COVID-19: The changing nature of Directors' duties at the onset of insolvency and the UK Government response

31 March 2020

Author: Paul McGuickin
Practice Area: Corporate - M&A, COVID-19

Boardroom

Directors are facing huge challenges at the current time, with the situation getting worse by the day. Although directors may take comfort from the fact that the statements from the UK Government in the last week indicate a willingness to do whatever it can to minimise the economic fallout from the virus, company cash flows are going to be hit hard. Whilst necessary, the unprecedented lockdown announced by the Prime Minister on 23 March in response to the global pandemic will undoubtedly increase those cash flow pressures. This may mean that previously financially stable companies are rapidly faced with the prospect of insolvency although on 28 March the UK Government announced certain changes to insolvency laws in an effort to assist companies and directors during this crisis.

The purpose of this note is to provide a general guide to the insolvency considerations applicable to directors as they stand today and to highlight the key proposals announced by the UK Government on 28 March.

Directors’ Duties

Ordinarily, a director is under a duty to act in the best interests of the company and its shareholders. However, where a company becomes insolvent or where there are reasonable concerns as to its continued ability to trade on a solvent basis, the directors' duty to promote the success of the company is displaced by a duty to act in the best interests of the company's creditors.

It is at this point that the potential for personal exposure becomes much more acute for company directors. Presently, if a director allows a company to continue to incur liabilities at a time when they know, or ought to have known, that there is no reasonable prospect of the company avoiding an insolvent liquidation or insolvent administration, they may incur personal liability for the losses sustained by the company's creditors. More information on this is given below in the section headed "Wrongful trading".

It should be noted where a director is a director of more than one company in a group, that director will need to consider the position of each member of the group separately. This can give rise to potentially irreconcilable differences in the actions and decisions required of the director in order to comply with his / her duties owed to each company.

Practical steps to manage the risk of potential personal liability in an insolvency situation

If a company’s continued solvency is at all in question, the directors should take some basic steps to guard against the risk of potential personal liability under specific insolvency legislation, with the most likely cause being a breach of wrongful trading laws. Such steps may include:

  • Regular dialogue with other directors and advisers - Full board meetings should be held regularly (weekly, or even daily) if the company is in financial difficulties. The commercial decisions of the directors and any relevant advice given by professionals with insolvency expertise should be carefully minuted;
  • Seek professional advice - Advice should be sought by directors of companies in financial difficulties about wrongful trading and related issues. Case law shows that this helps to protect against a claim that may be brought for wrongful trading;
  • Obtain robust financial information - Directors must ensure that they have up-to-date financial information and should also be satisfied that it is reasonable to rely on such information (such as verification by auditors in some circumstances (including cash flow) or based on justifiable assumptions);
  • Continuous monitoring - Directors should also be careful to continually monitor and review the company’s cash flows, expected expenditures and compliance with financial covenants contained in any arrangements with lenders; and
  • Don’t delay - As soon as a director is aware there is no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration, or reasonably fears that this is the case, they must raise the problem with the rest of the board so it can take immediate legal and financial advice.

When and how can a director be personally liable?

If a company enters into a formal insolvency procedure such as liquidation or administration, the insolvency practitioner appointed to manage the company's affairs will usually investigate the circumstances in which the company became insolvent. This investigation will typically include: (a) the conduct of each of the directors of the company and the decisions that the directors took with regard to the management of the company's affairs; and (b) the transactions entered into by the company in the lead up to its insolvency.

Such an investigation will typically comprise the following strands:

  • Wrongful trading.
  • Fraudulent trading.
  • Misfeasance or breach of fiduciary duty.
  • Transactions at an undervalue.
  • Preferences.
  • Personal guarantees.

Wrongful trading

Currently, under the Insolvency (Northern Ireland) Order 1989 (the “Insolvency Order”), a director who allows a company to continue trading when there is no reasonable prospect that it will avoid going into insolvent liquidation may be required to contribute to the company's assets. This is subject to the new proposals on wrongful trading announced by the UK Government on 28 March, further information on which is noted below.

A liquidator can apply for a court order requiring a contribution to the assets of a company from a person who is, or was, a director (whether a director, de facto director or a shadow director) of a company where:

  • The company has gone into insolvent liquidation; and
  • 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 such insolvent liquidation.

In deciding whether a director ought to have known that there was no reasonable prospect of avoiding the insolvency, a court will judge him by whichever is the higher standard of the general knowledge, skill and experience that he actually has, and the general knowledge, skill and experience which would be reasonably expected of someone in his position.

The court will not require a director to make a contribution to the assets if (after the time when he first concluded, or ought to have done, that an insolvency would not be avoided) he took every step with a view to minimising the potential loss to the company's creditors as he ought to have taken.

A wrongful trading claim against a director is compensatory rather than penal in nature, and is intended to provide creditors with recourse for the loss suffered from the point in time at which the director developed (or should have developed) the relevant awareness. That said, just because a company is potentially insolvent does not mean the directors should automatically take the decision to cease trading. There are relevant defences which recognise that there may be circumstances when the company should continue trading to improve the position for the creditors, even if insolvent liquidation or insolvent administration is unavoidable. However, any decision to continue to trade should be made only with the benefit of professional advice.

A director found liable for wrongful trading may also have a disqualification order made against him under the Directors Disqualification Order (see below).

Fraudulent trading

Under the Insolvency Order if, in the course of administration or winding up the company, it appears that any business of a company has been carried on with intent to defraud creditors, or for any other fraudulent purpose, the administrator or liquidator can seek a court declaration that anyone who was knowingly party to the fraudulent business make a contribution to the company's assets. This is known as fraudulent trading.

Fraudulent trading is also a criminal offence under the Companies Act 2006. A person found liable for fraudulent trading may also have a disqualification order made against him under the Directors Disqualification Order (see below).

Misfeasance or breach of fiduciary duty

If, in the course of winding up a company, it appears that a director has misapplied or retained, or become accountable for, any money or other property of the company, or been guilty of any misfeasance or breach of any other fiduciary or other duty, the court may, pursuant to the Insolvency Order, order that director to repay the money or property with interest or contribute such sum to the company's assets by way of compensation as the court thinks just.

Transactions at an undervalue

A liquidator or an administrator can apply to the court to set aside any transaction at an undervalue. A transaction will be a transaction at an undervalue if a company has transferred assets for significantly less than their market value when it was insolvent or if it became insolvent as a result of the transaction. The court can set aside the transaction if it was entered into during the two years before a company became insolvent. It has the power to order a director to refund property or proceeds of sale received by him to the company.

Preferences

Under the Insolvency Order, a liquidator or an administrator can apply to the court to set aside a preference. A preference is where payments are made or assets transferred to a creditor of the company in preference to another. Examples of preferences include paying an unsecured creditor in priority to other creditors or granting security to a previously unsecured creditor. This is because, if the company is insolvent, the company’s directors owe their duties to the company's creditors as a whole and must treat all the company's unsecured creditors equally. If the court believes the company has made a preference, it can set aside the transaction and order a director who has received the company's assets to refund them to the company. The court can set aside the preference if it was given in a period up to two years before the company became insolvent.

Personal guarantees

The directors of a company are generally not personally liable for the debts of a company. However, if a director has given a guarantee in respect of the liabilities of the company, they may be personally liable under it.

Directors’ disqualification and insolvency

Under the Company Directors Disqualification (Northern Ireland) Order 2002 (the “Directors Disqualification Order”), a court may make a disqualification order against a person that they shall not, without leave of the court, be a director of a company or in any way be concerned or take part in the promotion, formation or management of a company for a specified period.

A disqualification order may be made against a director of a company which becomes insolvent if their conduct as a director makes them unfit to be concerned in the management of a company. The minimum period of a disqualification order is two years and the maximum is 15 years. A disqualified director can apply to the court for leave to act as a director and manager of a company.

It is a criminal offence if a person acts in contravention of a disqualification order and that person will be personally liable for all the relevant debts of the company he is managing.

The Secretary of State may instead of initiating disqualification proceedings, accept a voluntary disqualification undertaking from a director. The advantage to directors of giving a voluntary disqualification undertaking is that they will not need to pay the costs of going to court and may also be given a discount on the length of any disqualification period. A breach of a disqualification undertaking has the same criminal and civil consequences as a breach of a disqualification order.

The Secretary of State may also apply to the court for it to make a compensation order against a disqualified person where the conduct of the disqualified person has caused loss to one or more creditors.

UK Government COVID-19 Insolvency Proposals

In order to support businesses encountering financial difficulty as a result of the COVID-19 outbreak, the Government announced on 28 March that it will shortly be introducing versions of the corporate insolvency reforms it first proposed in 2016 and then updated in 2018.

There are two aspects to the changes:

Retrospective suspension or relaxation of wrongful trading

It was announced that there is to be a temporary suspension or relaxation of wrongful trading provisions for company directors to remove the threat of personal liability during the COVID-19 crisis, applied retrospectively from 1 March 2020.

This would help alleviate the concern that, as a result of the crisis, directors could be pushed to file the company for insolvency proceedings prematurely out of a concern that they might otherwise have personal liability if the company ultimately falls into insolvency. Existing laws for fraudulent trading and the threat of director disqualification will remain in force as a deterrent against director misconduct.

Such changes ought to assist directors in their decision (i) to access Government or other funding without concerns regarding potential personal liability; and (ii) to continue trading pending greater clarity as to the likely duration of the lock-down and effect generally of the current crisis on the future viability of the company’s business.

An unintended consequence of the changes may be that directors of companies that were not viable before the crisis continue trading and thereby incur additional liabilities for longer than they might (and arguably should) have done without the changes. It remains to be seen if there will be anything in the legislation aimed at addressing this concern, beyond the protection afforded by existing rules on fraudulent trading and director disqualification.

New restructuring procedure and new temporary moratorium

The Government is fast-tracking the implementation of certain reforms that were announced in August 2018. New legislation will implement these plans to add the following new restructuring tools:

  • The option for a company in financial difficulty to obtain a new pre-insolvency moratorium or “breathing space” to give it time to explore options for rescue;
  • A prohibition on the enforcement of so-called ipso facto clauses i.e. termination clauses which permit one party to terminate a contract due to the insolvency or financial condition of the other party; and
  • The introduction of a new standalone restructuring procedure that may be proposed by solvent or insolvent companies and can be used to bind dissenting stakeholders to a restructuring plan.

The Government plans to bring forward legislation to effect these changes “at the earliest opportunity”. The precise timing remains uncertain. Parliament is currently in recess until 21 April. It is expected that any proposals enacted in England and Wales will be mirrored in Northern Ireland. Further details of all these proposals are awaited and are needed urgently.

Notwithstanding the new proposals to be introduced by the UK Government, discharging their statutory duties against the background of the COVID-19 pandemic is no doubt daunting, even more so when the prospect of entering into an insolvency procedure looms large. However, by taking appropriate professional advice at the earliest possible opportunity, directors can mitigate the threat of personal liability. If you have any queries, or if you would like to discuss directors’ duties with us in more detail, the Corporate team at Carson McDowell would be happy to help.

* This note reflects the position as at 31 March 2020.

*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice that is tailored to your particular circumstances.

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