Lifecycle of a Business – When insolvency beckons: tips for company directors
Setting up and running your own business is an amazing achievement. It requires vision, creativity, motivation and stamina. On occasion, it can even bring you fame, riches and fortune. But it can also result in reams of paperwork and cause sleepless nights. And as someone once said to me about children “It doesn’t get easier, it just changes”, so the same can be said for your business throughout its lifecycle. From setting up to exit, it will force you to consider issues that you might not previously have known anything about and it will need you to make many decisions, sometimes very quickly. What it certainly is not is mundane.
With this in mind, the corporate team at Forsters, together with some of our specialist colleagues, has written a series of articles about the various issues and some of the key points that it may help you to know about at each stage of a business’s life. Not all of these will be relevant to you or your business endeavours, but we hope that you will find at least some of these guides interesting and useful, whether you just have the glimmer of an idea, are a start-up, a well-established enterprise or are considering your exit options. Do feel free to drop us a line or pick up the phone if you would like to discuss any of the issues raised further.
We’ve already discussed various topics, including funding, employment and commercial contracts, but it’s now time to discuss when things go wrong…
When insolvency beckons: tips for company directors
Many companies will, at some point during their lifecycle, suffer financial difficulties. Hopefully yours will pull through if and when this happens, but directors need to be aware of their duties and potential liability when insolvency is on the cards. In this article, we set out some of the issues of which you should be aware and give a few tips which you will hopefully find helpful.
Directors’ duties
The Companies Act 2006 sets out a number of statutory duties for directors and we have covered these in an earlier article. Arguably the most significant of these duties is to promote the success of the company for the benefit of the members as a whole. However, this statutory duty is modified when a company is facing insolvency and instead of considering or acting for the benefit of the company’s members, the directors are instead required to consider and act for the benefit of the company’s creditors. The interplay between these two duties was clarified a couple of years ago, when the Supreme Court handed down its judgment in the case of BTI 2014 LLC v Sequana SA & Others. More detail about this case can be found in our article here, but essentially it clarified that directors of a company in financial difficulties need only consider the interests of creditors when insolvency becomes both inevitable and imminent. At this point, the interests of both shareholders and creditors should be borne in mind, although the interests of its creditors will become more significant as against the interests of its members as the company draws nearer to insolvency. Often, the interests of these two groups will align, especially when the company is first struggling, but the gap between the two is likely to widen the nearer to breaking point the company gets; it is at this point in particular when the directors may need to make some tough choices.
Personal liability
Directors are generally protected from personal liability for a company’s debts because a company is a legal entity and has a separate legal personality, i.e. if a company is in debt, its creditors can (generally) only claim against the company itself.
However, directors may be held personally liable in certain situations where the company becomes insolvent:
1. Wrongful trading
A director may commit the offence of wrongful trading if, in the lead up to insolvency, they:
- concluded, or ought to have concluded, that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvency administration; AND
- failed to take every step that a reasonably diligent person would have taken to minimise the potential loss to creditors, i.e. the company has continued to trade and as a result of such trading, is worse off.
So, for example, actions such as purchasing stock or supplies on credit which you know the company can’t repay and taking customer orders despite knowing that the company won’t be able to honour them would trigger the offence.
Note that no actual dishonesty on the director’s part is required and ignorance is no defence.
If the offence is established, the director in question may be ordered by the court to contribute to the company’s assets and could be disqualified from acting as a director for a given period of time.
2. Fraudulent trading
Fraudulent trading is both a criminal and a civil offence. It arises if a company has entered liquidation or administration and the directors acted, or carried on the company’s business, with an intent to defraud.
To be guilty of the offence, the director must have participated knowingly in the fraudulent activity or business and have done so dishonestly.
A director found guilty of fraudulent trading may be personally liable for the company’s debts, be disqualified from acting as a director, incur a significant fine and/or be sent to prison, not to mention the adverse publicity and damage to the director’s and the company’s reputation that are bound to follow.
3. Misfeasance
Misfeasance is a catch-all claim which can essentially be brought against a director guilty of wrongdoing in respect of the company, for example, because they have kept or misapplied company property or are in breach of their duties. It’s worth noting that insolvency isn’t a necessary element of the offence, so a director can be found guilty of misfeasance where the company is trading and profitable.
However, a defence may be afforded the director if they have acted honestly and reasonably and the court is of the view that, considering all the circumstances, the director ought to be excused.
If found guilty, a court may order the director to account for the money or property (plus interest) which has been retained or misapplied, or to contribute to the company’s assets.
4. Personal guarantees
The general rule that a director of a company will not ordinarily be liable for any debts of that company will not apply in respect of any personal guarantee that you have given regarding the company’s liabilities.
It’s vital to remember that personal guarantees should never be given lightly and independent professional advice should always be taken before doing so; third party lenders, such as banks, will usually require a guarantor to take independent legal advice as a condition for their lending the funds.
Conclusion
The above may sound concerning but provided that you are aware of, and comply with, the various duties of a director and act reasonably and sensibly in that role, your risks of falling foul of the above offences should be small.
To assist further, we’ve set out below our top tips for directors. Ideally, these should be practised at all times, not just when the company is making a loss:
Top tips
- DO stay informed about the business and its current financial position. Read board papers, understand the numbers and ask questions if necessary.
- DO keep written records of decision-making and the reasoning behind them.
- DO come to decisions independently after taking into account all of the information that you have been given. DON’T agree with the majority of the board unless you genuinely concur with them. Being put under pressure from other board members or taking the easiest option is no defence.
- DO communicate with creditors, customers and suppliers, especially if financial difficulties arise or are likely. Often, an open dialogue with stakeholders can stave off the worst case scenario and a plan of action can be put in place, which allows the company to keep trading.
- If difficulties arise, DON’T resign without first seeking legal advice. Leaving the board may not always be the answer and may not improve your situation; resignation could itself be a breach of your duties as a director.
- Most companies will go through tough financial periods at some point, but if there is a cause for concern, DO take professional advice as soon as possible before taking any other steps.
Disclaimer
This note reflects the law as at 24 February 2025. The circumstances of each case vary and this note should not be relied upon in place of specific legal advice.
