The current UK economic climate continues to present challenges for businesses, from inflationary price rises and volatile global markets to fluctuating consumer confidence and unpredictable world events. It is vital that company directors understand and fulfil their legal duties, particularly when a company faces financial distress or enters a state of potential insolvency. Failure to do so can lead to personal liability for company directors and/or disqualification.
The Foundation: Directors’ General Duties
The Companies Act 2006 codifies the general duties owed by directors to their company. These include:
- Duty to promote the success of the company (Section 172): This requires directors to act in good faith to promote the success of the company for the benefit of its members (or shareholders) as a whole. Crucially, this includes considering the long-term consequences of decisions and the interests of members (shareholders), employees, suppliers and customers.
- Duty to exercise reasonable care, skill and diligence (Section 174): Directors must exercise the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that may be expected of them.
- Other duties: These include acting within powers, exercising independent judgement, avoiding conflicts of interest, not accepting benefits from third parties and declaring interests in proposed transactions.
The Shift: Duties when Entering a State of Potential Insolvency
When a company starts to face financial difficulties to the point that its solvency and future viability is called into question, there is a fundamental shift in the duties owed by a company’s directors, and to whom they are owed.
While the Section 172 duty to promote the success of the company for the benefit of its members mentioned above technically remains, its focus shifts from primarily considering shareholder interests to giving primary consideration to the interests of the company’s creditors. This can cause difficulties for directors, particularly where they are director-shareholders and their own interests may conflict with those of the company’s creditors.
The rationale behind this is clear: when a company is struggling financially, the company’s assets should first be used to repay the creditors, rather than used for the benefit of shareholders. Directors must act to minimise the potential loss to creditors.
Key indicators of a company approaching insolvency can include:
- Inability to pay debts as they fall due (cash flow insolvency).
- Liabilities exceeding assets (balance sheet insolvency).
- Persistent trading losses.
- Creditor pressure, such as winding-up petitions or county court judgements.
- Dependence on short-term funding or extended credit from suppliers.
Navigating Insolvency: Practical Steps for Directors
When a company starts struggling financially, proactive and well-documented decision-making is important. Directors should consider the following steps:
- Closely monitor the company’s financial position: Consider the company’s financial position on a more regular basis. This can include preparing and considering frequently updated management accounts, detailed cash flow forecasts and regular reviews of the balance sheet. Identify key creditors and assess the extent of liabilities that are owed by the company.
- Prioritise creditors’ interests: Every decision of the directors must demonstrate a clear consideration of how the decision will impact creditors. This means avoiding actions that could worsen the position of creditors, such as:
a. Paying dividends to shareholders (this would be benefitting members over creditors).
b. Disposing of assets at an undervalue (this could potentially deprive the company of funds that could have been used to repay creditors).
c. Making preferential payments to certain creditors over others without a valid commercial reason (this could result in some creditors being paid, and others not).
d. Incurring new debts without a reasonable prospect of repayment. - Avoid wrongful trading: A director can be held personally liable if they continue to trade when they knew, or ought to have known, that there was no reasonable prospect of the company avoiding insolvent liquidation or administration, and they failed to take steps to minimise the potential loss to creditors.
- Maintain comprehensive records: All board discussions, decisions and the rationale behind them should be carefully minuted. This includes any professional advice sought and the information on which decisions were based. Such records are vital evidence if decisions are later scrutinised by an insolvency practitioner.
- Seek professional advice early: Engaging with experienced legal advisors and/or licensed insolvency practitioners at the earliest signs of financial distress can provide vital guidance on the company’s options, help navigate complex legal duties and significantly reduce the risk of personal liability for directors.
- Consider formal insolvency procedures: Where a rescue is not feasible, directors should consider initiating a formal insolvency process (e.g. administration or liquidation) at the appropriate time. This can ensure an orderly wind-down and help demonstrate that the directors fulfilled their duties to creditors.
The Consequences of Getting it Wrong: Personal Liability and Disqualification
If a company enters a formal insolvency procedure, the administrator or liquidator can investigate the company’s affairs in the years leading up to insolvency, including whether its directors complied with their duties. If it is considered that a director has failed to comply with their duties they may be reported to the Insolvency Service.
The Insolvency Service has a number of powers if there have been failings in performing those duties, including disqualification of directors. Disqualification orders can last for up to 15 years, preventing an individual from acting as a director or being involved in the management or promotion of any UK company.
Beyond disqualification, directors can also face personal liability for:
- Wrongful trading: Continuing to trade knowing (or having ought to have known) that the company is insolvent.
- Fraudulent trading: Carrying on business with intent to defraud creditors (a criminal offence).
- Misfeasance: Breach of any fiduciary or other duty in relation to the company by the directors.
- Transactions at an undervalue or preferences: Where an asset is sold for significantly less than its actual market value, or where some creditors are given favourable treatment over others. (In these circumstances, these transactions can be reversed and an order for repayment be made).
- Personal guarantees: Being personally liable for company debts if a guarantee was provided.
In these circumstances, a director could find themselves having to personally account to creditors for any losses that they have suffered.
Conclusion
While the principle of limited liability for directors of limited companies generally protects directors from personal responsibility for company debts, this protection can be removed if duties are breached, especially when a company is in financial difficulty. By understanding what their duties are, adopting a proactive approach and seeking expert advice early, directors can significantly mitigate the risks of personal liability and navigate their company through difficult times responsibly.
For advice on your duties as a director, contact a member of the Corporate & Commercial team at HK Law.
Author: Liam Voysey, Solicitor in the Corporate & Commercial team based in Dorchester. HK Law also has offices in Blandford, Bournemouth, Crewkerne, Poole, Swanage, and Wareham.
This article is intended for guidance only and is not legal advice.
