What Directors need to know about insolvency

Managing cash flow and trying to make the books balance is a challenge which companies can face from time to time. Indicators of financial difficulty become more transparent when the company has many unpaid creditors who are putting the company under increasing pressure to pay its bills and an overdraft facility is at its limit. At this point, action needs to be taken.

The directors are under a duty to act in the best interests of the company and its shareholders and continually review the financial performance of the company. If it’s not financially viable for a business to continue trading, certain steps need to be taken.

Insolvency law comes into force when a failing company reaches the point of no return and an Insolvency Practitioner is appointed. There are two tests which determine whether a company is insolvent. The first is known as the ‘cash flow test’, where a company cannot pay its debts as and when they fall due. The second is the ‘balance sheet test’, where the company’s liabilities exceed its assets.

Doing nothing to address a company’s financial difficulties is not an option. In an insolvency situation, the directors’ duties to promote the success of the company means that once the company is facing the prospect of insolvency, those duties to promote the success of the company switches to protecting the interests of the creditors.

Wrongful or fraudulent trading

If the directors continue to trade when there is no reasonable prospect that the company will be able to avoid insolvency, they may be held personally liable for wrongful or fraudulent trading and could be disqualified from acting as directors in the future. In some situations, the ‘Every Step’ defence is available. This defence is available to directors in circumstances where it can be shown they took every step that ought to have been taken, to minimise the potential loss to the company’s creditors.

Misfeasance

A director owes its duties to the company, its shareholders and it creditors. If a director misapplies, misappropriates, retains or becomes accountable for any money or other property of the company, this is known as misfeasance.

Directors are more likely to face a claim for misfeasance if their company has gone into liquidation or administration. The main purpose of misfeasance claims is to recover sums owed to creditors and pay off the company’s debts. In most cases, it will be an appointed liquidator who will bring a claim for misfeasance against a director personally, on behalf of the company. More about this here (hyperlink to misfeasance page).

Transactions at an ‘undervalue’ and preference payments

Transactions that have been made by a company at an ‘undervalue’ will be thoroughly investigated during the insolvency process. This is where goods may have been sold for significantly less than their current market value. This is often a sale to a third party connected to the director responsible, for example to another company owned by the director. A claim can then be brought against the directors to restore any loss of value to the company.

Where a creditor is placed in a better position such as paying off an unsecured creditor in full in preference to others (in the event of the company going insolvent) than they otherwise would have been in, an Insolvency Practitioner can bring a claim to prevent a creditor obtaining an improper advantage over the other creditors. As with transactions at an undervalue, this often happens where a director chooses to pay a creditor with whom the director has a connection instead of paying other creditors.

Directors Disqualification

When an insolvency practitioner has been appointed, and they discover a director has done one or more of these, the insolvency practitioner may also report the matter to the Secretary of State (for Business, Energy and Industrial Strategy) with a view to the Secretary of State starting proceedings to disqualify the director from being a director of any company under the Directors Disqualification Act1986.

What steps should be taken

Where a company finds itself in trading difficulties and has been for a number of months or even years, the easy option is to do nothing and hope the financial position of the company improves. This could possibly happen but what if things take a turn for the worse? The company may be forced into liquidation, voluntary or otherwise and it may be too late to take an alternative course of action.

Be pragmatic and seek legal advice now, from lawyers with the relevant expertise, who can give practical and sensible guidance on what the next steps to take are, according to the individual circumstances of the company.

If you would like any further information about insolvency contact our litigation team on 01908 662277 or [email protected].