When a limited company starts to face financial problems, its directors need to bear in mind a number of aspects of insolvency law:
Compliance with their duties under the Companies Act 2006
- S171 Duty to act within powers
- S172 Duty to promote the success of the company
- S173 Duty to exercise independent judgement
- S174 Duty to exercise reasonable care, skill and diligence
- S175 Duty to avoid conflicts of interest
- S176 Duty not to accept benefits from third parties
- S177 Duty to declare interest in proposed transaction
For many small business owners, this might be the first time anyone has pointed out these ongoing duties to them. And complying with these duties becomes more difficult, there’s more conflict when a company starts to struggle.
Duty to act in the creditors’ interests
‘Where a company is insolvent or on the verge of insolvency, the directors owe a duty to the company to act in the best interests of the creditors of the company’
– West Mercia Safetyware Ltd v Dodd – a 1988 case, now over 30 years old!
When is a company deemed by the law to be insolvent?
The law sets out two tests for insolvency:
- The cash flow test; or
- The balance sheet test.
The first, cash flow, test says a company is insolvent – S123 of the Insolvency Act 1986 – where it is ‘unable to pay its debts as they fall due’.
This is further defined as when:
- A statutory demand has been served on the company by a creditors owed above £750 and has not been paid or otherwise dealt with; or
- A judgement (of any sum) is returned unsatisfied in whole or in part;
- The court considers the company to be unable to pay its debts as they fall due.
The second, balance sheet, test – also set out in S123 of the Insolvency Act – says that a company is ‘deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’.
This calculation provides for the assets to be put in at value, not cost nor written down value, and for a good number of liabilities that are not ordinarily written into the company’s books to be taken into account, including employee redundancy and pay in lieu and pension fund deficits. The combination of asset ‘devaluation’ and unwritten liability inclusion means many companies would be deemed insolvent by the courts long before their directors might believe them to be.
Trading in the near insolvent period
The period between the company becoming insolvent and it going into liquidation or administration is a very difficult time, and often one that is not easy to define – there is no clear definition in statute. Yet if the directors allow a company to continue to trade during that period they could be attacked by a subsequently appointed liquidator for trading wrongfully, and made to personally contribute towards the company’s debts. They could also be disqualified. The key point is the Liquidator has the benefit of hindsight, while at the time the directors are making the decision to continue trading, they do not have such a luxury, they are crystal ball gazing.
The test is ‘did the directors know or ought to have concluded that the company had no reasonable prospect of avoiding liquidation?’ Whether this is so depends entirely on the circumstances. And from the point they knew or should have known, then they are under a duty to take all steps to minimise the loss to creditors. Yes, all!
But this does not mean that just because a company is insolvent, the directors cannot continue to trade, as sometimes doing so can be a good thing – in the case Secretary of State for Trade and Industry v Gash, it was said
‘The companies’ legislation does not impose on directors a statutory duty to ensure that their company does not trade while insolvent. Nor does that legislation impose an obligation to ensure that the company does not trade at a loss. Those propositions need only to be stated to be recognised as self-evident. Directors may properly take the view that it is in the interests of the company and of its creditors that, although insolvent, the company should continue to trade out of its difficulties. They may properly take the view that it is in the interests of the company and its creditors that some loss-making trade should be accepted in anticipation of further profitability. They are not to be criticised if they give effect to such view.’
Continuing to trade and incur debts in this period is neither a no-no nor a given, director exposure neither certain nor unlikely, the specific circumstances of the company at the time are key.
I’ve heard about something called misfeasance, what is it?
Administrators or Liquidators can take legal action against a current or former director of the company for misfeasance (S212 Insolvency Act) where they have breached any of their duties as a director.
Such action can be taken against any ‘person who:
- is or has been an officer of the company; or
- is or has taken part in the promotion, formation or management of the company has misapplied or retained, or become accountable for, any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company.’
So it includes more than just directors. If found guilty of misfeasance, they be forced to repay money they have received, return assets, or pay compensation at a sum set by the court.
The defence that directors might have to such a claim is that they did everything possible to minimise the possible loss to creditors.
Companies are almost always deemed by the courts to be insolvent before directors believe them to be at the time. If the company’s financial position is such that liquidation or administration might ensue, it’s a good idea to take advice as early as possible, with that advice coming from a licensed insolvency practitioner or insolvency lawyer at the earliest possible stage, and at all times thereafter.