can take to reduce your risk:

  1. As soon as you become aware of financial difficulties, discuss this with your board. If required, take independent professional advice on your position.
  2. To monitor the company’s financial position, hold regular board meetings. Ensure regular updated budgets, forecasts and management and trading accounts are reviewed; ideally weekly. All directors need to be aware of the realistic financial position. Keep detailed and accurate minutes of all discussions, particularly when making decisions on why a particular step was or wasn’t taken. These may be scrutinised later.
  3. Consider speaking to an IP early on the options for continuing to trade, and whether a recovery strategy or an insolvency strategy is necessary. They have a wealth of experience in this area and can provide invaluable advice on how to proceed. The sooner you take advice, the better your options.
  4. Take all steps to minimise loss to company’s creditors. This means you should not take on additional credit except for essential supplies to continue trading. However this should only be if carrying on trading the business is the best course of action for creditors, and you are confident they will be repaid. Again, if in doubt, take professional advice.
  5. Don’t incur further credit if it is unlikely the company can repay, do not issue cheques, or take customer deposits if it is unlikely the company can repay these.
  6. Communication with creditors is absolutely key. Creditors are more likely to be on side if they know your position and the steps you are taking to address the issue.
  7. Regularly keep in touch with lenders and key investors to make sure that there has not been any breach of any financial covenants. If there have, address this early on, and speak to your lenders about your options.
  8. Keep an eye on demands for payment. Never ignore legal proceedings served on the company. Speak to a specialist insolvency lawyer immediately if you receive a statutory demand or winding up petition.
  9. Don’t ignore your usual legal and regulatory requirements, including accounting and disclosure requirements. This can come back to bite you later.
  10. Don’t strike any deals with a particular creditor without taking advice on whether this might amount to a preference—this can include returning goods to a creditor when they do not have a validly retained title.
  11. Don’t repay directors’ loan accounts or pay off your overdraft if a personal guarantee has been given to the bank. This could be seen as a preference.
  12. If you are selling assets, get a proper market value. Don’t sell for less unless there is a compelling business reason for doing so. Make sure any transactions are explained in writing in the company records.
  13. Any director seeking legal advice on their position should do so with an independent solicitor, rather than the company’s own solicitor. It is possible, and indeed likely, that at some point a director’s personal liability may come into conflict with that of the company’s liability. To avoid any issues arising later on, it is advised to seek legal advice externally.

How we can help?

At Harper James we have a specialist team of insolvency lawyers with many years’ experience advising companies and directors in financial difficulties.  Now more than ever this is relevant to so many companies. If you are experiencing problems and are concerned about what to do, if creditors are pressing for payment, if you have received legal proceedings including a statutory demand or disqualification proceedings, contact one of our team today to discuss your options. A bad situation can be recovered if you take relevant advice early on.

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