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Business Law Update: Legal refresher and practical guidance for directors of companies in financial distress

20 April 2020

Companies of all sizes are facing unprecedented challenges, especially pressures on working capital, during the current crisis and beyond. Directors of a company in financial distress will often wish to keep the company trading for a period in the hope that they will be able to trade through such financial difficulties. However, this course can run the risk of the directors falling foul of the insolvency regime and it can also lead to directors contravening the duties they owe to the company or to creditors.

It is important, in times like this, for directors to remind themselves of their duties and the practical steps they should be taking to avoid incurring personal liability. This note seeks to do just that and what follows is a reminder of the duties that directors owe in England and Wales, how these duties can change in an insolvency situation, and practical guidance to ensure compliance with the relevant rules and maintain good corporate governance.

Most of what we identify is good practice in respect of the management and governance of any company at any time; however, it is particularly important when a company is in financial difficulties.  We are advising clients on a wide number of the issues raised in this note, largely, in planning for the steps they can take to effectively monitor and manage their businesses in the current crisis.

First, a legal refresher.

What duties does a director owe to a company and how do these duties change in an insolvency situation?

Directors owe general duties and responsibilities to the company both under the Companies Act 2006 and the common law.  A central duty is that directors must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole.

In seeking to satisfy this duty, the directors should have regard to a number of factors, including the likely consequences of any decision in the long term, the interests of its employees and the need to maintain high standards of business conduct.

This duty applies to all decisions made by directors and not merely formal decisions made by the whole board.

However, where a company is insolvent, or is close to insolvency, the directors’ duty to the company and its shareholders shifts to act in the best interests of the creditors of the company. This means that directors cannot, for example, repay shareholders’ debts or make any distributions to shareholders in such circumstances without the proper provision for each of the creditors.

Does insolvency law prohibit a company from trading if it is in financial distress?

The position under the insolvency regime is that directors may find themselves personally liable to contribute to the assets of the company if it is found that the directors continued to trade when it was “wrong” for them to do so (an offence known as wrongful trading). The fundamental elements of this offence are that:

  • the company continues to trade when the directors knew, or ought to have known, that the company could not reasonably avoid an insolvent liquidation or administration; and
  • the directors did not do everything a reasonably diligent director ought to have done to minimise the losses of the creditors of the company.

How is the wrongful trading legislation changing to accommodate the financial difficulties companies are facing in light of COVID-19?

The Government has proposed reforms to the UK’s insolvency legislation to temporarily suspend the rules around wrongful trading, as a direct result of the challenges many companies are facing during the COVID-19 crisis.

The Government’s proposals to help alleviate financial difficulties include suspending the application of wrongful trading provisions under section 214 of the Insolvency Act 1986 from 1 March 2020 for an initial period of three months (to be extended if required).

 What does this mean for a company of which I am a director?

The proposals are likely to be welcomed by directors who are facing difficult decisions about continuing to trade or taking on extra support and credit at a time where their ability to generate income remains in doubt. However, it should be emphasised that, although these insolvency rules may be temporarily suspended, these changes are unlikely to last indefinitely. It is likely that the law will be restored to the pre-COVID-19 position once the effects of the pandemic have subsided.

Are any other insolvency rules changing? What other legal issues should I be mindful of?  

It is not yet clear to what extent the Government’s proposals will change other law which is relevant to the actions of directors of companies in financial difficulties, including the existing rules in relation to transactions at an undervalue or the treatment of preferences. Directors should continue to exercise caution when entering into certain transactions or dealing with creditors of the company. An overview of some of the key rules in this regard are set out below.

Transactions at an undervalue

Under the current insolvency regime, the courts have the power to set aside any transactions where the company received no payment or the payment received was significantly less than the true value and the company is insolvent at the time of the transaction (or the transaction itself led to the company becoming insolvent).

Liquidators or administrators subsequently appointed to the company can apply to Court for an order to unwind any transaction that the company has entered into in a two year period prior to the onset of insolvency.

Preferring creditors

The Court can also set aside any transaction that puts a particular creditor of the company or guarantor of the company’s debts in a position that is more favourable than that person would have been treated in the event that the company went into liquidation (i.e. ahead of the statutory order of priority for settling a company’s debts in an insolvency process).

This is relevant to any transaction which occurred within six months prior to the onset of insolvency or two years in the event that the preferred party is a connected party.  Where the preferred parties are also connected parties to the company, a presumption that the company was influenced by the preferred party applies unless the contrary can be established.

The extent of a director’s responsibility for such transactions will also be relevant in assessing his unfitness for disqualification purposes.

Other legislation to consider

There does not appear to be any proposed changes to legislation covering the offences of fraudulent trading or misfeasance so these offences will continue to regulate the activities of directors and help protect creditors of distressed and insolvent companies.

What should directors do to ensure they do not prefer creditors or approve transactions which could later be set aside?

Directors should continue to ensure that any transactions are entered into in good faith for the purpose of carrying on the company’s business and they should also make sure that there are reasonable grounds for believing that the transaction will benefit the company.

The most effective way to evidence this is to discuss the proposed transaction at a board meeting of the directors and ensure that there are adequate minutes recording the actions, commercial decisions and intentions of the directors, bearing in mind the practical steps below.

Some practical suggestions

What are the practical steps directors should be taking to avoid an insolvency process (while ensuring  good corporate governance)?

  • Board meetings. Although board meetings should be used as the forum for reaching decisions in normal circumstances, it is all the more important for directors to make decisions collectively in times of financial pressure. Decisions should be taken by majority vote of the directors present (and in accordance with the company’s articles and any shareholders’ agreements). Ensure the board meetings are fully and promptly minuted to record the decisions of the board and to document that the directors have considered their statutory duties. Consider holding telephone or virtual board meetings and delegating areas of decision-making to select committees to improve efficiency or to cater to the expertise of certain directors.
  • Adequate knowledge and sophisticated practices. Directors of all companies, big or small, should continue to exercise caution. Experienced directors of large companies should make full use of sophisticated accounting procedures and equipment so they can be sure to conduct themselves in the highest standards. Equally, directors of smaller companies should ensure that they have adequate knowledge and skill and that the company’s accounting procedures are suitable for its size and business. The board should utilise the skills and experience which their fellow directors bring to the table. We commonly see, for example, start-ups and other SMEs appoint non-executive directors who can provide sector specific knowledge or strategic and financial advice, and are often well placed to keep the board in check. Although it can be difficult when under pressure, directors should ensure they have the most up-to-date, accurate and adequate financial and cash flow information possible relating to the company.
  • Stay insured. Directors should refer to their existing policies and determine whether they have sufficient coverage in place. In the current climate and the potential for large scale insolvencies, Directors and Office Liability (“D&O”) insurance is key. This is an opportune moment for directors to engage with their brokers in relation to their D&O policies and to determine whether adequate cover is in place.
  • Think carefully about resigning. If the board does not take action when it should have done so the director should persist and consider his or her personal position and, if appropriate, take independent professional advice.  Resigning from the board will be unlikely to avoid liability where all reasonable steps to persuade the board to act have not been taken.  If a director does elect to resign from the board under these circumstances, the director should clearly note his or her concerns in board minutes and communicate his or her concerns in writing to the rest of the board on resignation.
  • Beware of rushing into an insolvency process. It is possible that one of the steps that directors should take in order to minimise loss to creditors is to refrain from commencing an insolvency process too quickly. For example, time may be needed to weigh the completion of beneficial contracts against additional liabilities incurred in so doing and to consider the costs of termination of valuable rights (i.e. licences) upon liquidation.  The choice of date for putting the company into liquidation may materially alter the company’s taxation position or the final outcome.   It will be important for directors to obtain professional advice as continuing to trade in such a scenario will require careful management and such a decision should be kept under regular review.
  • Seek legal and financial advice and, if necessary, consider consulting an insolvency practitioner who will be able to advise on the best procedures to minimise the loss to creditors.
  • Avoid conflicts of interest and keep their duties in mind. In circumstances where a director is also a shareholder, that individual should ensure that it does not put his or her position as a shareholder over their responsibilities and the duties owed as a director. Equally, directors should remember to satisfy the other duties owed including the duty to exercise independent, judgment and reasonable care, skill and diligence. This can often be difficult where the directors need to balance the needs of different stakeholders (such as its employees, suppliers, creditors and shareholders).
  • Consider individual companies within a group. Where directors have cross directorships across a group of companies it is important for them to consider the duties owed to the creditors of the relevant company when making a decision in relation to that company.
  • Safeguard creditors’ interests. Directors should consider taking steps to safeguard the interests of creditors if a serious risk of an insolvent liquidation or administration is perceived.
  • Parent company aid. Directors could consider, if appropriate, taking loan facilities or equity injections from parent companies or external lenders. However, before entering into such arrangements the directors will need to be mindful of the Company’s ability to meet current and future obligations.

This information is part of a series of Harbottle & Lewis Business Law Updates, focusing on legal and business operational issues arising in the current COVID-19 crisis. 

If you have any queries on their content, please contact businesslawupdate@harbottle.com.

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