Potential personal exposure of directors if their company fails financially

December 6, 2011

The recent case of Langreen Limited (in Liquidation) [2011] revisited the question of the potential personal exposure of directors if their company fails financially.

The liquidator of Langreen brought a claim against directors under Section 214 of the Insolvency Act (known as a wrongful trading claim) on the basis that the "directors had known, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into insolvent liquidation".

The Liquidator's claim failed as the directors were able to show that, from the launch of Langreen's business, they had no reason to believe Langreen would not be profitable.

The directors admitted that, after a short period of trading, they were aware that they would need a significant investment to continue. However, the court acknowledged that the directors were taking active steps to try and secure such investment and manage debt. Whilst Langreen had cash flow problems, in common with a lot of other companies, the directors could not have been concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. As such, their decisions to carry on trading were objectively reasonable and had been taken in the interest of creditors (as a whole) and investors. The Judge also noted that the Liquidator’s case was based upon a significant amount of 20/20 hindsight.

However, as well as having to decide whether to continue to trade, there are other questions which directors must also address if their company is in financial difficulties:

  • Can/must I resign as a director?
  • What other sanctions am I facing if I take the wrong steps?
  • What are the right steps?
  • Can I take advice?
  • Whose interests must I be considering?

This article seeks to provide guidance to directors facing these difficult challenges.

Duties

When a company is clearly solvent, it is generally acknowledged that directors' statutory duties (for example to promote the success of their company), are mainly owed to the company's shareholders. However when a company nears insolvency, directors must have regard to the interests of creditors as a whole. 

The dual threat of personal liability and disqualification as a director, means that directors ignore the interests of creditors at their peril.

Personal Liability

a. Insolvency Act, 1986

As highlighted above, Section 214 of the Insolvency Act, 1986 enables a liquidator of a company to apply to the Court to seek contribution orders from directors and/or ex-directors (if in office within two years) if they have engaged in wrongful trading.

There are two main defences.

First, the liquidator has to show that the company was insolvent, or became insolvent, at the time of the alleged wrongful trading. There is no prescribed or unequivocal test of a company's solvency. Directors would be expected not only to consider the net asset position but also the ability of the company to settle its reasonably foreseeable liabilities out of its expected cash flow.

Second, a statutory defence is provided if it can be shown to the Court that the director "took every step with a view to minimising the potential losses to the company's creditors as soon as he knew, or ought to have concluded, that insolvent liquidation was unavoidable".

There are two particularly dangerous aspects of Section 214 for directors:

(a) in order to take advantage of the second defence, the director must show that he took every step available to him. The provision is not limited to every reasonable step;

(b) there is a strong degree of objectivity in the various tests. This means that a director may be liable even though he did his best having regard to his own experience and position on the board. For example, the point at which the duty arises to take every step to mitigate loss, is when he knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. Thus, the director may incur liability when he is in fact entirely unaware of the likelihood of an impending insolvent liquidation.

b. Breach of duty

One of the main substantive changes introduced by the Companies Act 2006 was to prescribe a wider range of circumstances in which a derivative action (claims instigated by a shareholder on behalf of the company) may be brought against a director.  For example:

  • a derivative action is expressly available for breach of duty of directors, even if the director has not benefited personally from the breach; or
  • it is unnecessary for the shareholder to show that those directors, who carried out the wrongdoing, control the majority of the company's shares.

The shareholder is required to make a prima facie case for permission to bring/continue a derivative claim. The courts must dismiss the application if the applicant cannot establish such a prima facie case.

c. Other risks of Personal Liability

For example, directors can also be made personally liable for national insurance contributions owing from the company.

Personal liability of the director was established in this case as a result of HMRC’s powers under Section 121C of the Social Security Act 1992. This section permits HMRC to issue a ‘personal liability notice’ (PLN) to an individual where HMRC is of the opinion that the company’s failure to pay National Insurance Contributions is attributable to the fraud or neglect of that individual director.

Directors can also be fined (and sometimes imprisoned) for breaches of other legislation such as failure to file accounts, breach of Health and Safety legislation etc.

Power to Disqualify Directors

Legislation provides that a person who has been a director of an insolvent company and whose conduct makes him 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 fiduciary or statutory duties or failure to keep proper company records.

In recent times the courts have attempted to offer guidelines as regards the definition of "unfit" conduct. Generally:

  • Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors.
  • Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of delegated functions.
  • The extent of the duty and the question whether it has been discharged must depend on the facts of each particular case, including the director's role in the management of the company.

Where the company has become insolvent, certain further factors will be considered, including the extent of the directors' responsibility for the company becoming insolvent and his co-operation with the liquidator/administrator. The court also has the ability to take into account the directors' track record with regard to other companies. To be unfit, the directors will usually have to display a lack of commercial probity which amounts to negligence or incompetence.

Steps which Directors should be taking

Resignation

Abandoning ship, by resignation from the board, will not necessarily save the director from liability. History would have frowned on Captain Smith if, after hitting the infamous iceberg, he compounded the sin by heading for the life boats rather than staying at the helm.

Mark Johnson of AGL Energy, explained: “Once you are on a board, it’s very hard to resign. We often get asked to join boards and we say: ‘Oh well, if it all goes wrong, I can easily resign.’ That is not really the case. Situations evolve and circumstances change... So there we are, stuck on the board, going down the slippery slope and we rationalise that we’ve got a duty to the company. I like to think it’s also a duty to the shareholders because when you think about it, why are you there in the first place? You are there as the steward of the shareholders and to make them wealthy.”

Other directors have commented “once you take on a board you can only go once you’ve done absolutely everything in your power to fix whatever the issue is and until that time you have got to stay and do your job,” and "whether its behaviour, transactions or organisational culture, I am one of those people who believe that we must still remember the duty that we owe to the company when we take on a board position and that we must do that duty before we can pull the pin.”

Resignation is very much a last resort and should only be considered, when the company is in serious financial trouble, if a director's concerns are being ignored and their departure could draw attention to the company's plight.

Other steps

Controls should therefore be established to minimise the risk of insolvent trading. These should include:

(a) the production of detailed, accurate and up-to-date management accounts;

(b) reviewing not only management accounts but all relevant trading information at regular board meetings where directors are encouraged to raise any specific concerns;

(c) formulating specific areas of responsibility for each director;

(d) reviewing not only past trading performance, but work-in-progress/orders going forward;

(e) reviewing the position of the creditors generally. In particular, you should be very careful about favouring one creditor over another (particularly if connected to the company or some incentive to pay him, e.g. he holds PGs from directors);

(f) considering their own financial position e.g. whether it is appropriate they are paid any promised bonus; and

(g) taking professional advice.

It is in the interests of each director to ensure that all deliberations of the board are fully minuted, thus ensuring that any subsequently appointed liquidator can establish the efforts taken, not only by the board, but by each individual director to protect the company's creditors. Also, a common complaint from directors, who had been required by liquidators to answer an extremely detailed questionnaire as to their conduct prior to an insolvency, is that they wished that they had kept better records of their attempts to protect the interests of the creditors.

Summary

As the above case of Langreen shows, a court will not impose sanctions if directors are able to show that they made honest and rational commercial decisions to protect the interests of creditors (even if they turned out to be wrong). To maximise their chances of being successful, the directors should be aware of the risk and act accordingly.

 


Related pages:

Corporate more

Restructuring and Insolvency more

Restructuring and Insolvency more

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