Directors’ duties

In this article, our Corporate Restructuring and Insolvency Team explore directors’ duties and the risks to those directors of personal liability in the event that their companies fail, whether this happens whilst they are still running the company or not, and they offer some tips on how best to manage those risks.

Directors’ duties in the face of potential insolvency: how to keep on the right side of the line

As we head into the Autumn of 2024 with a new government putting in their first economic reports and starting to get their hands on the ropes, the financial landscape for business remains a challenging one. Inflation may have eased, and interest rates may have been cut for the first time since March 2020, but consumer confidence still has a long way to go and growth – for the moment at least – has stalled. Certain sectors continue to experience significant strain.

At the same time, we have seen an unusually high level of activity in our courts, notably on the subject of when and how directors of limited companies may be held to account for getting some of the big calls wrong.

In this evolving environment, how are directors to best navigate the waters of ongoing economic volatility without exposing themselves to unnecessary risks of personal liabilities?

An earlier abridged version of this article was published in Hampshire Biz News on 23 November 2023. Please note that we are holding a training session on directors’ duties at 10am-12noon on Wednesday 13 November 2024 – book your place here.

Decisions, decisions…

We know from talking to our existing and prospective client base that continued uncertainty in terms of the economic outlook is causing almost every boardroom across every sector to keep their plans for exit or disaster scenarios close at hand.

These plans may involve discussions and decisions based around such diverse dilemmas as whether to borrow additional funds, whether to defer rent and/or tax payments, when/if to invest in reintegrating staff back into more traditional workplace models after long periods of working from home/hybrid working arrangements, when/if to consider consultation for redundancies if necessary, and even when is the right time to consider some form of corporate or debt restructuring.

The threat of personal liability upon directors for getting decisions wrong is ever-present. A potent reminder and recent example of this is the case of Re BHS Ltd (in liquidation) [2024] EWHC 1417, in which the company’s high-profile insolvency had already led to criminal sanctions against one of its directors, a disqualification order, select committee enquiries and changes to pension legislation to deter poor behaviour. In recent months, directors were held personally liable for more than £42 million in respect of breaches of their legal duties, which included notional liability for two directors who had already settled and who did not participate in the trial. This case underscores the importance of directors making well-informed decisions based upon appropriate considerations (and advice where appropriate), and documenting their processes carefully to mitigate the risk of personal liability.

A balancing act

There is no doubt that a very delicate balance needs to be maintained if directors are to take their businesses forward without the unnecessary distraction of having to look over their shoulders in fear of losing their personal wealth and assets. The risk of this, as most directors in our experience are aware of only in the broadest terms, is that in spite of their best efforts, the company is forced (whether as a result of creditor pressure or shareholder scrutiny, or both) to enter a formal insolvency procedure at which point serious questions will be asked as to the decisions which brought that about, or perhaps made things worse along the way. If a director’s actions are found to be culpable, the veil of limited liability will be lifted, and those directors will find themselves personally liable for some or all of the consequences.

Fortunately, however, there is a self-help solution which – steering far away from the sort of pitfalls which landed the BHS directors in such hot water – directors in general can apply to manage this risk, starting with:

1. Directors seeking information and knowledge as to what they are ‘supposed’ to have regard to in these circumstances;
2. Directors being careful at all times to proceed with those things in mind; and – above all –
3. Directors being able to produce written evidence that these thought processes were followed in a manner consistent with the duties the directors owed to the company.

This evidence can take many forms: from contemporaneous notes and emails which can be stored and easily retrieved, to formal board minutes forming part of the company’s books and records, right up to the very best evidence, which is taking and following appropriate professional advice which is recorded for posterity in the carefully maintained files of regulated advisors.

A brief summary of a directors’ duties under the Companies Act 2006

Whilst to some directors their company may quite understandably feel like their own personal project or “baby”, it is crucial at all times that they remember that, legally, the company is considered a separate entity, with a separate legal personality, and not as an extension of their own personal or household accounts. Directors benefit for the most part from limited legal liability, but observing their legal duties is the price of that limit, and if they fail to meet their duties, this privilege can and will be taken away. It follows that the director, as custodian and guardian to that entity, owes very specific legal duties to it, which can be enforced by others with an interest in the company, such as shareholders, creditors and, if things come unstuck, insolvency practitioners.

This separation of legal personality can be difficult for new directors to grasp, but once it is fully appreciated, directors inevitably learn to approach their responsibilities with the understanding that the company should be treated as an individual in its own right. Their duties as a director are designed to protect the company’s best interests, ensuring that it operates independently and is safeguarded from personal conflicts, and that directors put the company’s interests above their own. By adhering to these legal obligations, the director is not just fulfilling their role but also upholding the integrity and well-being of the company.

Many directors will of course be very familiar with their legal duties, some perhaps from having been through an insolvency procedure before. However, most directors who were trading businesses which were wholly profitable before will likely not have needed to concern themselves with such matters too much. Until, that is, their company becomes actually or prospectively insolvent.

For their benefit, we thought it would be helpful to highlight some of the most important and relevant duties which – amongst others – come into play when the long-term security of a business is starting to be called into doubt…

1. ACT WITHIN YOUR POWERS

Every director must act in accordance with the company’s constitution (broadly speaking, the Articles of Association) and only exercise their powers for the purposes for which they are conferred. This is an exercise in knowing your company. If you are not familiar with your constitutional documents, read them. If you do not understand them, or you realise they do not reflect the way you do business or will need to do business in the future, take advice on them, and if necessary change them with shareholder approval as appropriate. You may wish to review your trading terms and conditions at the same time.

2. PROMOTE THE SUCCESS OF THE COMPANY

This duty is harder to pin down, but in general terms it means that directors must act in a way which they believe is most likely to promote the company’s success for the benefit of its shareholders as a whole. Directors should consider, among other things, the following: the long-term consequences of any given decision; the interests of the company’s employees; the need to maintain the company’s business relationships with suppliers and customers; the likely impact of the decision on the community and the environment; the desirability of maintaining a reputation for high standards of business conduct; and the need to act fairly as between shareholders of the company.

When a company approaches insolvency, however, this duty to promote success transforms by degrees from a duty to the shareholders into a duty to the company’s creditors. At its lowest, the duty will require you to do all you reasonably can to minimise any shortfall which the creditors might suffer if and when the company does fail.

In trying to meet this duty, the Insolvency Act 1986 steps in to remind directors that treating one creditor more favourably than another (particularly if the favoured creditor is connected to you in some way), transferring company assets (including contracts and new business) to another party at an undervalue and paying yourself an income in the form of share dividends when there are no profits to justify it, are all expressly forbidden. If you do any of these things and the company finds its way into an insolvency procedure, you (and potentially anyone else who has benefited from this sort of conduct) can expect to be on the receiving end of claims.

Likewise, directors must not simply bury their heads in the sand and continue trading in exactly the same way if they are reasonably aware that the company is in difficulty. If directors simply failed to act in the interests of creditors when they could have done something about it, they may find themselves facing a claim.

3. EXERCISE INDEPENDENT JUDGEMENT

Every director should exercise their own personal judgement when taking decisions for the company; the law does not allow you to abdicate or contract out of your general duties This duty does not prevent delegation to others with particular expertise provided such delegation is authorised constitutionally, independent judgement is exercised when deciding to delegate and the delegating director maintains oversight. A marketing director would, for example, be entitled to rely on the advice and opinion of the finance director when considering financial matters but would have an obligation to scrutinise and exercise independent judgement when following such advice.

A director should not (except in exceptional circumstances that are outside the scope of this blog) enter into an agreement with another person to vote in a particular way at a board meeting. If in doubt about how you should vote at a board meeting, talk it out, insist that the board takes external advice, or ask for an adjournment so that you can take your own.

4. EXERCISE DUE CARE, SKILL, AND DILIGENCE

Directors are not expected to be able to see the future, nor are they expected only to take decisions which bring the company unbridled success. They are allowed to make mistakes. Whether those mistakes are ultimately culpable, however, will be judged by the standards to be expected of a reasonably diligent person carrying out the functions of a director. All directors will be held to the same minimum standard of competence when making company decisions, regardless of whether they kept quiet during the decision process or chose to take no part in those decisions. Directors will also be held to the standard of the knowledge, skill, and experience they themselves possess. This means that if a director is also a qualified lawyer or accountant, for example, they may be held to a higher standard than directors who do not possess such specialised skills or training.

5. AVOID CONFLICTS OF INTEREST AND DECLARE ANY PERSONAL INTERESTS IN PROPOSED TRANSACTIONS

Every director must avoid situations likely to give rise to a conflict of interests. Generally speaking, a director should not vote in a decision in which they have an interest but a conflict may be authorised by shareholders or (in certain circumstances) by other directors. As such, directors must declare the nature and extent of any direct or indirect interest they may have in a proposed or existing transaction or arrangement and this should be reflected in the minutes of the board meeting. Depending on the company’s Articles of Association, a director may be authorised to vote in relation to a proposed or existing transaction or arrangement provided such interests are declared but if in doubt, advice should be taken on this point to ensure that any decision has been taken with sufficient board authority. This is particularly important if, for example, the directors decide that the best thing they can do for the company’s creditors is to transfer some of its business to another company with which they are also involved.

6. NOT TO ACCEPT THIRD PARTY BENEFITS

Directors must not, as a rule, accept benefits from third parties gained through their position or through a decision they take as a director. In the event of the future insolvency of the company, any pecuniary benefit derived by the director personally is likely to ring loud alarm bells both in terms of director conduct reporting and liability.

To a certain extent, compliance with the above duties is a matter of common sense. In practice, however, directors should maintain the common-sense approach supplemented with a detailed understanding of their duties to avoid any breach of duty (also known as “misfeasance”) claims should the company later require a formal insolvency procedure.

Insolvency Practitioners’ role

If a company becomes, or appears likely to become, insolvent on the basis of its cash flow or balance sheet, a well-informed director will look to involve a qualified, regulated insolvency practitioner accountant (IP) at an early stage. This will increase the range of options available to the company to resolve any insolvency issues. Sometimes IPs will just advise, but sometimes their advice will result in a formal appointment of an IP (not necessarily the same one which gave the advice).

It is important to remember that any IP – whether ultimately appointed by the directors themselves, a lender, one or more creditors, or the court – is bound by their own legal duties to investigate and pursue (or to sell to a third party where appropriate for the benefit of creditors) any proper claims against directors. The Secretary of State has a similar duty to pursue disqualification and/ or creditor compensation orders where it is observed that the director’s conduct fell below expected standards.

This means that in terms of avoiding personal liabilities, there is everything to be gained by directors consulting with their own choice of IP well before the cash starts running out. The first thing the IP will do is undertake a health check on the company, which will help inform the directors’ decision making, and they will then explore all available options to hopefully ensure that the company does not need to enter an insolvency procedure at all. If their advice, however, is that a formal insolvency procedure cannot reasonably be avoided, they can help the directors to choose the right one, and to ensure that the directors do not fall foul of the sort of pitfalls along the way which might suggest that claims should be brought against them after the event. In being aware of their duties, seeking professional advice where needed, and maintaining clear records of their board decisions, directors keep themselves firmly on the right side of the line, and should have little or nothing to fear therefore if, in the end, the company itself cannot be rescued.

The very worst thing that directors can do during a crisis is to fail to recognise and address the issues that their business is facing and to put a misplaced trust in their ability to simply fold the company at the last minute when all the money has already run out. IPs are there to assist where they can. They are heavily regulated, specialist accountants who are trained to respond positively to a crisis. They add a huge amount of value to the economy through their work, which often preserves any value in a company’s underlying business which can be recycled and recirculated to minimise the impact on creditors, save or create jobs and productivity. Directors should never, therefore, regard the consultation of an IP as an admission of defeat. It is something to be welcomed, and may be just what directors need to help them in unprecedented times.

It should be remembered, however, that IPs are experts on insolvency, not the law, and that they cannot give legal advice, nor is their advice protected by legal professional privilege. Best advice to directors may therefore require input from both an IP and a specialist insolvency solicitor.

Summary

In a nutshell, when taking decisions every director who has even the slightest concern about their company’s ability to survive the crisis over the long term should:

• be aware of their duties: understand and stay updated on their legal obligations and responsibilities;
• take professional advice where needed: seek guidance from financial and legal experts to navigate complex situations;
• maintain clear records of board decisions and note any professional advice sought: you should document all decisions and the rationale behind them to demonstrate due diligence;
• cooperate as fully as possible with an insolvency practitioner if you find yourself needing their assistance: engage with insolvency experts to explore options and mitigate risks if facing financial difficulties; and
• remember that whilst the buck stops with the director, seeking the right advice at the right time is not the abdication of duty, but the fulfilment of it.

The ongoing economic landscape will doubtless claim a number of economic casualties. It is in all of our interests that directors of limited companies, who themselves are the life blood of the UK economy, understand the nature of the challenge ahead of them and carry with them as little fear of the unknown as possible, so as to minimise those casualties and/or the extent of the damage to people’s lives and livelihoods. Recent court cases have done little to reinforce certainty in terms of what directors should be doing, but by setting out the above steps, we hope that we will have helped our readers in some small way to cut through that confusion and alleviate any fears, so we have at least one less thing to worry about.

Should you or any of your contacts require any guidance with any of the issues highlighted in this blog, please get in touch with any of our CR&I team who have a wealth of connections with a variety of IPs and financial advisors, and we would be glad to assist you with putting you in touch with the right individuals for your business needs.

We have a training session coming up in January on directors’ duties.  Please take a look at the event and book your place if you would like to attend.

We publish blogs and social media posts to give a general overview of legal and commercial issues, relevant at the time of publication, which we hope you will find interesting. Please note that legal rules often change depending on the specific facts of a situation. The law also changes over time following changes in legislation or new court cases. We do not actively update our blogs or posts once they are published to reflect changes in the law.

As such, our blogs and posts are not intended to advise you on the law and must not be relied upon as legal advice. If you require advice on a particular issue then please contact us and we will be pleased to help.