Many businesses continue to face significant cash flow pressures due to ongoing issues surrounding the pandemic. Alongside the day-to-day concerns of running a business in these unprecedented times, directors need to be aware of their statutory and common law duties. Failure to discharge these duties may lead to civil, or even criminal, sanctions.
A director is required to exercise reasonable skill and care in the management of a company’s affairs. Ordinarily, a director is under a duty to act in good faith and in a way that is likely to promote the success of the company for the benefit of shareholders. However, when a company becomes insolvent, a director is obliged to act primarily in the interests of its creditors. This may involve placing the company into a formal insolvency process, such as liquidation or administration.
What happens if a company enters a formal insolvency process?
Once a company enters liquidation or administration (the most common corporate insolvency processes) a licensed insolvency practitioner will be appointed as liquidator/administrator to manage its affairs. They will investigate the circumstances leading up to insolvency, which can present the following risks to directors:
- Directors’ loan accounts/illegal dividends: It is common for directors of owner managed businesses to draw a monthly sum that builds up as an overdrawn director’s loan account (DLA) with the company. At the end of the accounting period, it is hoped a dividend can be declared and credited to the DLA. Be aware, this strategy will be flawed if the company enters a formal insolvency process as there will be insufficient distributable reserves to declare a lawful dividend. In these circumstances it is likely the liquidator/administrator will pursue the director for repayment of the unlawful dividend, as well as any other sums outstanding on the DLA.
- Antecedent transactions: Certain transactions may be set aside if they were entered into within relevant periods prior to the onset of insolvency. These include transactions at an undervalue e.g. writing off an overdrawn DLA without good cause, and preferences e.g. repaying a debt that has been personally guaranteed by a director in priority to the company’s other debts.
- Wrongful trading: Although wrongful trading liability has been temporarily suspended under the Corporate Insolvency and Governance Act 2020, this is due to end on 30 June 2021. Following this date, any director who allows a company to continue to incur liabilities at a time when he knew, or ought to have known, there is no reasonable prospect of the company avoiding insolvent liquidation or administration, may incur personal liability for the losses sustained by the company’s creditors – unless he took every reasonable step to minimise such losses (which is a high threshold to overcome).
In deciding whether a director ought to have known there was no reasonable prospect of avoiding insolvency, the court will judge by whatever is the higher standard of the general knowledge, skill and experience that he actually has, and the general knowledge, skill and experience which would be reasonably expected of someone in his position.
- Disqualification: Liquidators / administrators are obliged to report to the Insolvency Service on the conduct of all individuals who have been directors of an insolvent company within the previous three years. These individuals can be disqualified from acting as directors or managing or setting up companies if it is found their conduct makes them unfit to do so.
How do I know if a company is insolvent?
A company may be insolvent on either a cash flow basis i.e. unable to pay its debts as they fall due – or a balance sheet basis i.e. its assets are exceeded by its liabilities.
In practice, it may be difficult for directors to pinpoint the exact moment that the company became insolvent. Accordingly, directors should:
- Hold regular board meetings with the benefit of professional and legal advice to consider the company’s current financial position and ensure any decisions made at those meetings are appropriately minuted.
- Prepare up-to-date cash flow statements, management accounts and projections.
- Consider the implications of taking on additional credit (and deferring settlement of existing liabilities)
Shall I resign?
Resignation is generally frowned upon by the courts as it may be regarded as an abrogation of the director’s responsibilities.
Experience demonstrates that directors who act proactively in times of financial distress and seek professional and legal advice at the earliest possible stage, have the best chance of protecting themselves and preserving value for shareholders.
‘Sitting on the fence’ is never the answer and quite often increases the risk of personal liability for directors.
For further information and advice on directors’ duties and insolvency seek expert guidance as soon as possible.
I am currently offering a FREE 1-1 virtual meeting to discuss questions you may have including:
✅Options for restructure / rescue of a company in financial difficulties
✅Understanding ‘directors duties’ when a business is under pressure
✅Exploring avenues to safeguard your customers, your funders and your business.
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