Directors at risk in the twilight zone

Authored by Mike Pavitt (Partner, Head of Corporate Restructuring & Insolvency) with research and editorial assistance from Phillip Baldwin (Solicitor, Dispute Resolution). This blogpost was first published as an edited article in Business Magazine’s June 2016 edition (available here).

At the time of writing this article the Secretary of State for Business, Innovation and Skills, Sajid Javid, had opened the Insolvency Service inquiry into the demise of BHS. This was inquiry number 5, following 2 select committees (evidence before which has obviously received a great deal of press attention in recent days and weeks), the Pensions Regulator and the Serious Fraud Office. The high street retailer went into administration at the end of April 2016, just a year after Sir Philip Green sold it, in effect for £1 and to a former bankrupt with no retail experience. After it was determined that the purposes of administration could not effectively be achieved through a going concern sale, the administration was converted to a liquidation.

Clearly it is not every business failure which will attract this level of scrutiny, but at least some of the matters being investigated in the case of BHS will, at some level, also be present in a great many corporate failures on a smaller scale. Even the best of businesses can fail at some point in their life cycle and it would be quite wrong to assume that investigations and claims consequences only follow for directors already in the public eye. Indeed, directors of small businesses who face claims from liquidators and others and/or who are pursued by the Secretary of State for disqualification purposes may find themselves thrust into the limelight in a way which can be very damaging to their reputation and their ability to trade freely for many years to come. With this in mind, I thought it would be helpful to share a few thoughts and tips as to how such directors can, hopefully, avoid such undesirable consequences, or at least be in a position to deal with investigations and rebut potential claims if and when they arise.

A culture of excuses

I have spent pretty much all of my professional life (almost 20 years now) in or around the insolvency industry. During this time I have given almost as much advice to directors facing action following an insolvency as I have to the insolvency practitioners who pursue them. I have therefore heard pretty much every excuse imaginable as to why businesses fail, and why no fault should attach to those who were managing that business. Often these excuses fall upon deaf ears, whether before an insolvency practitioner or before a judge. Why? Surely not just because they’ve heard it all before (although invariably they have)? No, more often than not the difference between a former director who gets a relatively smooth ride following an insolvency and one who risks losing their home, or worse, over it is whether they are able to produce – readily and on demand – contemporaneous, documentary evidence which demonstrates the basis and/or reasonableness of their decision-making over time. Quite simply, it will make it a hundred times easier to deal with that sort of scrutiny, compared with the alternative of having to run around, attempting to justify actions after the event, and potentially tying oneself in knots in the process, particularly if answers are being given before legal advice has been taken.

I do not know, at the end of the day, quite how much genuine legal scrutiny will fall upon those managing BHS during the months and years before its demise, but I imagine it will be significant and expensive, that is if the many legal judgments I have read or been involved with and their painstaking analysis of each and every director level decision are anything to go by. Clearly the former directors of BHS are already having to face some severe criticism and a level of public vilification. Some directors will be able to afford and endure this scrutiny more easily than others, but I suggest none of them, nor their legal teams, will be complaining that they have too much contemporaneous documentary support available to justify their actions.

Back in the real world

Of course it is not every former director of every failed company who will be put through the wringer in this way. Some businesses will just wither on the vine and be dissolved quietly, hopefully owing no significant debt and/or benefitting from supportive or philosophical creditors, but most will enter an insolvency procedure of some kind at some point, and directors need to understand that it is then the duty of every insolvency practitioner so appointed to investigate and to report upon their conduct in the run up the insolvency event. Ultimately, subject to a number of variables including the will of the creditors, there is a risk in every case that one or more investigations and/or court proceedings could follow.

These proceedings might take a number of different forms, from breach of duty claims to wrongful trading, from disqualification to preferences, undervalues and unlawful dividends. Some might not come from the Secretary of State or from the insolvency practitioner appointed, but from a third party assignee and/or an aggrieved creditor. There is much that a director can do – both in advance of and during an insolvency – to guard against these risks, and to minimise any adverse impact, starting with how s/he records their decisions during the good times.

In this short article I can barely scratch the surface of this topic, but I have set out below my top 3 survival tips for directors of companies which, at any point, might become insolvent.

Tip 1: Books and records are your friend – keep them, and keep them close

For many entrepreneurs, record keeping is a bind, a distraction from the important job of opening up the next market, tracking down the next deal. Many will employ staff and/or pull in external help to do the ‘boring’ stuff, and will not even know necessarily where the corporate governance paperwork, company minute book, management accounts information and so on can be found.

Simply put, however, it is the obligation of every director to maintain a company’s books and records, to be able to produce them when required, and to keep abreast of the company’s finances – particularly its creditors and cash demands – at all times. Not only will a carefully prepared board minute or time stamped cash flow projection serve as a contemporaneous record of why the director’s decisions ought to be excused, but they will very often stop a potential wrongful trading claim or disqualification investigation in their tracks.

Having gone to the trouble of preparing them, however, don’t lose control of them, even after an insolvency. Questions may well be asked about them many years after the events in question (the Secretary of State now has 3 years to commence a disqualification, liquidators typically 6 years to bring a claim), years after the director last had reason to look at them. By then most or all of them may have been consigned to an insolvency practitioner’s archive and may not be easily retrievable or accessible. If you can, therefore, agree with the insolvency practitioner that you can retain copies of all of these records, invite them to image your hard-drives instead of taking them away, and try generally to ensure that you and your legal team (if required) can look at the same information they, or the Secretary of State / Insolvency Service (who will very often uplift files from the insolvency practitioner), will be looking at. It will save you a massive amount of time, cost and stress in the long run. The same applies for former directors who sell their interest in a company or its assets and resign but have reason to suspect that the buyer(s) may not manage to keep the company out of insolvency for at least 2 years following the sale.

Tip 2: Take – and follow – the right professional advice at the right time

No doubt this tip sounds every bit as self-serving as it should be obvious. When did anyone last meet a lawyer who suggested they take less advice? But seriously, from the very earliest point, when you as a board are contemplating that related party transaction, a major new product diversification, a sole agency agreement, entering into a piece of litigation, and so on – anything which is out of the ordinary course of your business, talk to your accountants, your lawyers, even your insurance brokers. Make sure that any professional advice you receive is recorded in some way and retained by you and/or filed with your minute book, and that you follow that advice or note down your reasons for not doing so.

It is worth noting that whilst it is generally not possible for directors to insure against criminal fines or regulatory penalties or the cost of an unsuccessful defence to a criminal action or civil claim brought by the company itself (which many insolvency claims will be), many liability risks associated with insolvency and faced by directors are insurable under D&O cover or via a qualifying third party indemnity provision.

The same principle applies when it comes to selecting the right insolvency practitioner accountant from whom to seek insolvency advice. The sooner you seek that advice typically the more options the company will have in terms of restructuring and turnaround with a view to avoiding an insolvent procedure, and if you secure advice to the effect that the company is still viable, subject no doubt to some changes, that advice will insulate the directors to a very large extent against claims for wrongful trading and disqualification in due course. Different insolvency practitioners may best suit different sectors, some will have particular experience and some will have greater access to a range of possible funding solutions. If in doubt I suggest you seek a personal recommendation from your lawyers and/or accountants and that you make sure that the person from whom you seek the insolvency advice is a qualified and fully licensed insolvency practitioner accountant rather than an unregulated intermediary.

Finally, remember that it is only professional advice sought from an appropriate provider of legal advice which is legally privileged. Whilst insolvency practitioner advice will often be invaluable, and whilst many will know the areas of law which most closely concern their practice intimately, they are not lawyers and any advice received from them is therefore not confidential in the sense of being privileged from production in court in most scenarios. It may therefore be prudent for directors to take independent legal advice in conjunction with insolvency advice, ideally from a solicitor specialising in corporate restructuring and insolvency. This may, of itself, serve as a type of insurance, with your solicitor holding a contemporaneous record of your explanations on their file pending any possible future claims or investigations.

Above all, though, if faced with any sort of conduct-based investigation, I suggest that legal advice should always be considered. Even an apparently innocent questionnaire or interview can result (and has often in my experience resulted) in interviewees inadvertently (and often simply mistakenly because they did not understand the question(s)) on the face of it admitting behaviours which in fact constitute quite serious criminal offences, such as acting in breach of an existing disqualification (whether the result of personal bankruptcy, an order or an undertaking).

Tip 3: Don’t blame your Accountant!

My final tip is also more serious than it sounds. If I had a pound for every time I have heard a director try to pass the buck onto their accountant to explain his/her own failings I would have amassed enough to cover a decent summer holiday for a family of 4 and still have some left over for kennel fees. Invariably this sort of approach backfires.

Whilst accountants are by no means infallible, directors have to recognise that the accountants are there to advise, not to manage, and that the buck stops with the directors. If you do not understand why you are being advised to take certain earnings as drawings or dividends or to set off this or that provision on a directors’ loan account, you should ask why, and whether there are any potential downsides to this, and record your understanding in writing. If the accountants’ advice, as clearly understood, then turns out to be at fault it may assist the directors in managing any claims, but by and large a director who escapes liability is one who accepts ultimate responsibility and demonstrates appropriate regret or contrition for the fact that a company’s creditors, employees, etc. may have been left out of pocket, particularly if the directors themselves are not similarly exposed as a result of the insolvency.

Likewise, if your accountants are involved in facilitating an insolvency procedure, you should still establish direct contact with the insolvency practitioner as soon as possible and you should not abdicate to the accountants responsibility for the company’s books and records.

Summary

Only time will tell if the various inquiries and investigations into the failure of BHS result in financial exposure for its former management. The insolvency of a company remains the main threat to the privilege of limited liability and the extent to which directors can expect to be deprived of it will very often come down to the quality of their record keeping and the prudence with which they approach their decision-making both before and after insolvency.

With appropriate care, therefore, there should be nothing for directors to fear in the event that they have to bring a business to an insolvent end. Comfort can be taken from the fact that qualified insolvency practitioner accountants should not be threatening or commencing any claims – having completed their investigations – if the evidence does not support it.

P.S. from P.S. – Beware of false promises

I should add here a final word to the wise, which is that I have become aware of a growing trend of (sometimes opportunistic) claims companies contacting corporate creditors and offering – for a fee of course – to help them bring direct claims against directors of insolvent debtors. These companies will not typically be solicitors or insolvency practitioners, who are closely regulated, but small, unregulated entities who may in truth have little or no intention of genuinely getting such a claim off the ground, and who feed upon aggrieved creditors’ desire to achieve some sort of revenge upon the people at the debtor who are perceived to have been responsible for the bad debt arising.

You can often spot such an approach by references to allegedly new case law (such as ‘the tort of deceit’) or legislation, which on closer inspection would be revealed to be direct remedies which have been available to creditors for decades. Another tell-tale sign will be the intermediary saying they will pass the case to their ‘legal advisor’. The reason many creditors do not know about these remedies is because they are usually very difficult and expensive to prove, essentially requiring the claimant to prove conduct which would likely also be actionable at criminal law. In the vast majority of cases I would advise that a creditor’s best (and ultimately cheaper) prospect of recovery lies in working with the appointed insolvency practitioner, perhaps joining any creditors’ committee if there is one, and trusting that appropriate investigations and claims will – if there is evidence and a route of funding available (and some IPs will quite properly invite creditors to contribute to advice or claims related costs) – be pursued on their behalf.

Directors of creditor companies who shell out with unregulated companies in the hope of achieving a recovery where the appointed insolvency practitioner does not consider there is a viable claim available to the company, acknowledging that they may well be spending good money after bad, will have to consider their own duties to the creditor company. On the flip side, directors of debtor companies which are struggling with cashflow should always avoid (so as not to give fuel to such companies and claims) making promises of payment which they expect to be relied upon but which are not realistic. It is quite true that directors can indeed expose themselves to additional personal liabilities, owed directly to the creditor affected, if they do so.

If you are affected by any of the issues discussed in this blog, please contact either myself or Phillip Baldwin.