Understanding Insolvency (Part Two)

The subject of last month’s newsletter was what your duties as a Director would be if your company runs into financial difficulties.  We covered the different types of insolvency procedure and suggested that your first step should be to take independent legal advice.

In this month’s newsletter we highlight the risks to you if you fail to take competent advice or do not act on that advice.

If you know of someone who you think would like to read this newsletter do forward them a copy.

James Hunt
and the team at Everyman Legal

Personal liability and risks

Following our overview of the various insolvency procedures open to the company we now look at the issues of a Director’s personal responsibilities, liabilities and risks.  We will start with fiduciary duties and wrongful trading because these are the key areas of responsibility and risk that you need to understand.  We will then offer you some practical tips on managing the risk and deal with some related issues.

Fiduciary duties

Directors must act bona fide in what they reasonably consider to be the best interests of the company.  They must act honestly, diligently and for a proper purpose and not allow their personal interests to influence their decisions.  They also owe a duty of skill and care.

Wrongful trading

The law here can be simply put: it applies if a Director allows a company to continue trading and taking credit from suppliers when no-one could reasonably think the company could avoid insolvent liquidation.  If a Director does so he can be made personally liable for those additional liabilities:

In practical terms this means:

Taking independent professional advice as soon as possible;

Ensuring there is up-to-date financial information; in addition to normal monthly management accounts and cash flow projections, a weekly cash flow may be advisable;

Being careful not to take goods or services on credit if the financial position of the company is very uncertain;

Ensuring that the basis for any decision to continue trading is carefully documented and minuted by the Board;

Considering the possible use of one of the insolvency procedures described in our August Newsletter.

If a company enters into one of these insolvency procedures its Directors will be asked to fill in a detailed form.  This will seek to establish what financial information the Board had to hand and on what basis they acted as they did.  Documenting decisions formally will help Directors to answer the questions in this form and avoid disqualification proceedings (see below).

Disqualification

The Department for Business Innovation and Skills has the power to bring proceedings to disqualify a person from acting as a Director.  Breach of fiduciary duty or allowing a company to
trade wrongfully would be grounds for such proceedings, as would other unlawful actions (see below).

Preferences

Where a company is in financial difficulties, Directors should not deal more favourably (or prefer) one creditor or group of creditors.  Again, the Directors should take and act on professional advice.

At first sight paying employee salaries when other suppliers are not being paid may seem wrong.  However, the key issue will be why the payment is being made. If it is made because the future viability of the business depends on employee support and confidence, and not with the intention of favouring the employees, then payment can almost certainly be made, but only if the Board reasonably believes the company can survive.

Self-Dealing by Directors

Sometimes Directors may choose to buy assets from a company in financial difficulty in order to provide an injection of cash. Care should be taken before doing this.  First, the transaction should be on arms’ length terms and, if not, could be set aside on the basis of a transaction at an undervalue if the company goes into insolvent liquidation.  Secondly, it is likely that formal shareholder approval will be needed; failure to obtain that approval will again leave the transaction vulnerable to be set aside by a liquidator.

Phoenix Companies

Suppose a company fails, can the Directors simply start trading again using a company with the same or a similar name?

The answer is usually ‘no’. If a company has gone into insolvent liquidation it is a criminal offence for a Director to use the same or a similar name for a new company for the next five years.  There are exceptions to this rule; in particular if most of the company’s assets have been bought from an administrator or liquidation and creditors have been notified so they are aware of the Director’s connection with the failed business.

False Accounting

The onset of financial difficulties may be a temptation to present the financial position of a company more favourably than should be the case (e.g. by over-valuing stock or recognising income too early).  Great care must be taken that window-dressing does not become false accounting.  This is a criminal offence.

Fraudulent Trading

Those who allow a company to trade dishonestly with the intent of defrauding creditors, will commit the criminal offence of fraudulent trading.

Resignation

A Director who is not happy with the way in which a company is being run may need to consider resigning his directorship.  Care must be taken, however.

In circumstances where the key director or Directors resign without having first initiated one of the insolvency procedures described in the section above entitled Different Insolvency Procedures, they may have failed to meet their obligations as Directors.

Final Thoughts

For a businessman who has put his heart and soul into a venture, the poor financial performance of that business will be a very stressful experience.  The insolvency of such a business is sometimes likened to bereavement.

The co-directors’ family and the friends of such a businessman should recognise these intensely personal issues in offering their help and support.