Directors often come to me troubled, worried about their position as a director of a company that’s at risk of failing, perturbed by all the scare stories about personal liability and other penalties, their minds racing. Yet it’s not a crime to be involved with a company that’s failing, most businesses at some time in their lives have gone through several periods of severe pain, often having to go through a formal insolvency process in order to survive. People and businesses do survive, but as managing a struggling business is alien to most people and the potential penalties for doing the wrong thing potentially quite punitive, it’s worthwhile both doing some homework yourself so that you understand how your focus has to change, what’s now expected of you and to seek some guidance from someone who’s been in this position before. Sometimes that person might be another trusted director, an experienced consultant, sometimes, especially when things have got really bad, an insolvency practitioner or lawyer. Unfortunately, the toxic combination of complex law, difficult circumstances and conflicting interests mean it’s impossible to give any safe, 100% reliable guidelines in an article, but here are some pointers to help you with your homework…
First off, on an ongoing basis, whether the company is struggling or not, directors owe a few general duties to their company.
Directors’ General Duties
These are set out in the Companies Act 2006. These are to:
- Act in accordance with the company’s memo and articles and exercise their powers for the purpose for which they were given;
- Act in good faith to promote the success of the company for the benefit of the shareholders as a whole;
- Exercise independent judgment;
- Exercise reasonable care, skill and diligence;
- Avoid conflicts of interest;
- Not accept benefits from third parties given by reason of their directorship or for them to do/not do something as a director;
- Declare to the other directors any direct or indirect interest that they may have in any proposed transaction or arrangement with the company.
These duties exist on an ongoing basis, regardless of the financial position of the company. However, once a company starts to struggle financially, and even more so when it becomes technically insolvent, conflicts can arise which could create breaches in these duties. For example, in one recent case I was approached by a key director of a struggling company whose mental health had deteriorated as a result of the pressure he was under, where he asked me whether it was reasonable for him to simply walk away and leave the company to his co-directors? Another instance was where a director proposed setting up a new company to carry out a different type of work that the struggling company could, in theory, do, worried any liquidator of the struggling company could attack him for doing so.
It’s worthwhile bearing in mind these duties apply at all times, but fall into sharper focus when times get tougher.
Talking about increasing risk to directors arising out of the company’s difficult financial position, let’s now talk about…
Risks to Directors if their Company goes into Formal Insolvency
When a company goes into formal insolvency its Insolvency Practitioner is given powers under the Insolvency Act 1986 to look back in time, to upset or seek compensation for any directors’ wrongdoing.
These are …
- Breach of Duty/Misfeasance (section 212)A Liquidator, Administrator, a creditor or a ‘contributory’ can ask the court to order a director to pay compensation for a breach of duty or misfeasance, or to make good any loss suffered by the company arising from any misapplication of company assets or money.An action for breach of duty and / or misfeasance can be a standalone action or it can accompany another action. It can for example accompany an action for preference (see below ) or a transaction at an undervalue (see below) against a third party or connected party, where a director has caused the company to enter into a transaction which causes loss to the company, with the two actions running concurrently. Note that under s212 action can be taken against not only the current but also former directors, so resigning after a transaction is of no benefit.
Misfeasance like most of the actions here is a civil rather than a criminal matter and therefore attracts a civil burden of proof – on the balance of probabilities, not beyond all reasonable doubt. That’s to say the bar to an IP succeeding in an action is not set ridiculously high.
- Wrongful trading (section 214)Directors can be forced to pay money into the liquidation or administration of a company if they allowed the company to continue trading and incur further unpaid credit when they knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation (the so called ‘relevant time’).The Insolvency Practitioner will try to ascertain the point when the ‘relevant time’ was reached. It’s often not easy to say when that time is, the IP will have his view, the directors and their advisors another, the court yet another. Unlike misfeasance (see above) there need be no dishonesty on the part of the director.The only defence available to directors to a wrongful trading action is that they took every step that they ought to have taken to minimise the loss to creditors. Yes, every step. As that’s a big ask, it’s a good idea for directors to take professinal advice early.
The court will decide the level of contribution, based on its assessment of the loss to creditors caused by the continuation. As with the relevant time, the IP will have his views of what that figure will be, the directors’ advisors their own figure, but it is the court’s decision that is the important one. And that can be a very big figure indeed.
- Fraudulent trading (section 213)Unlike Wrongful Trading, in Fraudulent Trading there must be an element of dishonesty in the directors’ actions.The consequences of being found guilty of fraudulent trading are the same as wrongful trading (ie personal liability under a ‘contribution order’), but there is an additional possibility of criminal proceedings being brought with potential imprisonment.Examples of dishonest conduct include:
- Deliberately allowing the company to incur further debt where it is patently clear that it won’t be paid.
- Taking deposits from the public in advance of the supply of goods or services;
- Making misleading statements to creditors; or
- Taking orchestrated steps to avoid paying creditors.
As fraudulent trading is a criminal matter, the criminal burden of proof applies – beyond all reasonable doubt – making it harder to prove than say wrongful trading, making it quite a rare action, but one that is normally more punitive.
- Transaction at an undervalue (section 238)
Liquidators and Administrators can apply to the court for the position of the company to be restored to what it was prior to it having entered into a ‘transaction at an undervalue’. This could be through returning money and/or assets. Transactions at an undervalue that are commonly upset by insolvency practitioners include the transfer of valuable assets to directors or group companies for less than their true value.
A transaction at an undervalue is where there has been a gift or where the value received by the company is significantly less in money or money’s worth than that given.
The transaction must have taken place within the relevant time -see below.
There is a defence, this is where the transaction was entered into in good faith and there were reasonable grounds for believing it would benefit the company.
- Preferences (section 239)Liquidators and Administrators can apply to the court for the position of the company to be restored to what it was prior to a preference, through the return of money or assets. Preferences that are commonly upset by insolvency practitioners include the repayment of directors’ or group company loans, the granting of security to directors, the transfer of assets to group companies etc.A preference is a transaction where:– The person preferred is a creditor, guarantor or surety. The ‘person’ can be any form of entity.
– The company has done or suffered something to be done which puts that person in a better position than they would otherwise have been in upon a liquidation.
– The company must have been ‘influenced by a desire to prefer’ (ie wished to improve the position of the person). Such desire is assumed if the person preferred is ‘connected’ to the company – a connected party is virtually anybody or organisation related to the directors or shareholders.
– The company was insolvent at the time of, or become insolvent as a consequence of, the preference taking place.
– The preference must have taken place within the relevant time (see below).Some transactions entered into by companies can be both a transaction at an undervalue and a preference and it is not uncommon for liquidators to attack a transaction on more than one ground.
- Transactions defrauding creditors (section 423)A transaction defrauding creditors is one carried out at an undervalue where the company’s intention was to put assets beyond the reach of creditors, or to prejudice their interests. An action under section 423 can be brought by a Liquidator, Administrator or (unusually) creditors. The purpose of the court order is to restore the position to what it would have been had the transaction not taken place.The aim of the law is to prevent companies from disposing of assets to the detriment of creditors. Section 423 does not specify a relevant time limit, so the insolvency practitioner can look back a lot longer than other sections of the Insolvency Act enable him. However, S 423 actions are subject to the usual rules on limitation and may be statute barred after 6 or 12 years depending upon the type of claim.Talking about time limits….
So what’s the time period for upsetting a transaction at an undervalue, preference and transaction defrauding creditors, and does it matter if the company is insolvent or not at the time of the transaction?
Here’s a summary…
| Provision | Relevant Time | Does the company have to be insolvent when the transaction occurs? | Is insolvency presumed? |
| Section 238 Transactions at an undervalue – in favour of an unconnected person | 2 Years | Yes | No |
| Section 238 Transactions at an undervalue – in favour of a connected person | 2 Years | Yes | Yes |
| Section 239 Preference – in favour of an unconnected person | 6 months | Yes | No |
| Section 239 Preference – in favour of a connected person | 2 Years | Yes | No (but ‘desire to prefer’ will be) |
| Section 423 Transactions defrauding creditors (whether in favour of a connected party or not) | Any time | No | No |
As you can see, it’s complicated, it’s worthwhile taking legal / insolvency practitioner advice before entering into a transaction.
- Re-use of company name (sections 216-217)This is a horribly complicated area of the law, one where because of its complexity and longevity, can easily trip up directors.Section 216 provides that a director (and any shadow director) of a company that has gone into insolvent liquidation is prohibited from being a director of a company known by a similar ‘prohibited name’ for a period of five years. Yes, five years, a long time.They must not act as a director of the new company, nor must they be in any way concerned, directly or indirectly in the promotion, formation or management of the company. If they do, then they could be fined and/or imprisoned.
But here’s the rub… they will also be made personally liable for the ‘relevant debts’. Relevant debts are those incurred by newco during the period during which they were involved in the management of, or acting on instructions in, the new company. Yes, it also applies to people who act on the directors’ instructions. The sum sought could be a very big sum, indeed quite a few people have been made bankrupt and lost all they own because they unknowingly breached these regulations. Ignorance is no excuse.
So what’s a ‘Prohibited Name’?
It’s any name by which the liquidating company was known in the 12 months prior to insolvency or one which is so similar that it suggests an association with the liquidating company. It includes trading names/styles and not just formal company names. And derivatives of the formal and trading names.
There are exceptions to section 216 exist. These are:
– Getting sanction of court by applying under section 216 (3) and R4.227A. My advice is you should use skilled lawyers to do this, you cannot afford to get it wrong.
– Under Rule 22.4, where the Insolvency Practitioner has transferred the whole, or substantially the whole, of the business to a successor company. There is a strict timetable and list of things to be done under this Rule eg Notice must be given to creditors of the insolvent company by the successor company within 28 days of the completion of the transfer. The notice must give details of the prohibited name, name and registered number of the insolvent company and circumstances of the acquisition.
– Under Rule 22.5 – this applies while the applicant is awaiting court sanction under s216(3). The applicant can use of the name for a maximum of 6 weeks until the court deals with the application.
– Rule 22.6 – This is where the successor company has been known by the name for 12 consecutive months prior to the date the insolvent company went into liquidation and that it was not dormant at any time in those 12 months.
As you can see the rules over the re-use of company names is complex, horrendously so. My advice to you is to take advice.
It’s worthwhile noting that none of these rules apply where a company goes into administration, or into administration and then is struck off without going into insolvent liquidation. Or in a CVA. But they do kick in when a company goes into insolvent liquidation (Creditors Voluntary Liquidation or Compulsory Liquidation) after an Administration.
Is there anything else you need to know?
When a company becomes insolvent a few more duties kick in…
Directors’ Duties to the Insolvency Practitioner
First off, let’s get out the way when the following duties do not apply – these are in Company Voluntary Arrangements of Fixed Charge Receiverships. That’s to say they do apply in Liquidations, Administrations and Administrative Receiverships.
Under the relevant legislation here, the Insolvency Act 1986, directors also include ‘relevant persons’ who:
- Are or have been officers of the company;
- In the 12 months prior to the start of the formal insolvency played a part in the company’s formation of the company or who were employed by the company;
- In the 12 months prior to the start of the liquidation were officers or employees of a company which is (has been) an officer of the company (this might even include an employee of the company’s auditors!).
In summary, more than just the directors!
The duties on these people include:
- Providing the Insolvency Practitioner with a statement of affairs;
- Co-operating with the Insolvency Practitioner (s235);
- Submitting to examination and subsequent court orders under sections 236 and 237;
- Attending on the Insolvency Practitioner at such times as he may reasonably require;
- Attend an initial meeting of creditors if required to do so by either a liquidator or administrator.
The law here is written so as to enable the Insolvency Practitioner to extract information from people who know about a company’s affairs, such as former decisionmakers who don’t want to assist him, so that the IP can do his job properly. These sections are not used a lot, but it’s worthwhile knowing about them.
What else can happen if you get things wrong?
Liquidators in Creditors Voluntary Liquidations, Administrators and Administrative Receivers are required to report to the Secretary of State on the conduct of past and present directors (and shadow directors), reporting on those transactions where their conduct makes them unfit to be involved in the management of a company. The Secretary of State then, on the basis of the IP’s report and their further investigations, decides whether to seek to ban the director. The ban could be up to 15 years, but is commonly 2-5 years (there’s a 2 year minimum).
Here’s what a ban means…
The person cannot, without getting the permission of the court first, for the period of time covered by the ban:
– Be a director of a company
– Whether directly or indirectly, be concerned or take part in the promotion, formation or management of a company.
If a director breaches a ban, he not only commits a criminal offence for which he could get a criminal record and potentially be imprisoned, he is also personally liable for the company’s debts while he’s acting contrary to the ban – it’s as if the company’s veil of incorporation is lifted. And this could render him liable for a very large sum, altogether making breaching a ban a simply awful idea.
Summary
I’ve only summarised here the more commonly encountered areas where directors’ conduct can be brought in to question such that they or others can potentially be personally attacked monetarily or in other ways. Given how complicated the law is, it’s always a good idea to employ the very best advisors you can, seek advice early and follow it.
If you need any advice on any matter or are thinking about liquidating your company, just call or email me.
Paul Brindley
01902 672323 paul@midlandsbusinessrecovery.co.uk