A Director is defined as any person occupying the position of a director by whatever name he or she is called. Directors do not need to be formally appointed but can also include people who act as if they were legally appointed directors. These people are often called or referred to as “shadow directors”.
Directors have various duties to a company, including:
- To act within their powers
- To act in a way, in which the company considers in good faith
- To exercise independent judgement
- To exercise reasonable care, skill and diligence
- To avoid conflicts of interest
- Not to accept benefits from third parties
- To avoid any conflicts of interest
However, when a company has reached a point where it is unable to meet its debts, or in the reasonably near future, a Director’s duty shifts from the company to the company’s creditors.
This is the point at which there will be no return to shareholders and it is the creditors money that is at risk. From this point until a formal insolvency procedure is “commenced” is often called the “twilight” period.
There are 2 tests for insolvency namely: 1. The cash flow test; and 2. The balance sheet test. Both relate to the company’s inability to pay its liabilities.
What are a director’s liabilities then?
If the company enters administration or liquidation then the administrator or liquidator will be able to “look back” from the date of commencement* of insolvency. Typically this will be a period of 2 years for anyone connected with the company or 6 months for anyone unconnected. Other potential claims such as fraudulent, or wrongful trading, or undertaking a transaction with a view to defrauding creditors, have no such limitation although in a lot of cases, the further back in time before commencement of insolvency, the less likely it is that there will be a risk to the directors. This is because the claims will become more difficult to prove and may be time barred.
Some misfeasance claims (claims against directors brought about by the liquidators, which often involve an allegation that a director has breached his/her duties as a director.) These claims can of course be highly stressful and may already be, or be close to being time barred, by the time of commencement of insolvency.
The risk of insolvency can be sudden, as in the case of a substantial customer’s unexpected insolvency, for example Carillion. Or it can be over an extended period, for example a changing marketplace for the company’s goods or services. The risks and liabilities for directors in each case, will depend on the circumstances of each individual case.
When a director realises the Company cannot avoid going into insolvent liquidation, he/she has an obligation to take every step to minimise the potential loss to creditors. Failing that the next step would be to place the Company into Liquidation, otherwise a director can be personally liable for debts incurred by the company after that point. This is called Wrongful Trading.
Once a winding up petition is issued against a company (also known as ‘compulsory liquidation’) any transaction involving a disposal of the Company’s property is void until approved by the court. This can take directors by surprise if they do not know the petition has been issued. However, unless the court approves of the disposal, a liquidator may still commence a claim regardless in order to recover the property, or its value against a director and/or the party to whom the property may have been transferred. Applications to court are difficult but in the right circumstances transactions can be approved.
A director should ensure so far as possible, that any Directors Loan Account (DLA’s), (a record of any transactions between the company itself and the director) is positive at all times, or is at least not in large deficit.
Unfortunately, once a company becomes insolvent, it is then too late to declare dividends to bring the account back from negative to positive. DLA’s with a negative balance ie where the Director owes the Company money, are actually a very fertile ground for Administrators and liquidators to look at as soon as appointed. These are relatively easy claims for Liquidators and Administrators to recover money to pay immediate costs in the insolvency to cover their own fees and as funds for payment to lawyers to make other claims against the Directors.
Directors’ liabilities can be civil and criminal. In both cases directors can be disqualified from acting as a director for periods up to 15 years and can be personally fined. Therefore, it is very clear that any behaviour that falls short of the requirements, can have significant consequences.
All that said there are steps directors can take to minimise exposure to these risks and liabilities.
· Taking advice on what to do as soon as they realise the company may be in financial difficulties.
· Making a proper record of the advice and action taken in compliance with the advice given.
· Follow the advice correctly This can help in defending claims considerably.
· Conversely if a director decides not to follow the advice it can negatively impact chances of a defending claim unless there are valid reasons not to.
*Commencement of insolvency is defined in the Insolvency Act 1986