Our thinking Quick reads Directors of cash-squeezed and distressed companies – 5 liability points to note
Credit and private debt
April 2020
8 min read

Directors of cash-squeezed and distressed companies – 5 liability points to note

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We recently published an article that covered dealings between directors and their companies, and concluded with a reference to acts that can be challenged in the unlikely event of administration or other insolvency process. How quickly circumstances change; two months later, even the healthiest of businesses are preserving cash and those ‘unlikely’ events are weighing heavily on the minds of directors, shareholders and creditors alike.

In that context, for the next three editions we are collaborating to cover topics that are of direct and urgent relevance, including what you need to be aware of in your existing debt facility, whether your financing bank could call on its loan, how you might approach bank renegotiations, and (in this edition) how directors might become personally liable if the company’s prospects decline significantly.

1. Who is liable as a director?

Under the UK Companies Act a ‘director’ is anyone occupying the position of director, by whatever name called. The Companies Act makes no distinction between executive and non-executive directors. A ‘director’ will include a person who has been properly appointed in accordance with the company’s constitution and notified to Companies House (a de jure director), but also anyone who acts as a director despite not being formally appointed or publicly recorded as such (a de facto director).

Liability can also attach to a third category of persons as if they were directors; so-called “shadow directors”. Under the Companies Act a ‘shadow director’ is a person in accordance with whose directions or instructions the directors of the company are accustomed to act. In the context of a troubled company this categorisation can be worrying to, for example, a creditor or significant shareholder that has sufficient influence to (and in practice does) determine how the directors operate the company.

2. What are the relevant Director’s duties?

Under the Companies Act, a director must (among other things) act within his powers, promote the success of the company, exercise reasonable care, skill and diligence, and act independently, avoiding conflicts of interest and conflicts of duties. These duties are owed to the company, but there are mechanisms by which other parties, such as insolvency practitioners, shareholders and creditors, can enforce them or bring a claim for breach in the company’s name.

In the context of a cash squeeze, attention is usually drawn to the second of those duties; “promoting the success of the company”. The Companies Act elaborates that this means “the success of the company for the benefit of its members as a whole” but, in doing so, “have regard” to a second list of factors, including any long-term consequences, the interests of employees, and impact on the community and the environment.

In practice directors should still have primary regard to the long-term value of the company as a commercial enterprise, but if the second list of factors is particularly relevant to steps being considered (e.g. redundancies, business closures) the directors should carefully consider, and document, how they have reconciled those duties with the decisions eventually made.

A final – but critical – point to note is that, as a company faces insolvency (and arguably on a sliding scale as insolvency becomes increasingly likely), the duty to operate the company for the benefit of its members is replaced by duty to act in the interest of a company’s creditors. This is a complex area, but the key take-away is that directors should not, in distressed circumstances, assume that preserving shareholder value to the detriment of creditors will shield them from liability.

All of the above duties will also be owed by de facto directors and, depending on the context, shadow directors.

3. Wrongful trading

If a company enters insolvent liquidation (which can be the outcome of administration), a director or shadow director can (personally) be required to make a contribution to the company’s assets if it can be proven that the director knew before winding-up was commenced, or should have concluded, that there was no reasonable prospect of the company avoiding insolvent liquidation.

The bar to wrongful trading is – by design – relatively low. There is no requirement to prove intent to prejudice the company or any third party, nor dishonesty or fraud. Failure to act can give rise to liability just as misconduct could. A director’s only defence is to demonstrate that he took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken which, ultimately, may mean ceasing to trade and placing the company into an insolvency process.

This low bar, and the fact that only the civil standard of proof (a balance of probabilities) needs to be satisfied, puts wrongful trading at the top of most directors’ worry-list where a company is cash-poor or distressed.

In the context of the current Coronavirus crisis, the government has announced that wrongful trading will be retrospectively “suspended” for three months from 1 March 2020, i.e. directors will not need to fear personal liability for their actions even if an insolvent liquidation looks unavoidable. However it is not yet clear how other directors’ duties, such as the duty to act in the interests of a company’s creditors noted above, are impacted by this suspension, so professional advice is recommended.

4. Fraudulent trading

Though similarly named, fraudulent trading is fundamentally different to wrongful trading. It is committed if a person is knowingly party to the carrying on of a company’s business with the intent to defraud creditors, or for any other fraudulent purpose. In addition to the relevant person becoming liable to contribute to the company’s assets, fraudulent trading is a criminal offence, with no defence of taking steps to minimise loss, and applies to any person (not only a director) who engages in the prohibited behaviour.

It is rarely pursued (the requirement to prove fraudulent intent makes it hard to prove), but should not be too readily dismissed. For example, directors will need to be comfortable that corporate or financing restructurings do not intentionally place assets out of a creditor’s reach or illegitimately tamper with the order of priority for recovery of debts.

5. Misfeasance

If, in the course of winding up a company, it appears that any current or former director (among others) has misapplied, retained or become accountable for any money or property of the company, or has committed any misfeasance or breach of duty, the liquidator or any creditor of the company can petition to have that person repay or return the relevant money or property (plus interest), or make other contributions to the assets of the company.

Similarly, this cause of action should serve as a warning to directors to avoid any irregular personal dealings and to be extremely mindful of their legal duties if a company is stressed or distressed.

Bonus point: Reviewable transactions

As covered in February’s article, if a company becomes insolvent the insolvency practitioner (typically an administrator or liquidator) appointed to oversee the insolvency process has the power to look back at what the company did leading up to the insolvency. In particular, the insolvency practitioner would look for transactions at an undervalue and preference transactions.

Undervalue transactions are deals in which the company disposes of an asset and in turn receives nothing, or significantly less than fair value, for that asset. A preference transaction occurs when the company owes money to a number of creditors and, intending to help a specific person, treats that person more favourably than that person would have been treated in the event that the company went into liquidation (i.e. ahead of the statutory order of priority for settling a company’s debts).

Directors are subject to a longer period of scrutiny than people unconnected with the company. The insolvency practitioner can look back only six months in most cases, but can look back up to two years at transactions with a person connected to the company, such as a current or former director. Certain key facts which are required to establish a preference or undervalue transaction are also presumed where the transaction took place with a director, e.g. that the company was insolvent at the time of an undervalue transaction and that the company was influenced by a desire to prefer the director over other creditors. This reverses the burden of proof and so requires the director to bring evidence to disprove that presumption.

If such an act is found to have taken place, the insolvency practitioner can petition a court to reverse the transaction, restore relevant property to the company, and compel payment of other compensation.

Is this brief too brief? Expert legal advice is on hand from MJ Hudson’s Finance and restructuring law and M&A and corporate law team teams.

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