Directors' duties in the context of financially distressed companies

With economic pressures faced over the last few years showing no sign of easing and new announcements daily regarding further cost increases, what does that mean for British business?

Brexit, the War in Ukraine, the cost-of-living crisis and the increases in fuel and energy costs point toward 2022 being another difficult year. The Government has made attempts to stave off or delay the impact of Coronavirus, but with furlough schemes and bounce-back loans coming to an end, many businesses are starting to feel the financial impact, particularly in respect of cashflow.

What do directors need to know?

Directors are in a position of trust and, depending on the circumstances, owe certain duties to the company, creditors and shareholders. Although conducting business through a limited company is a vehicle via which directors can seek to limit their personal liabilities for company debt, directors must be aware that this does not give them carte blanche to avoid any and all liability should their company eventually go into liquidation or other formal insolvency processes.

The duties that any director owes to a company are codified in sections 171 to 177 of the Companies Act. In broad terms, they require directors to:

1. act within their powers;
2. promote the success of the company and act in the interests of the members (i.e. shareholders) as a whole;
3. exercise independent judgment;
4. exercise reasonable care, skill and diligence;
5. avoid conflicts of interest;
6. not accept benefits from a third party; and
7. to declare their interest in any proposed transaction or arrangement that the company is to enter into.

Directors must be aware of their duties towards a company under the Companies Act 2006 and, specifically, the differences in those duties where the company is either insolvent or at real risk of insolvency. These duties can be enforced through civil proceedings under section 178 of the Act.

What does this mean in practice?

The Insolvency Act 1986 contains two statutory definitions of insolvency that directors need to consider:

• the assets of the company are exceeded by the company's liabilities (the Balance Sheet Test); or
• the company is not able to meet its debts as they fall due (the Cashflow Test).

If the company fails either of these tests, then the Directors need to consider whether the company is, in fact, insolvent. If this is the case, the general duty to promote the success of the company is modified so that the directors must act in the best interests of the company's creditors. This duty applies to each and every decision that the directors make between it becoming apparent to them that there is a risk of insolvency and either its eventual insolvency or its rescue.

If the directors cannot show that a particular course of action is to the benefit of the general body of creditors or, at the very least, does not prejudice their interests, the course of action should not be taken. In any event, proper records need to be kept by directors of what they consider the interests of the creditors to be and why a particular course of action is necessary.

That is not to say that the company cannot trade because it has financial difficulties; it's just that the directors need to be more careful. Transactions in the usual course of business will usually be fine, but care needs to be taken when making payments to creditors and/or disposing of assets.

The insolvency regime works off the principle of equal distribution of remaining assets amongst creditors. If a company has £100k of debt split evenly amongst three creditors but only has £30k in assets, each creditor should receive £10k each.

While it is appreciated that, in practice, there are other commercial considerations and a strictly even approach as set out above isn't always possible, directors must be seen to be trying to treat all creditors fairly.

It may be tempting to ensure that a family member is repaid their loan to the company or that a particular supplier receives payment in full because of a pre-existing relationship, but there are extensive powers available to insolvency practitioners to undo previous transactions and restore the position to what it would have been had the payment not been made. The family member or creditor will be contacted by the IP and asked to pay the money back. Court proceedings could be necessary.

Personal liability

Directors can be found personally liable for such transactions under the wide-ranging misfeasance provisions contained within the Insolvency Act 1986.

Section 212 allows the Court to make an order against any director found to have breached their duties and can order them to compensate the company for any losses it sustained as a result.

Under the "reasonable director" defence a court may grant relief to a director who acted honestly and reasonably. In practice, this means that directors need to be seen to be proactive in the steps that they take. They should seek advice from insolvency practitioners if necessary, regularly meet to assess the company's financial situation and, most importantly, record how and why any decisions are made or action taken.

Directors must remember that it is their legal duty to consider the company's financial health at all times. Unfortunately, this means asking some tough questions right now. But failure to do so could lead to significant difficulties down the line.

But it's not all doom and gloom! The proactive director has nothing to fear from the insolvency process. What is important is that action is taken as quickly as possible.

Even if the business in its current form has issues, there is usually something that can be done to help everyone move forward.

If you need help and advice in regards to any of the issues raised in this article please contact insolvency specialist Laura Keegan on 0191 211 7970 or by emailing [email protected]