Directors – what to do, and what not to do, if your business is struggling financially or facing other Covid related difficulties

1. Directors’ duties under company law
2. Particular issues arising out of insolvency
3. Liability in the pandemic
4. Practical steps
5. Conclusion
6. Contact us

The directors of the many companies that are currently struggling to survive financially with the spectre of insolvency looming will be trying to do what they can to get to “the other side” of the pandemic with a viable business.  At the same time, they will need to remain compliant with the many duties and responsibilities placed on them personally by the Companies Act, the Insolvency Act and many other pieces of legislation.

A failure to comply with these duties and responsibilities can result in those running the business becoming personally liable for debts and obligations of the company, making directors a target for a liquidator appointed to manage an insolvent company, as well as any party (perhaps an employee or supplier) seeking to bring a claim against the company and against the directors personally.    

Here is our short guide to the duties which directors owe to the company and others and how not to fall foul of them.   

Directors’ duties under company law

Directors are responsible for the day to day running of a company’s business.  The Companies Act 2006 (the “Act”) set out directors’ duties in legislation for the first time, distilling a morass of judicial decisions into a few short sections in the Act.  Shortly stated, the duties are to:

• act within the powers conferred on the directors
• promote the success of the company
• exercise independent judgment
• exercise reasonable care, skill and diligence
• avoid conflicts of interest
• not accept benefits from third parties
• declare an interest in a proposed transaction or arrangement.

The duties listed above are owed by the director to the company.  Ordinarily in this context ‘the company’ means the shareholders, but when the company becomes insolvent the interests of creditors become paramount and directors must act with creditors in mind.  Even before insolvency occurs, directors must have regard to creditors’ interests when it has become likely that the company will become insolvent.

The key advice to directors in all situations is set out below.  Directors should be especially vigilant to comply with this where the company is in financial difficulties:

• Apply your own judgment.  A director must not act as a “yes man”.  Directors must apply their own judgment to decisions and can’t simply do what they are told to do by those who appoint them.  Nor can they surrender their judgment to other directors. 
• Don’t be negligent.  Directors will be judged against a standard comprised of what skill a reasonable director ought to have plus what they actually have through particular experience or expertise.  Understand your company, its business, the decision you are taking and its consequences before taking it.
• Avoid conflicts.  The classic case is the director who is on the boards of two companies in similar lines of business and becomes aware of confidential information relevant to company B by reason of his directorship of company A.  It also applies where the director is presented with an opportunity that can be exploited by the company but decides (maybe because the company is not doing so well) to exploit it outside of the company.
• Don’t accept bribes.  This one is really obvious, but the section catches any form of benefit from a third party unless authorised by the company’s articles.  Taking bribes is also a criminal offence.
• Don’t approve any transaction in which a director is interested without declaring clearly to the board the nature of the interest.  The interest can be direct or indirect and therefore applies to the director or a “connected person”.  The director can still vote to approve the transaction following the declaration of interest if this is permitted by the articles.  Sole directors don’t need to declare an interest to themselves but would be wise to check the articles and then tell the shareholders.
• Act in good faith in the best interests of the company while having regard for the interests of the company’s stakeholders (employees, suppliers, customers and creditors).

Where directors breach any of these duties it can result in shareholders taking action against the directors (through claims known as a “derivative action”).  In the case of an insolvent company, breach of duty can result in administrators or liquidators commencing proceedings and/or in an investigation by the Insolvency Service and disqualification as a director. 

However, insolvency law is not the only legislative area in which directors can find themselves personally liable.  There are a number of pieces of legislation that place personal responsibility on directors.  Of particular note during the pandemic is the Health and Safety at Work etc. Act 1974.  Under this act directors can be prosecuted and find themselves personally liable for fines and other sanctions, if they do not ensure compliance with the company’s health and safety obligations to its employees and customers.  Most importantly for present purposes, this means they must follow all of the existing Health and Safety Regulations (such as the requirement to carry out risk assessments of the Covid risk) and follow the UK Government’s “Covid secure” guidance on operating safe workplaces during the pandemic.   

Particular issues arising out of insolvency

If your business is struggling to make ends meet, there are a number of legal pitfalls under insolvency law which directors must take care to avoid.

Anyone who is knowingly party to running a company for fraudulent purposes, or who has sought to defraud creditors, is personally liable for fraudulent trading under sections 212 and 213 of the Insolvency Act 1986. 

This liability extends to anyone who is knowingly involved in the conduct and is therefore much broader than just the directors.  The court can order a person found liable under these sections to make a contribution to the assets of the company.  Liability under section 212 requires proof of actual dishonesty involving moral blame.

There have been many reports in the media regarding fraudulent claims relating to the UK Government’s furlough scheme.  For example, reports have highlighted instances where an employer has continued to require employees to work, but has at the same time claimed payments from HMRC on the basis that they were furloughed.  This type of fraud may leave the directors responsible personally liable to contribute to the company’s assets during insolvency (in addition to potential criminal and civil liability under other laws).    

Section 214 of the Insolvency Act governs a lesser form of wrongdoing known as “wrongful trading”.  This section enables the liquidator of a company to apply to court to seek contribution orders from directors and/or ex-directors, which they must pay out of their personal assets. The liquidator must show that before the commencement of the winding-up, the company carried on incurring liabilities when the directors “knew, or ought to have concluded, that there was no reasonable prospect of the company avoiding an insolvent liquidation”.  Where the director is found liable for wrongful trading (which requires a finding that there was an increased reduction in the company’s assets), he or she may be ordered to contribute an amount of money which the court considers proper.  The directors will not be found liable for wrongful trading if they can show that they took every step with a view to minimising loss to the company’s creditors.

The Company Directors’ Disqualification Act 1986 provides that a person who has been a director of an insolvent company and whose conduct makes him/her unfit to be concerned in the management of a company may be disqualified for a period of between two to fifteen years.  Various matters will be taken into account in determining whether a director is unfit, including any breach of duties and/or failure to keep proper company records.

Liability in the pandemic

In addition to making some financial support available to businesses, the UK government’s response to the pandemic also included emergency legislation to forestall corporate insolvencies and relieve directors of liability that might have arisen from directors taking the view that they and their companies would soldier on in unprecedented conditions.  The Corporate Insolvency and Governance Bill was introduced in Parliament on 1 June 2020 and became law on 25 June 2020.  The Act contains temporary measures to help businesses cope with the pandemic conditions as well as permanent measures directed at facilitating corporate recoveries and turnarounds.  The temporary provisions include:

A.     Temporary suspension of the ability of creditors to recover debts

Statutory demands served between 1 March 2020 and 30 September 2020 (now extended to 31 March 2021) cannot be used in support of winding-up proceedings commenced on or after 27 April 2020.  These statutory demands will essentially be void, preventing them from being used as a debt-recovery tool.

The Act also prevents follow on winding-up proceedings from being commenced by a creditor from 27 April 2020 unless the creditor has reasonable grounds for believing that coronavirus has not had a “financial effect” on the company; or the grounds which exist to wind-up the company would have existed even if coronavirus had not had a financial effect on the company. Again, this has been extended to the end of March 2021.

B.     Temporary suspension of liability for wrongful trading

The Act directs the court, in a case of wrongful trading, to assume that the director is not responsible for any worsening of the company’s financial position.  The original period from which this ran was 1 March to 30 September 2020, but this has now been extended to 31 March 2021.

Practical steps

While liability for wrongful trading under section 214 has been suspended in respect of the period of the pandemic, it does not mean that such liability no longer exists or that there can be no consequences for it.  Disqualification proceedings might still be brought against those responsible for wrongful trading and directors still need to comply with their duties in a pandemic. 

It is therefore imperative that directors remain vigilant and continue to take steps to avoid breaching their duties during such challenging trading periods. These steps will normally mean, at the very least, you should:

1. produce detailed, accurate and up-to-date management accounts and cash flow statements on a regular basis
2. keep detailed board minutes setting out the rationale for decisions
3. obtain independent valuations when disposing of assets
4. carefully consider if there is sufficient retained profit to permit dividend payments
5. formulate specific areas of responsibility for each director and avoid conflicts
6. keep work-in-progress and the pipeline of new orders under constant review
7. review the position of the creditors generally and be very careful about favouring one creditor over another
8. consider the directors’ own financial positions, including policies around the payment of bonuses and the ability to claw back bonuses that have been or are due to be paid.

Directors fearing insolvency and the consequences of this for them personally frequently seek professional advice from lawyers, accountants, and insolvency practitioners for guidance on their duties in their particular circumstances.  This will also assist them, if necessary, to demonstrate at a later date that their actions were reasonable and compliant in all the circumstances.

Conclusion

There are a handful of overarching lessons for directors and managers from all of the pitfalls we discuss above.  Most importantly, you should where possible anticipate the hazards posed by the pandemic and its economic consequences before they arise.  However, when problems do arise, they can be dealt with much more easily when the issues can be detected via clear reporting lines and properly mapped responsibilities.  Otherwise, valuable time and energy might be diverted to the blame game and exercises to pass the buck elsewhere, instead of focussing on remedying the problem.  Seeking professional advice at an early stage is of course important to mitigate any issues which have arisen. 

Contact us

If you have any questions about these issues in relation to your own organisation, please contact a member of the team or speak with your usual Fox Williams contact.