Directors Duties and Insolvency

Generally, the directors of a solvent company owe their main duties to the company and to the shareholders of that company.  The seven general duties of a director are set out in the Companies Act 1986 and are as follows:

1. To act within the powers of the company’s constitution (its articles);
2. To promote the success of the company for the benefit of its members (shareholders), this is often referred to as the s172 duty;
3. To exercise independent judgement;
4. To exercise reasonable care, skill and diligence;
5. To avoid conflicts of interest;
6. Not to accept benefits from third parties; and
7. To declare interest in transactions or arrangements with the company.

The directors should be aware that when a company is, or may be about to become insolvent, their duties change significantly. When a company becomes insolvent, or insolvency threatens, then the director’s duty is to protect the interest of the company’s creditors, effectively the company’s assets must be managed to give priority to creditors.  The directors’ duty to the creditors override all other duties.

If directors act in any way that contravenes their duties, then a liquidator has certain powers to pursue them.  These principles are set out in the Insolvency Act 1986 (IA86). Insolvency Practitioners are obliged to investigate the conduct of an insolvent company’s directors to ensure that they have not breached their fiduciary duty.

What actions can directors be liable for?

• Misfeasance (s212 IA86)

This is a summary remedy against delinquent directors and states that directors can held personally liable where it appears that they have misapplied or retained, or become accountable for, any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company.

• Wrongful trading (s214 IA86)

Where a company is doubtful solvent and all shareholder value has eroded, directors hoping for a change in fortune do so at the risk of creditors.

If, during the course of winding up a company, it appears to the investigating Insolvency Practitioner that at some time prior to the winding a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation the court, on the application of the Insolvency Practitioner, may declare that the director is liable to make such contribution to the company’s assets as the court thinks proper unless the court is satisfied that the person took every step to minimise the potential loss.

This provision exists to protect creditors from additional losses being forced upon them as a result of directors continuing to trade when they should have taken decisive steps to prevent the situation worsening.

• Transaction at an undervalue (s238 IA86)

The disposal of any assets in the lead up to an insolvency process may be challenged under s238 IA86 as a Transaction at an Undervalue, where an asset is transferred at below market value.  The Director should remain cautious about the disposal of any asset during this period and seek advice prior to the disposal of any asset prior to an insolvency process.

• Preference payments (s239 IA86)

Where insolvency is likely, a company should treat all creditors equally.  If one creditor’s interests are prioritised over another so that creditor is in a better position, directors could be personally liable for the payments made to the preferred creditor.

How can you avoid breaching Directors’ Duties?

If a company is facing insolvency, the directors should take steps to demonstrate that they are acting in the best interest of the company and its creditors, this may include:

• Clear and detailed record keeping – the more information you can present to insolvency practitioners, creditors and banks, the better. If you can give detailed reasons as to why particular decisions were taken, when and by whom, you will be in a much better position to show that you have acted in good faith.
• Regular, in-depth forecasting – your position will be much stronger if you regularly update your forecasting to show the knock-on effect of any financial decisions made
• Keep your stakeholders updated – keeping your creditors in the dark in the hope of a financial turnaround is never a good idea. It’s much better to have an open and honest line of communication with all your stakeholders, even if the news isn’t good. It will openly demonstrate that you are working towards their best interests and will restore faith.
• Avoid making risky financial decisions – it can be tempting to take risks on trades with the hope of recouping losses – this is a breach of directors’ duties and might result in legal action and, even if there are gains made, you will be seen to be acting recklessly

Finally, and most importantly, where directors are concerned that their company is in the zone of insolvency should seek specialist advice.