Phoenix Companies

Directors: Role and Responsibilities

What is a director?

Although this may seem obvious, it is not necessarily just those people who are called ‘directors’. For instance, company law provides that a director includes ‘any person occupying the position of director, by whatever name called’. This means that if a person is fulfilling the role of a director, then he or she may be deemed to be one and fully liable as such. Equally, if the directors are accustomed to act in accordance with the directions and instructions of a third party, that person may be deemed to be a ‘shadow director’ of the company. Company law subjects shadow directors to many of the responsibilities of directors.

What is the director’s role?

Although companies are legal entities in their own right, they can only act through human agents. Company directors fulfil this role and the operation and management of the company is typically delegated to them. The directors’ powers to manage the company are subject to the terms of its constitution and any restrictions that may be contained within it.

Directors generally exercise their powers through the board of directors, which will meet to consider matters relating to the company and will make its decisions through resolutions. However, in practice, the running of a large company would be impossible if all decisions required a full board meeting. Whilst in small companies with few directors, day-to-day decisions can be taken at meetings of all of the directors, board meetings of larger companies are relatively infrequent and are generally used to discuss and formulate policy or to approve and authorise important transactions.

The operation of most companies is delegated to their executive directors, who are usually employed under the terms of a service contract with the company. A great many companies also appoint one or more non-executive directors, who are selected for their commercial experience and expertise, but who are generally not involved in the day-to-day running of the company and do not devote their whole working time to it. Their relative distance from the daily operations of the company gives them an objective overview, which operates to the benefit of members.

Which duties are imposed on directors?

As directors may be given extensive powers, the law imposes certain duties on them to safeguard the rights of shareholders and others.

Directors’ duties are now principally set out in a statutory statement of directors’ duties introduced by the Companies Act 2006.

The seven main general duties owed by directors to a company are as follows:

– to act within powers

– to promote the success of the company

– to exercise independent judgement

– to exercise reasonable care, skill and diligence

– to avoid conflicts of interest

– not to accept benefits from third parties

– to declare interests in proposed transactions or arrangements with the company

The statement codifies and replaces the common law and fiduciary duties that have been developed by the courts in case law over many years. The case law remains relevant because the Act expressly states that in interpreting the statement, regard should be had to the case law that it replaces.

In addition to the statutory statement, there are also a wide range of other duties imposed upon directors – for example under health and safety legislation. The statutory statement is by no means a “one-stop shop” for a full understanding of all directors’ duties.

There are various remedies that may be sought against directors for breach of their duties, depending upon the circumstances. These include both civil and criminal penalties, depending on the breach. In some cases, there may be opportunities for the director to mitigate his or her liability. In certain situations, the court may grant relief from liability if he/she has acted honestly and reasonably; in other circumstances, the shareholders of the company may ratify the unauthorised acts. It is also possible for companies to indemnify their directors against certain liabilities to third parties. Finally, many companies purchase Directors and Officers Liability Insurance to protect their officers against such liabilities

Corporate Governance, Directors’ Duties and Shareholder Relations

We advise private companies and their directors on a full range of corporate governance issues. We also advise on relations between shareholders and on resolving any disputes that may arise. The Companies Act 2006 has made and will continue to make significant changes in this area.

Frequently asked questions

What changes have been made to my duties as a director? The Companies Act 2006 provides for a statutory statement of directors’ duties which replaces the current common law and fiduciary duties. In many ways these duties are similar to existing duties but there are some significant changes. There have also been changes to the rules on directors’ dealings with their companies – for example, it is now permissible for companies to make loans to their directors with prior shareholder approval.

What are my duties as a director? Directors generally have responsibility for the day to day running of the company and the management of its business. The seven main general duties owed by directors to a company are as follows:

to act within powers;

to promote the success of the company;

to exercise independent judgement;

to exercise reasonable care, skill and diligence;

to avoid conflicts of interest;

not to accept benefits from third parties:

to declare interests in proposed transactions or arrangements with the company:

Looking beyond these internal duties, directors also have wider duties imposed by statute and breach of these statutory duties will usually be a criminal offence, punishable by fines or imprisonment.

Isn’t there one set of rules I can follow? Unfortunately, there is no one place for a director to look for his responsibilities. Even though the statutory statement of directors’ duties condifies (with some significant changes) and replaces the common law and fiduciary duties that have been developed by the courts in case law, the case law remains relevant in terms of interpreting the statutory statement. As well as the statutory statement of duties, there are also a wider range of other duties imposed upon directors, eg under health & safety legislation. In addition to the legal responsibilities which apply to all companies, directors of companies whose securities are listed on an investment exchange are subject to a further layer of regulation eg the Listing Rules or the AIM Rules. Directors of companies must also have regard to the corporate governance guidelines set out in the Combined Code. The new statutory statement of directors’ duties is by no means a “one-stop shop” for directors’ duties.

What are my obligations to shareholders of the company? Directors’ duties under company law (as opposed to specific duties under other statutes such as those relating to health and safety or the environment) are owed to the company, rather than directly to an individual shareholder or group of shareholders. Breaches of those duties can (subject to certain exceptions) be enforced only by the company, not by its shareholders. However, while in most cases shareholders will have the same interests as the company, there can be conflicts if the company, through its directors, is proposing to act in a way which benefits some shareholders to the detriment of others or, indeed, which is seen to benefit the directors. In those circumstances, the affected shareholders may be able to take action themselves. As a general rule, directors should ensure they act fairly towards all shareholders although this will not necessarily mean exact equality of treatment.

The changes introduced by the Companies Act 2006 are anticipated to make it significantly easier for shareholders to enforce directors’ duties on behalf of the company. A key change is that shareholders may be able to bring claims against directors for alleged negligence if the company fails to pursue them. However, any claim must still be brought in the name of the company so shareholders bringing such claims will benefit only indirectly. There are also safeguards against frivolous claims so it may be that this will not greatly increase the risk to directors.

What is a shadow director? A shadow director is a person in accordance with whose directions or instructions the directors of a company are accustomed to act. An example of a shadow director would be a major shareholder whose instructions the directors would always obey, without independently using their judgement. For many purposes of the Companies Act and the Insolvency Act, shadow directors are deemed to be directors and can be liable for breach of the duties imposed on directors in the same way as any other director.

Can I be personally liable to third parties for my actions as a director? Other than directors’ liabilities to the Company and its shareholders, directors are not generally personally liable in carrying out their functions. For example, if a director signs a contract on behalf of the company he will not be liable to the other party if the company then breaches it. However, there are duties imposed specifically by statute, for example, under the Companies Act and health and safety legislation, which can result in third party liability. A key situation where a director can be held personally liable for the debts of a company is if he continues to allow the company to trade when he knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation.

Over the years directors duties have been spread out over numerous statutes and case decisions making it difficult for directors to know when they may have breached their duties to the company. Finally, in 2005 we had a white paper proposing to reform company law which included a proposal to codify director’s duties. Those proposals have now been made into law with the enactment of the Companies Act 2006. Part 10 of the 2006 Act sets out the laws relating to company directors and; Chapter 2 of Part 10 (sections 170-180) sets out the statutory duties on director’s.

The general duties of directors are based on and replace those previously decided and set by case law. However, the statutory duties are to be interpreted as before. The provisions of the Act extend to shadow directors (those who are not appointed directors but whose decisions the company follows) and de facto directors (those who act as directors although they have not been formally registered as a director at Companies House) in circumstances as before. They also apply to a person who ceases to be a director.

It is important that any director whether of a big or small company is familiar and complies with their duties. Ignorance is no defence and; the consequences can be severe both for the company and personally. As a director you have no hiding place, you must always act in the best interests of the company.

It is particularly important when starting a new business and considering which trading medium to use to consider the duties which are placed on directors. For example, in small companies where family members are appointed just to make up numbers, you must ensure that they are aware that they cannot simply sit back and have no involvement in the company. There is much more to being a director of a company than being registered at Companies House as will be seen below.

It is reasonable to split the workload of directors based on the talents of the individuals. However, all directors are jointly responsible for the company and the duties towards it. If you are appointing directors with specific expertise such as an accountant as finance director they are also expected to use their professional skills in the best interests of the company.

Sometimes, it is difficult to distinguish between the individual running and/or owning the business and the company. However, the company must be seen as a distinct entity separate from the directors and shareholders.

We have vast experience in advising directors of their duties in any specific situation. If you have any specific questions we will be happy to answer them (and strongly suggest that you ask before any trouble occurs) or come and see you to discuss director’s duties and other issues in the context of your business. We can also assist you in the setting up of your company and the running of your company together with advice on finance, shareholders and employees.

Here is a checklist of the main statutory duties on a director and some other best practice points to be considered.

The main point to remember is to treat the company as a separate entity. It has its own rights and can take its own actions against you and others.

  1. Section 171 – Duty to act within powers – as a Director you should not exceed the powers conferred on you by the company’s Articles of Association. You should always check that you are using the powers conferred on you properly and that the Company does not exceed what it is allowed to do in its Memorandum of Association.
  2. Section 172 – Duty to promote the success of the company – as a Director you must act in good faith for the success of the company and benefit of the shareholders having regard to the likely consequences of any decision long term. This will include considering the interests of employees, business relationships with suppliers, customers and others, the impact on the community and environment, maintaining the reputation of the company for having high standards of business conduct, acting fairly between members of the company and; subject to the legal requirements, to consider and act in the interests of creditors.
  3. Section 173 – Duty to exercise independent judgment – the company is a completely separate entity to you as director. Therefore, as a director you must consider whether a deal with the company which you own will be the best deal for the company as opposed to yourself. At the time a decision is made the matters raised in the rest of Chapter 2 of the Act need to be considered so that you are you acting in good faith and solely for the benefit of the company taking all the circumstances into account and not for example, creating a conflict as set out in Section 175 below.
  4. Section 174 – Duty to exercise reasonable skill and care and diligence – you should act in a manner that any reasonably skilled director would generally act in your particular area of management. You should go to as many board meetings as you can and make sure you know at all times what is happening. As stated, ignorance is no defence and as a director you will be jointly liable for any mistakes made as well as placing your company at risk of claims against it should it fail to use skill and care in providing its services to others or complying with other statutory requirements for example health and safety (Section 178) for example.
  5. Section 175 – Duty to avoid conflicts of interest – as a Director you must avoid a situation in which you have or could have a direct or indirect interest that conflicts or may conflict with the interests of the company. If there is a conflict of interest between you (personally) and the company, ensure that the company always wins. The way to avoid there being any issues over conflicts is to disclose all matters to the board of directors so that the company (acting through its directors) can make a decision with all the facts in front of them.
  6. Section 176 – Duty not to accept benefits from third parties – as a Director you should refrain from dealing in your own interests rather than the company’s when dealing with company business and property and must not, for example make a secret profit from any undisclosed and unauthorized transaction or divert work away from the company for your own benefit. Any benefits obtained in this way will have to be account for to the company even if the company benefits as well. You should not accept loans or the benefit of guarantees from the company. This section coincides with and extends Section 175.
  7. Section 177 – Duty to declare the nature and extent of any interest in a proposed transaction or arrangement – as a director, you must disclose all interests in relation to all transactions for example property, information, shares held irrespective of whether or not the company could take advantage of it. You should obtain directors and shareholders approval when it is required before steps are taken. Again, this coincides with and extends the other duties in Sections 171 to 176 above.
  8. Know your rights as a director and/or shareholder in relation to the calling of meetings, voting etc. Keep up to date with all the record keeping and administrative requirements set out in the Companies Act and on top of the duties of directors in relation to specific areas applicable to your business such as health and safety, taxation etc.
  9. If you think that the company may not have enough money to cover its debts obtain advice straight away. Do not wait as it could affect your personal liability.
  10. In addition to the above, you should remember your contractual duties under your employment contract. Beware of your rights and responsibilities as both an employee and a director.

Keep this checklist of some of the duties of a director in mind as a guide to best practice. It is not a comprehensive list and the law continues to develop as each new case is heard so please call us if you need further assistance or advice and we will be happy to help. This article gives a general overview only and the legal position at the time of writing this article. It cannot be relied upon in any particular case.  Specific legal advice must always be considered to include consideration as to whether the legal position contained in this article has changed since going to print.

Set out below is a summary of the principal legal considerations to be borne in mind by a director of the Company, in where there is underperformance, distress or crisis in the financial position of the Company.

This note addresses issues which should be considered by the directors of the Company both individually and collectively in pursuing a strategy designed to avoid a formal insolvency procedure.

It is important for directors to clearly understand the responsibilities that they have and the consequences of not acting, or not being seen to act, in the best interests of the Company’s creditors.

1               THE DIRECTORS’ DUTIES

In very general terms, the directors owe duties to the Company:

To promote the success of the company

When the Company is clearly solvent, each director of the 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:

the likely consequences of any decision in the long term;

the interests of the company’s employees;

the need to foster the company’s business relationships with suppliers, customers and others;

the impact of the company’s operation on the community and the environment;

the desirability of the company maintaining a reputation for high standards of business conduct; and

the need to act fairly as between the members of the company.

However, where the Company is insolvent, or possibly even when it is of doubtful solvency, the directors are under a duty to consider the interests of creditors above the interests of members.  One consequence of this is that the directors cannot assume that shareholder ratification or sanction for actions damaging the interests of creditors will relieve them of liability.

To exercise independent judgment

Each director must make up his own mind on every decision he is required to take and should not allow himself to be influenced by his own interests or the interests of others.  His duty is to act in the interests of the Company.           To avoid conflicts of interest

There are several distinct duties that can be viewed as dealing with conflicts of interest.  The overall principle of these duties is to ensure that each director separates his own interests (as shareholder, executive, creditor, etc) from the Company’s interests and does not allow those interests to come into conflict or affect his judgment.

The principle duty is that each 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.  It may be possible for the other directors to authorise a conflict, however, they need the power to do so and they must consider their own duties in giving such authorisation.

To take steps to avoid loss to creditors

Under section 214 of the Insolvency Act 1986, personal liability for wrongful trading may arise for directors of a company which has gone into insolvent liquidation.  Liability for wrongful trading is established if, on an application to court by a liquidator, it can be shown that at some time before the company went into insolvent liquidation, the director knew or ought to have concluded there was no reasonable prospect that the company would avoid insolvent liquidation, unless it can be shown that the director thereafter took every step he ought to have taken with a view to minimising the potential loss to the company’s creditors. This potential liability for wrongful trading is explained in more detail below.

The directors should never allow the Company to accept credit if in their view there is no reasonable expectation of the creditor being paid, since this would involve them in the criminal offence of fraudulent trading

Not to enter transactions at an undervalue or make preferences

Under sections 238 and 239 of the Insolvency Act 1986, the administrator or liquidator of a company may apply to the court to set aside or vary transactions at an undervalue and preferences entered into within a specified period before the commencement of the insolvency proceeding.  Transactions at an undervalue and preferences cannot be set aside unless the company was insolvent at the relevant time or became insolvent as a result of the transaction.  In formulating a strategy to avoid a formal insolvency procedure, the directors need to be aware of these provisions since, if transactions are set aside as being either at an undervalue or preferences, there is a risk that the court may make a disqualification order against any director responsible for the transaction concerned in addition to the risk of personal liability.

The relevant provisions are explained in more detail in paragraphs below.

General

The above list is not intended to be an exhaustive list of directors’ duties but to highlight those which may be particularly relevant when the solvency of the Company may be in issue. Other normal duties should not be overlooked, for example, the duty to keep adequate accounting records, the duty to act within powers, the duty to exercise reasonable care, skill and diligence, the duty to declare an interest in transactions or arrangements with the Company, the duty not to accept benefits from third parties, etc. It should be pointed out that all such duties fall equally on executive and non-executive directors.

DIRECTORS’ POTENTIAL PERSONAL LIABILITIES

Wrongful trading

Where a company has gone into insolvent liquidation, a director or shadow director can be required to make a contribution to the company’s assets. The Court may make such a contribution order if the liquidator can show that before the commencement of the winding-up that person knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation.

It should be noted that this provision does not merely cover “trading” activity. Any kind of act, or failure to act, unless it minimises losses to creditors, may attract liability under this section.

Purpose of the section

This provision, introduced by the Insolvency Act 1986, is the principal means of deterring directors from continuing to trade where there is no reasonable prospect of the company avoiding insolvent liquidation.  It does so by imposing personal liability on directors.

The defence

The only defence open to a director is that he took every step with a view to minimising the potential loss to the company’s creditors that he ought to have taken. This assumes that he knew or ought to have known that there was no reasonable prospect that the company would avoid insolvent liquidation. The onus is on the director to prove this defence.

The standard expected

A director is deemed to know facts which ought to have been known or ascertained by a reasonably diligent person having regard to:

the general knowledge, skill and experience that can be reasonably expected of a person carrying out the functions of a director (i.e. “the reasonable company director”); and

the general knowledge, skill and experience that he in fact possesses.

The same “knowledge” test applies to the conclusions that the director ought to have reached as to the impending insolvency and, in the context of his defence, the steps he ought to have taken to minimise the loss to creditors.

There is no requirement to prove intent, dishonesty or fraud.  The standard of proof is the civil standard of a balance of probabilities only. There is no requirement for positive misconduct; mere inadvertence can give rise to liability if the liquidator can show that the director knew or ought to have known of the impending insolvency.

The Court’s power

Once liability is established, the Court has a complete discretion to order a person to make such contribution to the company’s assets as the court thinks proper.  In each case the Court will either examine the particular financial position of a director and decide what he is able to pay or will examine the extent to which money is required to meet the claims of creditors and make orders against particular directors regardless of their ability to pay.  It is likely that which attitude the court takes will depend upon the level of culpability of the director.  The sanction for wrongful trading is civil only – no criminal sanctions attach for wrongful trading, although they may if the director acts with an intention to defraud creditors.

Disqualification

If the court makes a declaration under these provisions, it may also make an order to disqualify the director from being in any way concerned in the management of a company for a minimum period of two years and a maximum of fifteen years.

Fraudulent trading

If any business of the company is carried on with the intent to defraud creditors or for any other fraudulent purpose, the liquidator of the company can apply to the court under section 213 of the Insolvency Act 1986 for a contribution from any person who was knowingly a party to the carrying on of the business in that manner.  This provision is not invoked often since it requires proof of intent to defraud.  However, where the directors allow the Company to continue to trade and incur liabilities when they know there is no real prospect that these will be repaid, the directors are at risk under this provision. The provision is wider than the wrongful trading provision in the following respects:

  • it applies to “any persons”, not just directors, who were knowingly parties to the carrying on of the business in question; there is no defence of taking steps to minimise loss to creditors; and
  • it attracts a criminal penalty of 7 years’ imprisonment or an unlimited fine, or both, as well as civil liability.

3               OTHER CONSIDERATIONS

When deciding how the Company ought to proceed either to minimise the loss to its creditors or to implement a strategy to avoid a formal insolvency, it is important for a director to consider how those actions will be viewed with hindsight.  In particular, any actions should ensure they do not contravene the statutory provisions relating to transactions at an undervalue and/or preference.

Transactions at an undervalue

Where a company has entered into a transaction at an undervalue, the court may make an order under section 238 Insolvency Act 1986 to restore the position to what it would have been if the company had not entered into the transaction.  A director who is responsible for a company entering into a transaction at an undervalue, may be disqualified from being included in any way in the management of a company for a minimum period of two years and a maximum of fifteen years.

Definition of an undervalue

A transaction will be regarded as being at an undervalue if the company does not receive any consideration for the transaction or the value of the consideration it does receive is significantly less than the value of the consideration it provided.  A transaction is defined to include “a gift, agreement or arrangement“, and examples include:

the purchase of an asset the value of which is significantly less than the price;

selling an asset for a price significantly less than its value;

agreeing to pay for services a sum significantly more than their value;

gratuitous payments to employees; and

guaranteeing a debt due from another group company.

Circumstances when transactions can be set aside

Before a transaction can be set aside the following conditions must be satisfied:

the company must go into liquidation or administration;

the transaction must be at a “relevant time”, i.e. within two years before the commencement of the liquidation or administration;

the company must be unable to pay its debts at the time or become unable to pay its debts as a consequence of the transaction (but see 3.2.3 below);

application to the court for an order must be made by the liquidator or administrator.

It should be noted that a company is deemed unable to pay its debts if it is proved that the value of the Company’s assets is less than the amount of its liabilities taking into account its contingent and prospective liabilities.

Connected Person

If the transaction is with a “connected person”, the company is presumed to be unable to pay its debts. It is therefore much easier to establish that a transaction was at an undervalue if a connected person is involved. A connected person is very widely defined and includes directors, shadow directors, their “associates” (employers, close relatives, partners), and associates of the Company (other group companies).

Defence

A defence will be available if the court is satisfied that the company entered into the transaction in good faith and for the purpose of carrying on its business and at the time it did so, there were reasonable grounds for believing that the transaction would benefit the company.  This defence protects a wide range of bona fide business transactions that might otherwise be vulnerable, although there must be reasonable grounds for the belief that the transaction in question would benefit the company.

Transactions outside the scope of directors’ powers

A transaction at an undervalue may be set aside even though it does not strictly fall within this section. A transaction entered into with shareholders which is either a gift or at an undervalue may be regarded as an unlawful distribution of capital. This problem is considered below in paragraph 3.4.  The directors should also consider whether any corporate benefit follows from a transaction, having regard, where there is a serious question as to the Company’s solvency, to the interests of creditors.

Transactions defrauding creditors

Where a person enters into a transaction at an undervalue, the court may make an order under section 423 of the Insolvency Act 1986 to restore the position to what it would have been if the transaction had not been entered into, and to protect the interests of persons who are victims of the transaction. The court must be satisfied that the transaction was entered into for the purpose of putting assets beyond the reach of a person who is making, or may at some time make, a claim against him, or of otherwise prejudicing the interests of such a person in relation to a claim.

There is no time limit before which transactions cannot be set aside under this section.

Preferences

Where a company has given a preference, the court may make an order under section 239 Insolvency Act 1986 to restore the position to what it would have been if the company had not given the preference.  A director who is responsible for a company giving a preference may be disqualified from being involved in any way in the management of a company for a minimum period of two years and a maximum of fifteen years.

Definition of preference

A “preference” occurs where a company does anything, or allows anything to be done, which puts one of the company’s creditors, sureties or guarantors into a better position than he would have been in if that act had not been done. Examples of preferences include:

payment of one creditor in full or in part when others remain unpaid; and

granting security in respect of existing debts.

Circumstances in which transactions can be set aside

Before a preference can be set aside, the following conditions must be satisfied:

the company must go into liquidation or administration;

the transaction must be at a “relevant time”, i.e. within six months before the liquidation or administration;

the company must be unable to pay its debts at the time or become unable to pay its debts as a consequence of the transaction; and

application to the court for an order must be made by the liquidator or administrators.

It should be noted that a company is deemed unable to pay its debts if it is proved that the value of the company’s assets is less than the amount of its liabilities taking into account its contingent and prospective liabilities.

Desire to prefer

A transaction can only be set aside under this provision if the company was “influenced by a desire” to put the creditor surety or guarantor in a better position.  It is not sufficient, in order to prove that a company was influenced by a desire to bring this about, for the liquidator or administrator to show that the company was merely aware that the transaction would put a creditor in a better position – a positive wish to achieve this end is needed.  Thus, in our view, a transaction entered into for a proper commercial reason should not fall within this provision.

A liquidator or administrator will generally look very carefully at transactions which benefit directors, either directly (e.g. paying directors’ salaries, loan accounts etc) or indirectly (e.g. paying off an overdraft guaranteed by directors). Requests by banks to secure current loans need to be examined with this principle in mind.

Connected person

If the transaction is with a “connected person” (see definition in paragraph 3.2.3 the “relevant time” during which transactions are at risk is extended to two years before the onset of insolvency, and the company is presumed to have been influenced by a desire to put the creditor in a better position.

Unlawful capital distributions

Transaction with or payment to a shareholder may also be regarded as an unlawful distribution of the company’s assets. Assets may be distributed to a company’s members only if there are profits available for this purpose (i.e. accumulated realised profits less accumulated realised losses).  If there are insufficient distributable reserves, a transaction with or payment to a shareholder could constitute an unlawful distribution of capital.

A director of an insolvent company is under a duty to have regard to the interests of creditors. There is accordingly a risk that any gratuitous distribution of assets will be a breach of that duty. Such a breach cannot be waived by the shareholders.

Disqualification of directors

A director of a company which became insolvent whose conduct makes him unfit to be involved in the management of a company in future may be disqualified from becoming involved in the management of a company for a period of between 2 and 15 years. An application for a disqualification order can be made within two years of a company becoming insolvent. The matters to be taken into account by the court will include misfeasance, breach of fiduciary duty, misapplication of company property, the director’s responsibility for entering into any transaction liable to be set aside under the provisions described in this memorandum, and failure to comply with the accounting and registration requirements of the Companies Act. Incompetence, as well as commercially or morally culpable behaviour, can be sufficient to enable the court to disqualify a director. A public register of disqualified directors is kept.

PRACTICAL GUIDANCE FOR THE DIRECTORS

This section sets out practical guidance for you as a director.  It is important not only that the steps explained below are carried out, but that they are seen to be carried out, since the actions of the directors will be carefully scrutinised by any future liquidator of the Company for the reasons set out above.  It is therefore important for the directors both collectively and as individuals that whatever actions they take in the interests of the Company and its creditors are fully documented.

The tests for solvency

The directors should be aware at the outset of the implications of continuing to trade when the Company is technically insolvent, that is when it is unable to pay its debts within the meaning of s.123 of the Insolvency Act 1986. At least by the time this stage is reached, the directors’ duty to have regard to the interests of creditors will have arisen. Indeed, where there is a serious question as to the Company’s solvency, directors will be under duties to creditors. If the Company is insolvent, the following dangers should be noted:

the Company is in danger of being compulsorily wound up;

transactions entered into by the Company are at risk of being set aside by the court as undervalues or preferences;

an event of default may occur for the purpose of loans to the Company;

the termination of other commercial contracts and agreements (such as joint ventures) may be automatically triggered; etc.

It is therefore important for the directors of the Company to be aware of the following tests and to be certain that the Company does not fail them when going through a difficult period.

A company should be regarded as unable to pay its debts whenever it is either:

  • unable to pay its debts as they fall due (“cash flow insolvency”); or
  • the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (“balance sheet insolvency”).

A company is deemed to be unable to pay its debts as they fall due if either:

  • a creditor owed more than £750 has served a statutory demand at the Company’s registered office and the debt has not been paid for 3 weeks thereafter; or
  • execution of a judgment or other court order remains unsatisfied, i.e. following a bailiff’s or sheriff’s officer’s visit.

In addition, the directors need to remain satisfied that there is a reasonable prospect that the Company will avoid insolvent liquidation in order to avoid potential liability for wrongful trading (see section 2 above).  If they cease to hold the view that there is a reasonable prospect of avoiding liquidation, they come under a duty to take every step to minimise losses to the Company’s creditors.

Accordingly, the current financial position and the prospects of the Company should be kept under close scrutiny, and in particular the directors are recommended to take the actions set out below.

Advice

In order to assess properly the various alternatives open to the Company, all the directors should ensure that they have access to proper financial commercial tax and legal advice as necessary dependant upon the circumstances.  It may be essential to involve auditors or independent advisers in discussions on the financial position of the Company.  In addition, a team may need to be assembled to deal with discussions with the company’s bankers and other lenders.  The Company may have existing advisers who should be involved in this and the formulation of a strategy to avoid insolvency. An assessment should be made of each and every act/omission by you as a director to consider whether any proposed transaction could be vulnerable as a preference or for some other reason (see section 3 above). It may also be appropriate for the Company to retain an Insolvency Practitioner to advise the Company on the alternative strategies.

The directors either individually and/or collectively may wish to take advice individually in view of the personal risks involved in management of a company approaching insolvency. That is what you have done in seeking this advice from us at this stage.

Monitoring the financial position of the Company

The director/s should be able to assess regularly the Company’s financial position, in order to assess whether the Company is solvent, and to assess its prospects of avoiding insolvent liquidation.  This will generally involve the preparation of regular balance sheets, cash flow projections, and other current financial information.

The director/s should establish a procedure to keep all the director/s informed of the financial position and prospects of the Company.  This will generally involve frequent board meetings to consider the implementation of a strategy and for the directors to satisfy themselves that, taking into account their duties to creditors (and shareholders and employees), the Company may properly continue to trade.  Where appropriate, the auditors should be involved in preparing or reviewing the cash flow projections and the current financial information.

Formulating a viable strategy

In assessing the prospects of the Company avoiding insolvent liquidation, the director/s will be relying upon a strategy for restoring the Company to a healthy financial position and avoiding a formal insolvency proceeding.  In general terms the strategy may include one or a number of the following:

  • different trading strategies;
  • disposals;
  • maximising existing asset values;
  • cutting overheads;
  • delaying capital investment;
  • (f) further bank finance (possibly with a grant of security);
  • converting debt to equity, converting short-term debt to long-term debt, or raising new equity;
  • a debt issue; or
  • an informal arrangement with major creditors, or scheme of arrangement or voluntary arrangement.

It is important that this strategy has the support of the board (the full board if possible), that its viability is reviewed by appropriate advisers, and that its implementation is fully monitored.  Provided the director/s are satisfied that the current strategy is reasonable and that it offers a realistic solution to the Company’s financial problems, then the Board is entitled to pursue this without taking more immediate steps to protect the Company’s creditors.

As a minimum, at each board meeting, the director/s should review the strategy and confirm that, in their view, there is a reasonable prospect of avoiding insolvent liquidation.  They should reconsider the various assumptions underlying the strategy and confirm that in their view they are still reasonable.  As part of the strategy the board may have committed the Company to cutting overheads, delaying capital investment, relocating premises, selling part of the business, procuring fresh equity etc.  At each meeting, the board will need to be updated on the extent to which steps to be taken under the strategy are being fulfilled and whether the underlying assumptions (e.g. as to value of properties etc) are still valid.

Where appropriate, advisors should be asked to provide assistance in preparing the  paper. The director/s should not proceed unless the appropriate advisers are prepared to confirm that the strategy has a reasonable chance of success.  Where the strategy involves a programme of disposals, or the sale of key parts of the business, the financial advisers should be asked to give their view upon the real prospects of successfully concluding a disposal at the values estimated.  This may be a difficult exercise but, if the director/s view as to the prospect of avoiding insolvent liquidation depends upon disposals, it is important that the prospect of these disposals being successfully concluded is independently assessed and confirmed as reasonable.

Holding regular meetings

Board meetings should be held at regular scheduled intervals.  All the director/s should endeavour to be present in person.  Detailed minutes should be kept of all meetings and circulated in a timely manner.  Additional meetings should be called as and when new significant events occur.  Briefing papers should be circulated prior to all such meetings to facilitate an informed discussion on the matters in hand.  Absent directors should be informed as soon as possible of critical decisions taken at Board Meetings.

Directors of a company will of necessity have different skills and specific functions to perform.  It is important to ensure that all the directors are kept fully informed of the progress or otherwise which is being made and, in particular, it is generally helpful if non-executive directors are fully informed and involved in the rescue strategy.

It is in order for specific aspects of the strategy to be delegated to Committees of the board or individual directors but the board as a whole should ensure that Committee discussions are reported on a regular basis and should not hesitate to request additional information if thought necessary.

Valuation problems

The question may arise as to whether, in valuing the Company’s assets, the director/s are still entitled to assume a going concern valuation, rather than valuation on a break-up basis. If the director/s are satisfied there is a reasonable prospect of avoiding insolvent liquidation, the directors may be entitled to make valuations on a realistic going concern basis.  However, for assets which are to be sold, the valuation should be the price which may realistically be achieved on sale.  Where assets are to be retained, the director/s may make a going concern valuation but need to be aware of the extent to which current market conditions may have operated to reduce the value of assets as stated in the last statutory accounts.  Discussions with the Company’s auditors and/or financial advisors/bookkeepers may be helpful on this point.

Keeping major creditors informed

Information to be released to creditors should be carefully discussed with, and in appropriate circumstances presented by, the company’s advisers.  Where the strategy to be implemented requires creditors’ support (principally the lending banks although this will vary depending upon who are the key stakeholders in the business’) a careful and clear presentation is required.

Reviewing Financial Obligations

The board should continually monitor the Company’s financial situation and ensure that the Finance Director and Company Secretary are aware of the need continually to review:

  • the maintenance of capital imposed by statute;
  • the borrowing restrictions imposed by the Company’s articles of association;
  • the financial covenants in its loan documentation; and
  • any regulatory requirements affecting the Company;

and if there is any possibility of a breach, to ensure that appropriate action is taken.

INSOLVENCY PROCEDURES

The following is a brief summary of the insolvency procedures available to the Director/s. These will need to be reconsidered when (and if) you have confirmed that the Company is insolvent.  We can provide more detailed advice at that time, but it is perhaps appropriate for you to have a general understanding of these at this time.

Administration order

The directors, the company or any one or more of the company’s creditors can apply to the court for an administrator to be appointed under an Administration order.  In making such an order the court must be satisfied that:

  • the company is or is likely to become unable to pay its debts; and
  • that the administration order is reasonably likely to achieve the purpose of administration.

The purpose of administration is the performance by an administrator of his statutory functions with the objective of:

  • rescuing the company as a going concern; or
  • achieving a better result for the company’s creditors as a whole than would be likely if the company were wound up (without first being in administration); or
  • realising property in order to make a distribution to one or more secured or preferential creditors.

An administrator’s role is to avoid immediate liquidation and a sharp reduction in realisable value of the Company’s assets.

The effect, and great advantage, of an administration order is that, while it is in force:

  • the Company cannot be wound up;
  • no legal proceedings can be taken against the Company; and
  • a receiver cannot be appointed by a charge-holder

Administration is nevertheless a process intended to benefit creditors generally. A charge-holder entitled to appoint an administrative receiver can block the application for an administration order Once an administrator has been appointed he will take over The Company from the directors in the day to day management of the company.  This will relieve the directors from taking the critical day to day decisions and accordingly minimise any risks from that point on.

Voluntary arrangements

The voluntary arrangement procedure is generally used where a liquidator or an administrator has been appointed but may be used in other cases by directors.  A liquidator or administrator of a company (or where there is no liquidation or administration order, its directors) may propose a composition in satisfaction of its debts, or a scheme of arrangement of its affairs.  The implementation of the arrangement is supervised by a qualified insolvency practitioner.  This is a relatively simple procedure which may require meetings of shareholders and/or creditors but not class meetings or the approval of the court. It can therefore be of assistance to small and medium sized companies which urgently need a composition or moratorium without having to follow a more complex and time-consuming procedure.  However, until the arrangement takes effect there is no moratorium to prevent creditors from enforcing their rights and so for that reason is often used in conjunction with an administration order which creates a moratorium from the date of the order.

An alternative procedure is available under section 425 of the Companies Act 1985 whereby a scheme of compromise between a company and its creditors can be approved by the court. Such a scheme will be binding on all creditors but does not otherwise create a moratorium. In practice a voluntary arrangement or administration order is likely to be a more appropriate solution for the Company.

Voluntary winding-up

There are two types of voluntary winding-up.  Both have the same end result in that the life of the company is brought to an end.

The first type is a members’ voluntary winding-up which depends on a declaration of solvency being sworn by the directors to the effect that they have made a full enquiry into the company’s affairs and have concluded that the company will be able to pay all its debts together with interest at some time within 12 months from the date of the declaration.  The company, at a general meeting, must pass a special resolution to wind the company up and must appoint an Insolvency Practitioner as liquidator.

The other type of voluntary winding-up is a creditors’ voluntary winding-up. This is commenced by the shareholders passing an extraordinary resolution that the company cannot by reason of its liabilities continue its business and that it is advisable to wind up.  In this case the creditors’ wishes regarding the appointment of the liquidator and the conduct of the winding-up generally override the shareholders’ wishes.

In the case of a members’ voluntary winding-up the wrongful trading provisions will not apply as the company is not in insolvent liquidation.  In a creditors’ voluntary winding-up only the directors’ conduct prior to the winding-up resolution being passed is relevant when considering the wrongful trading provisions.

Compulsory winding-up

Unlike a voluntary winding-up a compulsory winding-up can be commenced without the involvement of the Company’s shareholders.  A petition is filed at court, and at a hearing some weeks later the court will decide whether to make a winding-up order.  If it does, the company is then in liquidation.

A petition will usually be filed by a creditor, but it is also open to the company, certain shareholders, and the directors to do so.  If the directors feel that this is the best route for the company a unanimous resolution of the board should be obtained.   In most cases, however, a voluntary winding-up or petition for an administration order is likely to be a more appropriate course of action.

A petition can be applied for on the ground (inter alia) that a company is unable to pay its debts.   This can be shown by failure to comply a statutory demand for payment of a debt exceeding £750 or by showing that the Company’s liabilities exceed its assets.  Wilful failure to pay a debt has also been held to be sufficient evidence of inability to pay.

The consequences of a winding-up petition being filed are that disposals of property will be invalid from the date of filing the petition if a winding-up order is ultimately made.  Hence the company’s cheques will be dishonoured immediately.  If a winding-up petition is filed the directors will wish to consider whether to convert to the administration procedure or a voluntary arrangement.  Other courses of action include paying the debt or challenging the order, but these steps may constitute giving a preference and/or wrongful trading.

Receivership

A receiver or administrative receiver (pre 15 September 2003 debenture only) or administrator will be appointed by a charge-holder under a fixed or floating charge granted by the Company.  Typically the Company will be served with a demand for repayment of the monies due, which will be followed within hours by the appointment. Alternatively the Company may invite the charge-holder to appoint a receiver.  An administrative receiver will be appointed under a floating charge over the whole or substantially the whole of the Company’s property and has wider statutory powers than a receiver.  The primary duty of a receiver or a administrative receiver is owed to the charge-holder (subject to the rights of prior charge-holders). His main function is to realise the Company’s property and to apply the proceeds to satisfy the debt owed to the charge-holder.  He will have powers to manage the Company’s business and to dispose of the Company’s property.

The consequences of the Company being placed in receivership are that the Directors will be relieved of their power to manage the Company’s affairs, though they will remain subject to their statutory duties.  An administrative receiver has powers to obtain information from officers of the Company and can examine persons capable of giving information concerning the Company or its property. It is usual for a company to be placed in liquidation at the end of receivership.

SUMMARY

Practical considerations

When considering the possible relevance and impact of the various provisions referred to in this letter, you, should:

Ensure that all the deliberations of the board are fully minuted thus ensuring that a future liquidator or administrator can see what attempts the board or individual directors took to protect the company’s creditors;

Carefully consider the company’s ability to pay before arranging for the receipt of any further goods or services on credit and the board should, on a regular basis, review the company’s financial position. These reviews should be fully minuted.

You should also make your opinion known to all your fellow directors, preferably by means of a full board meeting.  For your own protection you should ensure that the board minutes for that meeting fully describe your views and your reasons for holding those views;

If your fellow directors refuse to accept the position then you should take no part in incurring further indebtedness and you should continue to point out your opinion at every opportunity and, as a last resort, if your views are still not accepted, you should consider resigning.  However, it should be noted that mere resignation by itself will not necessarily enable you to avoid liability under the various provisions referred to above as the court could take the view that any director acting in this manner is merely shirking his responsibilities to the Company and its creditors rather than take “every step” to minimise potential loses to creditors.

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