A limited company is an incorporated entity. It has legal fiction, meaning in the eyes of the law, it is for all intents and purposes a natural person. Of course, the separate legal entity does not have arms or legs or a mouth, and so it needs officers to act on its behalf.
Directors appointed tend not to be personally liable for obligations of the entity they are appointed by, unless they have offered personal guarantees. Directors do owe duties of a fiduciary nature to the company. Contravention of these duties can give rise to personal liabilities. See our articles on the Fiduciary Relationship here.
This Article considers the Directors’ duties in the context of an insolvent company and whether they can be held out as personally liable for actions taken in the run up to and during a company’s insolvency.
Consequences for Directors for carrying on business whilst the company is insolvent:
Note, this refers to an instance when proceedings are not commenced on behalf of the company to put it into some form of formal insolvency regime.
The definition of Insolvency is when a company is unable to pay its debts as fall due.
It can be summed up in three tests:
- The Cash Flow Test (When a company is unable to pay its debts as they fall due).
- The Balance Sheet Test (Whether a company’s liabilities outstrip its assets).
- The Legal Action Test (Whether a company has failed to resolve debt proceedings brought against it by a creditor).
The definition is found in the Insolvency Act 1986:
123 Definition of inability to pay debts.
(1)A company is deemed unable to pay its debts—
(a)if a creditor (by assignment or otherwise) to whom the company is indebted in a sum exceeding £750 then due has served on the company, by leaving it at the company’s registered office, a written demand (in the prescribed form) requiring the company to pay the sum so due and the company has for 3 weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor, or
(b)if, in England and Wales, execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part, or
(c)if, in Scotland, the induciae of a charge for payment on an extract decree, or an extract registered bond, or an extract registered protest, have expired without payment being made, or
(d)if, in Northern Ireland, a certificate of unenforceability has been granted in respect of a judgment against the company, or
(e)if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.
(2)A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
On the basis of these three tests, it is possible to be insolvent before formal insolvency proceedings have begun and therefore possible to continue trading. Such action would be wrongful.
Section 214 subsection 6 of the Insolvency Act 1986 provides that this would occur where “a company goes into insolvent liquidation” and it is deemed to be in such situation “if it goes into liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the winding up.” A consequence of carrying on business when insolvent can be that the court finds a director guilty of wrongful trading under section 214 of the Insolvency Act which provides:
214 Wrongful trading
(1)Subject to subsection (3) below, if in the course of the winding up of a company it appears that subsection (2) of this section applies in relation to a person who is or has been a director of the company, the court, on the application of the liquidator, may declare that that person is to be liable to make such contribution (if any) to the company’s assets as the court thinks proper.
(2)This subsection applies in relation to a person if—
(a)the company has gone into insolvent liquidation,
(b)at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, and
(c)that person was a director of the company at that time;
but the court shall not make a declaration under this section in any case where the time mentioned in paragraph (b) above was before 28th April 1986.
Section 214, subsection 4 sets out the test for determining wrongful trading as the objective reasonable director who would be in the same position as the director in question test.
(4)For the purposes of subsections (2) and (3), the facts which a director of a company ought to know or ascertain, the conclusions which he ought to reach and the steps which he ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both—
(a)the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and
(b)the general knowledge, skill and experience that that director has.
(5)The reference in subsection (4) to the functions carried out in relation to a company by a director of the company includes any functions which he does not carry out but which have been entrusted to him.
Consequence for Wrongful Trading
Where a director has acted in contravention of section 214, the court may declare that the director is liable to make such contribution to the company’s assets as the court thinks proper, the amount being compensatory rather than penal.
It should be noted that the insolvency bill introduced as a result of COVID, introduced temporary measures to reduce or do away with the contribution that directors of certain companies must make to a company’s assets if they are found liable for wrongful trading.
In relation to wrongful trading, assuming that the necessary limbs of the statute are met (ie, the director at the time knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration), then there is a defence available to the director if he or she has taken every step to minimise the potential loss to the company’s creditors as he or she ought to have taken. I.e. if any director has acted as the objective reasonable ordinary director in their position would have acted (section 214 (3)), then this will be a valid defence against claims of wrongful trading.
(3)The court shall not make a declaration under this section with respect to any person if it is satisfied that after the condition specified in subsection (2)(b) was first satisfied in relation to him that person took every step with a view to minimising the potential loss to the company’s creditors as ( [on the assumption that he had knowledge of the matter mentioned in subsection (2)(b)] ) he ought to have taken.
Resignation is not a defence. On the contrary, it is likely to be viewed as “buying your head” and amounting to an insufficient step to minimise the potential loss to creditors (and therefore such director would not be able to rely on the defence given in subsection (3) referred to above).
Section 213 of the Insolvency Act deals with fraudulent trading. A director may be liable for fraudulent trading where it appears they have carried on business with intent to defraud creditors or for any fraudulent purpose, the court may declare that any persons who were knowingly parties to the carrying on of business in that manner are liable to contribute to the company’s assets. This section goes beyond directors and officers and applies to anyone who has been involved in carrying on the business of the company in a fraudulent manner. As this is a fraud, a higher standard of proof is required beyond the usual “balance of probabilities” and it must be “beyond reasonable doubt” with actual dishonesty proven. It would be grave circumstances in which should proceedings are brought. Usually they would be brought by a liquidator or relevant insolvency practitioner.
213 Fraudulent trading.
(1)If in the course of the winding up of a company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, the following has effect.
(2)The court, on the application of the liquidator may declare that any persons who were knowingly parties to the carrying on of the business in the manner above-mentioned are to be liable to make such contributions (if any) to the company’s assets as the court thinks proper.
The consequence of a finding of section 213 Fraudulent Trading would be an order to make contributions to the Company as the court may see fit, along with any criminal liability under sections 206 to 211 of the Insolvency Act for fraud, misconduct, falsification of the company’s books, material omissions from statements and false representations. They are also liable to disqualification from being a director of any company for up to 15 years under the CDDA. The court can also make a compensation order where a director has been disqualified. A director can also be disqualified in Great Britain if he or she has been convicted of (among others) an offence in connection with the promotion, formation, management, liquidation or striking off of a company outside Great Britain. Lastly, environmental and health and safety legislation may provide for personal liability on directors and officers.
Do the duties that directors owe to the company shift to its creditors when an insolvency event is likely?
When a company’s financial position has deteriorated to the point where its solvency is in question pursuant to the three insolvency tests discussed above, the focus of the directors’ attention must shift away from the shareholders and towards protecting the interests of creditors.
The Companies Act 2006 recognises this shift in section 172(3) of the CA 2006, which sets out the Director’s fiduciary duty to promote the success of the company.
172 Duty to promote the success of the company
(1)A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—
(a)the likely consequences of any decision in the long term,
(b)the interests of the company’s employees,
(c)the need to foster the company’s business relationships with suppliers, customers and others,
(d)the impact of the company’s operations on the community and the environment,
(e)the desirability of the company maintaining a reputation for high standards of business conduct, and
(f)the need to act fairly as between members of the company.
(2)Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.
(3)The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.
Subsection (3) specifically makes reference to this shift. Directors must consider the interests of creditors as a whole, and not just the interests of any individual creditor or class of creditors. A director is subject to these duties irrespective of whether they are an executive or non-executive director and even if appointed as a nominee of a particular creditor or shareholder.
Remedies against offending Directors
In the event a director is in breach or threatens a breach of his fiduciary duties or their duties under the Insolvency Act, the company should consider seeking legal advice in respect of the remedies available to them, which include:
- Setting aside a transaction, restitution and account of profits
- Restoration of company property held by the director
- Statutory remedies under Insolvency Act 1986, including criminal liability under sections 206 to 211 of the Insolvency Act for fraud, misconduct, falsification of the company’s books, material omissions from statements and false representations and bannings under CDDA.
In deciding whether to bring any proceedings against offending actions, considerations for the burden of proof required for each claim should be considered.
What Control to Directors have if the Company is in Insolvency?
Where a company is insolvent pursuant to one of the three insolvency tests mentioned above, the director retains full control as usual, until a formal insolvency regime is entered into. However at this point, pursuant to its s172 fiduciary duty, the director’s focus must shift to the Company’s creditors.
Where a moratorium has been put in place following entering administration, the directors retain control of the company given that the rationale for administration is company rescue rather than liquidation, although a licensed insolvency practitioner is appointed with certain oversight duties. Directors will need to seek permission from the monitor to engage in certain acts such as disposing of property (unless disposed of in the ordinary course of business or in pursuance of a court order), granting security or paying certain pre-moratorium debts for which a payment holiday applies (this permission is only required if the total payments to a person exceed the greater of £5,000 or 1 per cent of the value of the debts and other liabilities owed by the company to its unsecured creditors when the moratorium begins).
In a company voluntary arrangement (CVA), the directors remain in control with the assistance and supervision of the nominee and supervisor of the CVA.
In a liquidation, the directors’ powers will cease unless in a voluntary liquidation, the creditors’ committee and the creditors; or in a members’ voluntary liquidation, the shareholders in general meeting or the liquidator, agrees otherwise.