When a director has reason to believe that a business is insolvent, a director must act quickly and seek advice to either (a) put in place a strategy for turnaround, or (b) to enter in to a formal insolvency process. Absent a director taking urgent advice, it could lead to personal claims made against them. Office holders’ (usually insolvency practitioners) are required under the Statement of Insolvency Practice 2 to investigate the circumstances leading to the insolvency which can result in claims against the directors under the Insolvency Act 1986.
Below are a number of frequently asked questions that can arise in the minds of directors of insolvent businesses. If there are any questions unanswered or follow up questions please do not hesitate to contact a member of the insolvency team.
Who is a director?
A director is any person occupying the position of director, howsoever called.
A person who carries out executive functions are known as executive directors, who is usually an employee of the business. A non-executive director is not normally an employee, but devotes part of their time to the affairs of the business as an advisor.
A person validly appointed as a director is known as a de jure director, whereas a person who acts as a director without having been appointed validly or at all is known as a de facto director.
A person who provides directions or instructions to validly appointed directors are known as shadow directors. To be deemed as shadow director, the board must do something to conform with the instructions of that person. Mere advice, direction or guidance will not normally result in a shadow director relationship.
What are the general duties owed by a director?
Directors owe general duties under the Companies Act 2006, namely:
- To act within powers – a director must act in accordance with the company’s constitution, and only exercise powers for which they are conferred
- To promote the success of the company – a director must act in a way they consider, in good faith, would be most likely to promote the success of the company
- To exercise independent judgment – directors must exercise their powers independently, without subordinating their powers to the will of others, whether by delegation or otherwise
- To exercise reasonable care, skill and diligence – a director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person with both (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company (known as the objective test), and (b) the general knowledge, skill and experience that the director actually has (known as the subjective test)
- To avoid conflicts of interest – a director must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company
- Not to accept benefits from third parties – A director of a company must not accept a benefit from a third party conferred by reason of either (a) his being a director, or (b) his doing (or not doing) anything as director
- To declare an interest in a proposed transaction or arrangement – If a director of a company is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors.
A company’s articles of association can go further than the general duties and can include further duties for the directors to adhere to as well as proscribing or limiting their powers.
Who are the duties owed to?
The duties are owed to the Company. Directors owe no direct duties to the shareholders or creditors. When a Company is solvent the duty to the Company is to act in the best interests of the shareholders. When the Company becomes insolvent that duty shifts to acting in the best interests of the creditors of the Company.
When do the duties start and stop?
The duties will start on the date that a director is appointed, and usually end of the date of resignation.
Some duties will however continue post-resignation, including;
- duty to avoid conflicts of interest – this will continue to apply to cover the exploitation of any property, information or opportunity of which at director became aware of at the time prior to resignation
- duty not to accept benefits from third parties – this will continue to apply to cover the things done or omitted at the time prior to resignation
What is the test to show that a company is Insolvent?
A company is normally deemed insolvent if it cannot pay its debts as and when they fall due.
Statute provides for two simple tests to show that a company is insolvent:
- Cash flow test – this is where a company cannot pay debts as and when they fall due
- Balance sheet test – this is where the value of a company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities
Do the duties remain the same when a company is insolvent?
Yes, a director will still owe duties to the company. However, where a company is insolvent, a director must consider the interests of creditors as his/her paramount concern and must take those interests into account when carrying out their duties owed to the company.
Should a director authorise payment of some debts but not others?
This will depend of the factual background of each case. However, when a company is insolvent and will likely enter into formal insolvency, a director should not priorities certain creditors over others unless it is in the interests of the creditors generally. Circumstances in which it may be permissible includes payments to key supplies to enable ongoing trading. Payments made to specific creditors whilst others remain unpaid are liable to be claimed back as a preference payment and/or misfeasance, as this will offend the principle of distribution on a parri passu basis amongst a company’s creditors.
Please see ‘Claims made by insolvency practitioners‘ for more information.
Should a director sell company assets at a less than market value to help with cash flow?
This will depend of the factual background of each case. However, when a company is insolvent and will likely enter into formal insolvency, a director should not sell company assets at less than market value. A sale of assets made for less than market value are liable to be challenged as transactions at an undervalue and/or misfeasance, as the true value of the assets will not available to be distributed amongst the company’s creditors.
Please see ‘Claims made by insolvency practitioners‘ for more information.
Should a director allow a company to continue trading if they know, or believe, that the company will not be able to pay all of its debts?
This will depend of the factual background of each case. However, if a director believes, or has reason to believe and that a company cannot pay all of its debts and will need to enter into some form of formal insolvency, a director should not allow the company to continue trading and should seek immediate advice. When a company is insolvent, the paramount concern should be the creditors of the company and continued trading may affect the monies available to be distributed.
Please see ‘Claims made by insolvency practitioners‘ for more information.
When should a director seek professional advice in an insolvency context?
As soon as a director has reason to believe that a company cannot pay all of its debts or is otherwise insolvent. It is key to get advice at an early stage in order to maximise the changes of a potential turnaround via restructuring, alternatively to enter formal insolvency at an early stage to minimise loss to creditors.
When a company is insolvent, the paramount concern should be the creditors of the company. A director should be able to show the steps that he/she has taken to protect the creditors position.
Can anyone else see the advice received?
Yes. If the company has paid for the advice to be received, the advice is deemed to be company property, which will be available to all directors and subsequently any insolvency practitioner that is appointed if the company enters into formal insolvency.
If a director has received personal advice from lawyers which he/she has paid for, this is privileged advice and will not be available to others, unless such privilege has bene expressly waived by the director. This does not apply if the advice is provided by an insolvency practitioner.
What are the options available if the Company is insolvent?
The below represents a summary of the main options available, known as formal insolvency.
Creditors Voluntary Liquidation
This is a process started by the shareholders of the company and managed by a liquidator whereby a company is placed into liquidation, the assets of the company are then realised and the proceeds distributed to the shareholders and creditors. The company will be dissolved at the end of the liquidation.
Compulsory Liquidation
This is also known as winding up. This is a process started via the filing of a winding up petition at court. A winding up petition can be filed by the Company, a director, a shareholder or a creditor. If a court is satisfied that a company cannot pay its debts as and when they fall due, or is otherwise insolvent, a winding up order will be made and the company placed into compulsory liquidation. The process is then managed by a liquidator and the assets of the company are realised and distributed to the company’s creditors.
Administration
This is a process usually started by either (a) the company (b) the directors or (c ) a floating charge holder. An application for an administration order may also be made by a creditor. An insolvency practitioner is appointed as administrator in order to take control of the business and assets, with a view to achieving one of the statutory purposes of administration. Administration usually used in order to allow a company a chance to reorganise or realise assets whilst having the protection of a ‘statutory moratorium’ whereby creditors are unable to take any action to enforce any claims.
Receivership
Is a process whereby a certain individual (known as a receiver) is appointed in order to take control of a certain asset of the company. The receiver will then sell the asset on behalf of the company. There are different types of receiver however the most common are fixed charge receivers and administrative receivers. A fixed charge receiver is appointed by a fixed charge holder, whereas an administrative receiver is appointed by the holder of a floating charge.
Company Voluntary Arrangement
Is a process whereby a company comes an agreement with its creditors to pay a proportion of the debts due. This is undertaken with the supervision of an insolvency practitioner who is known as a ‘nonimee’ when an arrangement is proposed, as a the ‘supervisor’ when an arrangement is agreed. An arrangement can only be agreed provided that the necessary majority of creditors agree to it by way of decision procedure. Not all creditors need to agree. The agreement can also include future or contingent liabilities. Once agreed, this will bind all unsecured creditors.
What alternatives are there to formal insolvency?
There are of course alternatives to formal insolvency:
Informal arrangement
A company can seek to discuss the position with creditors and come to an informal repayment arrangement and/or new terms in order to spread payments across a time period that the company can afford.
Seek external finance
A company can seek external finance in order to fund a particular difficult trading period, provided that the repayments for such funding are affordable.
Sale of the company
A company can of course be sold as a going concern to an external third party.
What happens after the company enters in to formal insolvency?
This will depend of the form of formal insolvency that the company entered into.
In liquidation, usually an insolvency practitioner is appointed, or this may remain with the official receiver. The insolvency practitioner will then investigate the dealings of the company, consider any claims that can be made which will include the recovery of any book debts, and sell off any assets of the company in order for any realisations to be distributed parri passu amongst the creditors.
In administration, an insolvency practitioner is appointed. The insolvency practitioner will take control of the business and assets, with a view to achieving one of the statutory purposes of administration.
In a company voluntary arrangement, an insolvency practitioner (as the supervisor) will supervise the arrangement to ensure that the company adheres to the specific terms of the arrangement.
What is the effect of formal insolvency on the powers of the director?
This depends on the type of formal insolvency that the company enters into-
- If the company enters into compulsory liquidation, the director loses all power to conduct acts in the company’s name or to control the company’s affairs. Such powers are lost on the date of compulsory liquidation. If it is a voluntary liquidation (either members or creditors) such powers are lost at the date of the voluntary liquidation. If a director tries to exercise his/her powers after this date, any such action is void;
- If the company enters administration, a director will need to seek the consent of the administrator before he/she can exercise any management powers.
Can a director be personally liable for the company’s debts?
Yes. There are a range of claims that can be made by various stakeholders. Each case is fact specific.
Please see ‘Claims made by insolvency practitioners‘ for more information.
Can a director be disqualified?
Yes. A court may make a disqualification order against a person that he shall not, without leave of the court, be a director of a company or in any way, whether directly or indirectly, be concerned or take part in the promotion, formation or management of a company for a specified period beginning with the date of the order. The minimum order is two years with a maximum of fifteen years. The process is usually started via the Secretary of State, following a referral by an insolvency practitioner, on the basis that a director’s conduct makes him/her unfit to be concerned in the management of a company.
If you are faced with disqualification proceedings it is important to seek advice at an early stage which may lead to avoiding disqualification, limiting the period or undertaking not to act as a director. It may also be possible to agree conditions that allow an individual still to act a director