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Potential liabilities of directors in insolvency situations: a cautionary reminder

Author headshot image Posted by , Solicitor
Contributing authors: Bharti Moore

With the recently announced Corporate Governance and Insolvency Bill introducing a temporary suspension of wrongful trading actions, our Corporate team outline other potential claims that may be brought against directors of an insolvent company.

Directors liability

Our first blog on the topic provided a brief summary of the measures announced in the Corporate Governance and Insolvency Bill first set out in the House of Commons on 20 May. The Bill has since progressed through a second reading, the ‘Committee’ and ‘Report’ stages, and subsequently through a third reading in the House of Commons, with no major changes being made. The Bill will now be progressed to the House of Lords on its journey to Royal Assent, and ultimately introduction as law.

One of the key measures this blog will focus on is the temporary suspension of the wrongful trading provisions under the Insolvency Act 1986 (Insolvency Act), motivated by an effort to afford directors greater opportunity when seeking to steer their companies away from insolvency in the midst of the Covid-19 pandemic. The provisions are to be applied retrospectively running from 1st March 2020 to 30th June 2020.

What is wrongful trading?

The wrongful trading provisions can typically be used to impose personal liability on the directors of insolvent companies where:

a)  The company has continued to trade despite there being no prospect navigating the company away from insolvency; and
b)  The company’s net liabilities have increased as a result of this.

In normal circumstances, these actions can be brought against the directors by the liquidators/ administrators of a company.

The suspension of these provisions, does not, however, relinquish the directors of any risk of personal liability in the event of a company going insolvent, and there are a number of other possible actions that can be brought against directors.

Other potential claims against directors

1.  Fraudulent trading

Firstly, a director can face extensive liability in instances of fraudulent trading under section 213 of the Insolvency Act.

What is fraudulent trading?

Fraudulent trading differs from conventional wrongful trading actions due to the need for actual dishonesty, as opposed to an element of recklessness.

Consequence for directors

Where there has been fraudulent trading, a liquidator or administrator can seek a court declaration requiring anyone who has knowingly been involved in the fraudulent activities of a company to make a contribution to the company’s assets, and subsequently distributed to unsecured creditors. The individuals against whom such actions can be brought includes the directors and other officers (company secretary or managers) of a company.

Fraudulent trading is also actionable under the Companies Act 2006 (Companies Act), for which individuals found to have acted fraudulently may face criminal liability and up to 10 years imprisonment.

Steps directors can take to mitigate the risks

  • act with integrity and be guided by the duties imposed on them by the Companies Act
  • formally ratify decisions of the board, and document these approvals with full board minutes, retaining these records for at least 10 years
  • investigate and report any suspicions of fraudulent activities being carried out by other individuals involved in the management of the company

2.  Misfeasance

Directors also need to be aware of the potential for actions for misfeasance to be brought against them.

What is misfeasance?

Actions of misfeasance generally encompass the following:

  • the misappropriation or retention of money or other property of a company
  • becoming accountable for money or other property of a company
  • breaching fiduciary or other duties owed to the company

A misfeasance claim can be brought by a liquidator or creditor of a company, against any officer, or former officer of that company in accordance with section 212 of the Insolvency Act.

Fiduciary duties are duties owed by the officers of a company to that company in their capacity as an officer of that company. In the context of directors, a breach of such duties will commonly relate to the general duties owed under sections 171 to 177 of the Companies Act. These duties are as follows:

  • to act within the company’s powers – you have to follow the rules set within the company’s articles of association.
  • to promote the success of the company – this places a duty on the directors to act in good faith, therefore requiring them to consider the effects on shareholders and stakeholders (e.g. employees and customers) of the company.
  • to exercise independent judgment – each director must therefore deploy their own judgment when making decisions.
  • to exercise reasonable care, skill and diligence – the benchmark that is applied is that of a reasonably diligent person with the general knowledge, skill and experience that could reasonably be expected from a person carrying out the director’s functions, however, directors with particular specific professional skills, training, experience or qualifications (such as accountants) will be held to a more onerous standard than those that are less qualified.
  • to avoid conflicts of interest – this restricts parties from being involved where they have external business or personal interests which are likely to be affected by the company’s activities, or where the director is seeking to take advantage of property or information that belongs to the company for their personal benefit.
  • not to accept benefits from third parties – this prohibits gifts or benefits from third parties, as this poses a risk to the independence of a director.
  • to declare an interest in a proposed transaction or arrangement –any director must make the rest of the board aware of any interest that they have in a proposed transaction or arrangement, and seek prior ratification.

There are a number of wider duties which, when breached, may give rise to an action for misfeasance. These duties include the duty of care owed by a director to the company and its creditors, which may be breached by a director acting negligently.

Consequence for directors

The usual remedy for misfeasance actions is a court order for any individual found to have been misfeasant to repay, restore or account for misappropriated money or property to the company, and to compensate the company by way of that individual subsequently making a contribution to the company’s assets.

Steps directors can take to mitigate the risks

  • follow the rules and duties set out in the Companies Act
  • reference and consider these rules and duties where relevant in the board minutes confirming ratification of any decisions.

3.  Reviewable transactions

There are certain types of transaction that can be reviewed by the administrators or liquidators of a company under the Insolvency Act so that liquidators and administrators can achieve the best possible return for the creditors from the assets of the insolvent company.

The most common examples of reviewable transactions are:

a)  transactions at an undervalue (under section 238 Insolvency Act) ; and
b)  Preferences (under section 239 Insolvency Act).

What is a transaction at an undervalue

A transaction at an undervalue occurs when:

  • the company makes a gift or otherwise enters into a transaction on terms that the company receives no value, or less value than the consideration paid by the company;
  • such a transaction takes place in the two years leading up to the company becoming insolvent; and
  • the company is left unable to pay its debts (at least partly) because of that transaction.

An example of this could be the gift of a company asset to the family member of a director, or an unconnected third party for which no consideration is received.

Steps directors can take to mitigate the risks

  • again, consider the duties set out in the Companies Act
  • consider obtaining a formal valuation of any assets which are intended to be disposed of.

What is a preference

A preference occurs if each of the following happen:

  • the company does, or allows to be done, anything which has the effect of putting a person (who is a creditor or surety or guarantor or any of the company’s liabilities) into a better position than they would have been in the event of insolvency;
  • the company was influenced in deciding to give the preference by a desire to prefer that party;
  • The preference was given:

a) during the six months before the onset of insolvency; or
b) two years where the person that has been preferred is connected with the company. For these purposes, a connected person or party would include a director, a spouse or civil partner of a director, or an associated company. An associated company will mean a direct holding company or subsidiary, or a company in which the same individuals or their spouses / civil partners hold shares

  • the company was unable to pay its debts at the time of the transaction or became unable to pay its debts as a result of it.

An example of a preference could be where the directors of a company on the verge of insolvency use available funds to repay a loan made by a spouse of one of the directors to the company, and as a result the company is unable to meet its obligations and debts to other unsecured creditors.

Consequence for directors

The administrator or liquidator will be able to apply to the court to make an order to set aside the transactions in question.

Steps directors can take to mitigate the risks

  • consider the interests of all creditors, and indeed the solvency of the company when looking at making a repayment to a creditor
  • consider obtaining legal advice if you have concerns about the solvency of your company

4.  Personal guarantees

Directors also need to be wary of any personal guarantees that they may have given to secure the liabilities of the company, imposing personal liability on the guarantor if the company defaults on its obligations. These are common in the context of leases for commercial premises, loan agreements and high value supply contracts.

Steps directors can take to mitigate the risks

  •  obtain legal advice prior to giving personal guarantees to fully understand your obligations
  • carefully review the terms of any agreements or guarantees if you are concerned about the solvency of your company

5.  Directors disqualification

Under the Company Directors Disqualification Act 1986, the courts are afforded general remit to make an order preventing an individual from being directly, or indirectly concerned with the promotion, formation or management of a company for a specified period of time. The minimum period of disqualification in this regard is 2 years, and the maximum is 15 years.

Orders for disqualification may be made against directors where a company has gone insolvent, where their conduct has rendered them unfit to be concerned with the management of a company.

These are also commonly considered where there has been a breach as outlined above, and therefore a director may be disqualified in combination with another action being brought.

If you require advice on how these potential actions may affect you, or more generally in what the proposals set out in the Bill may mean for your business, please get in touch. Our Corporate team has the legal expertise and professional contacts to help you. Contact us on:

0800 923 2073     Email uscorporate.enquiries@roydswithyking.com

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