Consideration for directors if Coronavirus creates financial difficulty

Here we take a look at directors’ duties and potential personal liabilities in relation to companies in financial difficulty in light of the Coronavirus crisis.

If we can provide further advice on this or any other insolvency related issues, please call on 01905 900939 or email to andrew@bradleyhayneslaw.co.uk.

Background

The current strain on businesses due to the Coronavirus is unprecedented and will no doubt result in serious cash flow difficulties for some.

It is imperative for all directors of companies in financial difficulty to be very careful in their dealings to seek to avoid, as far as possible, personal liability if the company was to fail.

This note sets out several possible scenarios where directors could face such personal liability. If the note raises concern, then it is strongly advised to take further advice as soon as possible.

Quite how the government and courts may determine such matters going forward when businesses are faced with such an unprecedented issue is unknown, however our advice would be that directors should be mindful of the existing legal provisions and make decisions based on the law as it stands.

Directors of companies in financial difficulty face several issues.  These include:

• What can they do to keep the company in business without committing an offence or incurring personal liability?
• At what stage must they decide to cease trading?
• If they do decide to cease trading, which insolvency procedure should the company enter?

If we can help at all with any of these issues, please feel free to contact us.

Wrongful trading

If, in the course of an insolvent winding up or insolvent administration of a company, it appears that a person who is, or was, a director of the company knew or ought to have concluded at some point before the commencement of the liquidation or administration that there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the liquidator or administrator of the company can seek a court declaration that the director make a contribution to the company’s assets.

Only directors can be liable for wrongful trading. “Director” is widely defined to include “shadow directors”

Liability only arises if it is shown that the company is worse off as a result of the continuation of trading. The court will not make an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken.  Dishonesty is not required and accordingly, there is a lower burden of proof than that required to prove fraudulent trading.  It is therefore, in principle, considerably easier for a liquidator or administrator to obtain an order for wrongful trading than for fraudulent trading.

Fraudulent trading

If, in the course of the winding up or administration of a company, it appears that any business of the company has been carried on with the intent to defraud creditors, or for any other fraudulent purpose, the liquidator or administrator can seek a court declaration that anyone who was knowingly party to the fraudulent business make a contribution to the company’s assets.  This is known as fraudulent trading.

Only those who were knowingly parties to the fraudulent trading are caught by this section. Case law has shown that it is not enough for fraudulent trading to show that the company continued to run up debts when the directors knew that it was insolvent; there has to be “actual dishonesty, involving … real moral blame”

The court may order the respondent to make such contribution as the court thinks proper, although the amount of contribution cannot include a punitive element.

Fraudulent trading is also a criminal offence under the Companies Act 2006 and a person held liable in respect of fraudulent trading may also have a disqualification order made against him by the court.

Reviewable transactions

Commercial pressure on a company’s finances may lead to creditor demands, or commercial pressure, on the directors to cause the company to undertake actions which may be designed to ease the company’s day-to-day problems but which may constitute reviewable transactions, such as a preference or a transaction at an undervalue if the company later goes into liquidation or administration.

Example of actions which should be carefully considered to determine whether, in the circumstances, they may be later open to challenge, for example as a preference or a transaction at an undervalue, include:

• The granting of security to a previously unsecured supplier in respect of debts incurred for goods previously supplied.
• Acceding to new supply terms from an existing supplier on more onerous terms (such as to extend retention of title terms to include terms purporting to allow claims against goods where title has been retained to cover all sums outstanding, rather than merely the purchase price of those goods).
• The granting of security to a lender who is lending new monies where security required would create new security over, or increase existing security over, assets in respect of sums previously lent.
• Paying some unsecured creditors while leaving others unpaid. The payment of employee wages as they fall due is commonly effected and justified by reference to an argument that the immediate cost to creditors is likely to be outweighed by the financial benefit to them from retaining the business in a configuration where it is capable of being, and likely to be, sold in any later insolvency process as a going concern. One would hope that using any government loans to supplement payroll would be interpreted accordingly. The payment of non-business critical suppliers however, especially for supplies already made, is likely to attract more scrutiny and criticism.
• The making of severance payments to senior employees or directors in any attempted business restructuring.
• Causing the company to repay any debt which has been guaranteed by a director.

All of these actions clearly need careful consideration if a company is in difficulty.

Personal guarantees

The directors of a company are generally not personally liable for the debts of a company. However, if a director has given a guarantee for the liabilities of the company, the director may be personally liable under the guarantee.

Misfeasance or breach of fiduciary duty

If, in the course of a winding up, it appears that a present or former director 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, the court may order the director to repay, restore or account for the money or property with interest or contribute such sum to the company’s assets by way of compensation as the court thinks just.

Fraud and misconduct offences

Additional offences that can apply to directors are:

• Fraud in anticipation of winding up.
• Transactions in fraud of creditors.
• Misconduct in the course of winding up.
• Falsification of company’s books.
• Material omissions from statement relating to company’s affairs.
• False representations to creditors.

Breach of common law duties

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.  Directors cannot, for example, cause an insolvent company to enter into an agreement to repay shareholders’ debts or make distributions to shareholders out of the profit from company contracts if this effectively amounts to a winding up of the company and an attempt to distribute the company’s assets without proper provision for all the creditors.

Resigning as a director

Resignation as a director is not generally looked on favourably by the insolvency profession or the courts, as it may be regarded as an abrogation of the director’s responsibilities. However, if a director comes to the conclusion that there is no reasonable prospect of the company avoiding an insolvent liquidation but fails to persuade the majority of the board of that despite his best efforts, it may be sufficient if he resigns as a director. A director who resigns from office may still be liable for any wrongful trading that took place during the director’s time in office. Once the director has resigned, the director should step away from any executive function entirely, to avoid the risk of being considered a shadow director of the company.

Summary

As soon as a director is aware that there is no reasonable prospect of avoiding insolvent liquidation or insolvent administration, or fears that is the case, he must raise the problem with the rest of the board with a view to taking immediate independent professional advice.

It is crucial that regular full board meetings are called if the company is in financial difficulties and that the commercial decisions of the directors are reported in full in the company’s minutes. It is also important that the directors reach their commercial decisions at board meetings independently, based on the financial and legal information and advice available to them.

Directors must always ensure that they have up to date financial information. Directors should not wait for an event such as a creditor’s claim, a winding up petition or administration application or a failure to meet sales or cash flow forecasts to alert them to the fact the company is in financial difficulty. Directors should be careful to monitor compliance with financial covenants contained in any arrangements with lenders.

A company can simply cease to trade without resorting to a formal insolvency procedure, but unless the company is solvent and can pay off all its debts, the directors should consider pre-empting any action by an unpaid creditor, and definitively bringing to an end any period for which they might be found liable for wrongful trading, by themselves causing the company to implement a formal insolvency procedure, such as administration or liquidation.  There may however be various other restructuring options available which professional advisors can assist with which could be considered first.

If we can provide further advice on this or any other insolvency related issues, please call on 01905 900939 or email to andrew@bradleyhayneslaw.co.uk.