Companies in financial difficulty – the potential for personal liability

In the ordinary course of business as a director, you are under a duty to act in the best interests of the company and its shareholders. However, when a company becomes insolvent, you have a legal duty to act primarily in the interests of the company’s creditors, instead of its shareholders. Failure to do so can expose you to the risk of personal liability for losses sustained by the company’s creditors following any insolvency.

The general view is that a company is irredeemably insolvent if its financial position is such that any reasonable director would conclude that it has no reasonable prospect of avoiding going into insolvent liquidation.

In practice, it may not be possible to identify a precise point in time at which the company becomes irredeemably insolvent (if, indeed, the company reaches that position). In any case directors are advised to continually monitor and review the financial state of the company and in line with the above, begin to consider the impact of the company’s affairs on its creditors.

When and how can you be personally liable?

If the company goes 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. In addition to an analysis of the transactions that the company undertook in the lead up to its insolvency, this will also include your conduct as a director, and the decisions that you took with regard to the management of the company’s affairs.

Below, we have detailed some of the potential ways in which you could become personally liable.

Wrongful Trading

One of the most commonly found circumstances leading to personal liability is ‘wrongful trading’. This occurs when a director allows a company to continue trading when there is no reasonable prospect that it will avoid going into insolvent liquidation. In such circumstances, directors may be required to contribute to the company’s assets.

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

As a director, you cannot simply avoid the issue of wrongful trading by resigning from the company. If you conclude that the company cannot continue to trade, you must put in place one of the insolvency procedures as soon as possible to avoid liability.

Fraudulent Trading

If, in the course of winding up the company, it appears that any business of the company has been carried on with intent to defraud creditors, or for any other fraudulent purpose, the 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 (Companies Act). A person found liable for fraudulent trading may also have a disqualification order made against him under the Directors Disqualification Act (see below).

Misfeasance or breach of fiduciary duty

Under the Insolvency Act if, in the course of winding up the company, it appears that a director has misapplied, retained, or become accountable for any money / property of the company, or been guilty of any misfeasance or breach of any other fiduciary or other duty, the court may order the director to repay the money or property with interest or contribute such sum to the company’s assets by way of compensation.

Transactions at an undervalue

Under the Insolvency Act, a liquidator or an administrator can apply to the court to set aside any transaction at an undervalue. Transactions at an undervalue are those involving the transfer of assets for significantly less than their market value when the company was already 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 the 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 Act, 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. This is because if the company is insolvent, you will be under a duty to the company’s creditors as a whole and you must treat all the company’s creditors equally.

Personal guarantees

The directors of a company are generally not personally liable for the debts of a company. However, if you have given a guarantee in respect of the liabilities of the company, you may be personally liable under it.
Fraud and misconduct offences under the insolvency act

There are additional offences under the Insolvency Act that can apply to directors, such as falsification of a company’s books and false representations to creditors.

Restriction on reuse of company names

Under the Insolvency Act, there is a restriction on the re-use of company names. This applies where a director or a shadow director of a company that has gone into insolvent liquidation operates without leave of court as a director or shadow director of a new company with a similar name to that of the insolvent company in the five-year period following the date of insolvency. The penalties if found liable include imprisonment, a fine or both, together with personal liability for the debts of the new company.

In addition to the financial penalties that can be imposed, a court may make a disqualification order against a Director. Direcort disqualification means that, for a minimum of 2 and a maximum of 15 years, that person can 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.

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.

In order to minimise the risk of personal liability directors are advised to keep matters under continual review. In particular, it is important to:

• Hold frequent board meetings convened specifically for the purpose of reviewing the company’s financial position and keep proper minutes of those meetings, noting in particular any decisions made and the reasons for them.
• Maintain accurate and up-to-date company financial records.
• Continually monitor the company’s financial position and future cash flows and consider ways to reduce expenditure.
• Continue to take professional advice aimed at reviewing whether insolvent liquidation is inevitable or whether there is some way of resolving or mitigating the company’s financial difficulties.
• View resignation as a last resort, but if it becomes unavoidable, minute dissent with other directors at a full board meeting and set the reasons out again in a resignation letter to the whole board.

For further information or guidance regarding corporate insolvency or directors duties in general, please don’t hesitate to contact our Commercial & Corporate Law department on 0845 050 1958, or alternatively you can email us.