Insolvency: considerations for directors

Directors can potentially incur personal liability when the company they are a director of proceeds into an insolvency process.  However, directors can take steps to protect themselves against potential personal liability.  The below seeks to offer some outline points of note to directors where the company they are a director of faces insolvency.

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Duties as a director

Ordinarily a director is under a duty to act in the best interests of the company and its shareholders.  However, once they form the view that the company is insolvent (meaning that its assets are exceeded by its liabilities), their duty shifts and is to act primarily in the interests of the company’s creditors.

If there is no reasonable prospect of avoiding an insolvent liquidation or insolvent administration, their obligation is to manage the affairs of the company with a view to minimising the potential losses to creditors from the company’s financial position.  Typically, in such circumstance, they are likely to be well advised to place the company into some form of insolvency process.

When and how can a director be personally liable?

If a company goes into a formal insolvency procedure such as liquidation or administration, the insolvency practitioner appointed to manage the company’s affairs will usually investigate the circumstances in which the company became insolvent.  This investigation will typically include:

• The conduct of the directors, and the decisions that they took with regard to the management of the company’s affairs.
• The transactions entered into by the company in the lead up to its insolvency.

The investigation will typically encompass the grounds highlighted below.  In addition, there are restrictions on the re-use of company names that, if breached, could result in personal criminal and civil liability.

Wrongful trading

Under the Insolvency Act 1986, a director who allows a company to continue trading when there is no reasonable prospect that it will avoid going into insolvent liquidation or insolvent administration (which is known as wrongful trading) may be required to contribute to the company’s assets.

Fraudulent trading

Under the Insolvency Act if, in the course of administration or winding up the company, it appears that any business of the company has been carried on with intent to defraud creditors, or for any other fraudulent purpose, the administrator or liquidator 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.

Misfeasance or breach of fiduciary duty

Under the Insolvency Act if, in the course of winding up the company, it appears that a 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 other fiduciary or other duty, the court may order the director to repay the money or property with interest or contribute such sum to the company’s assets by way of compensation as the court thinks just.

Transactions at an undervalue

Under the Insolvency Act, a liquidator or an administrator can apply to the court to set aside any transaction at an undervalue.  A transaction will be a transaction at an undervalue if the company has transferred assets for significantly less than their market value when it was insolvent or if it became insolvent as a result of the transaction.  The court can set aside the transaction if it was entered into during the two years before the company became insolvent.  It has the power to order a director to refund property or proceeds of sale received by them to the company.  There are exceptions and defences available under the Insolvency Act.

Preferences

Under the Insolvency Act, a liquidator or an administrator can apply to the court to set aside a preference.  A preference is where payments are made or assets transferred to a creditor of the company in preference to another.  Examples of preferences include paying an unsecured creditor in priority to other creditors or granting security to a previously unsecured creditor.  This is because, if the company is insolvent, directors are under a duty to the company’s creditors as a whole and they must treat all the company’s unsecured creditors equally.  If the court believes the company has made a preference, it can set aside the transaction and order a director who has received the company’s assets to refund them to the company.  The court can set aside the preference if it was given in a period up to two years before the company became insolvent.

Practical steps

Where a company is potentially facing insolvency, directors are best advised to keep matters under continual review.  In particular, it is prudent to:

• Hold frequent board meetings convened specifically for the purpose of reviewing the company’s financial position and keep proper minutes of those meetings, noting in particular any decisions made and the reasons for them.
• Maintain accurate and up-to-date company financial records.
• Continually monitor the company’s financial position and future cash flows and consider ways to reduce expenditure.
• Take professional advice aimed at reviewing whether insolvent liquidation is inevitable or whether there is some way of resolving or mitigating the company’s financial difficulties.

How we can assist

If you are a director of a company which is potentially facing insolvency, we can provide focussed advice to you with the aim of mitigating your potential personal exposure.  Likewise, if you are an insolvency practitioner seeking to pursue a director, we regularly assist with such claims too. 

For further information contact Christopher Buck, Associate Partner and Solicitor, on 01908 660966 / 01604 828282 or by email at Christopher.Buck@franklins-sols.co.uk.