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
Despite recent signs around the time of the 2023 Autumn Statement that the inflation crisis may finally be easing, growth in the economy has been non-existent for months, consumer confidence remains low, and the cost and security of supplies, materials and affordable refinance options across many sectors remains volatile and uncertain.
Whilst these stress fractures may be more apparent in certain sectors such as retail, hospitality and leisure, it is always naturally concerning when we see long-established, previously successful businesses and much-loved cultural amenities facing the prospect of imminent closure. There is clearly a great deal (too much) for directors to ponder here, so how can directors best identify the wood from the trees?
An abridged version of this article was published in Hampshire Biz News on 23 November 2023.
We know from talking to our existing and prospective client base that the continued uncertainty in terms of the depth and duration of the economic crisis is causing almost every boardroom across every sector to at least start planning for worst-case scenarios.
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 invite staff back to their traditional workplace after a period of working from home/hybrid working arrangements under the lingering effects of COVID-19, 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 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 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 directors can apply to manage this risk, starting with:
- Directors seeking information and knowledge as to what they are ‘supposed’ to have regard to in these circumstances;
- Directors being careful at all times to proceed with those things in mind; and – above all –
- 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
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 now.
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
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 there is everything in fact to be gained by directors consulting with their own choice of IP at an early stage, i.e. 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 you 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 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 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 these unprecedented times.
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;
- take professional advice where needed;
- maintain clear records of board decisions and note any professional advice sought;
- cooperate as fully as possible with an insolvency practitioner if you find yourself needing their assistance; 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 current economic crisis will doubtless claim many 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.
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.