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Directors Duties and Insolvency

Directors duties and insolvency

If an insolvent company goes into administration or liquidation:

  • Its directors can be sued in their personal capacity for losses made by creditors if the directors continued to trade after the company had become insolvent (wrongful trading).
  • The administrator or liquidator reports to the Insolvency Service, an agency of the Department for Business, Energy and Industrial Strategy (BEIS), on the conduct of the directors and, if appropriate, BEIS will bring director disqualification proceedings.

These risks are in addition to any liability that the directors have for any breaches of duty to the company.

This note is a guide to directors’ duties and potential liabilities in relation to companies in financial difficulty, including liability for wrongful trading and under the directors disqualification regime.

Wrongful trading 

What is wrongful trading?

If, in the course of an insolvent winding up or insolvent administration of a company, it appears that a person who is, or was, a director of the company knew or ought to have concluded at some point before the commencement of the liquidation or administration that there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the liquidator or administrator of the company can seek a court declaration that the director make a contribution to the company’s assets (sections 214 and 246ZB, Insolvency Act 1986 (IA 1986)).

Liability and remedies for wrongful trading

Only directors can be liable for wrongful trading. “Director” is widely defined by the IA 1986 to include any person occupying the position of director, by whatever name called (section 251, IA 1986) and by section 214(7) of the IA 1986, references in section 214 to a director include a shadow director. This means that a de facto director or a shadow director may be liable for wrongful trading. 

The person must be a director of the company at the time he knew or concluded that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration

Liability only arises under section 214 if, on a net basis, it is shown that the company is worse off as a result of the continuation of trading. Further, the directors will not be required to contribute the liquidator’s costs and expenses incurred investigating and pursuing the wrongful trading claim.

The court will not make an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken (sections 214(3) and 246ZB(3), IA 1986).

When assessing the quantum of a director’s liability for wrongful trading the court will have consideration to the following: 

  • the increase in the company’s net deficiency of assets over the relevant period, that is, from the time when the directors first realised (or ought to have done so) that there was no reasonable prospect of the company avoiding an insolvent liquidation up to the time when the company went into insolvent liquidation;
  • the total loss to the company, and accordingly the court will not make any order if, over the relevant period there is no increase in the net deficiency of the company’s assets. If there is an increase in the net deficiency of assets over the period, the maximum quantum of any liability for wrongful trading will be the amount of that increase;
  • the availability of the defence under section 214(3) (that the director took every step with a view to minimising the potential loss to creditors). However, if the defence does not apply, the quantum of loss caused to any creditor or group of creditors will be irrelevant to the maximum liability for wrongful trading: the fact that disproportionate loss may have been incurred by one of more creditors may however mean that other creditors have been preferred and remedies for preference under section 239 of the IA 1986 may need to be considered. 

What is “insolvent liquidation” or “insolvent administration” for the purposes of wrongful trading?

The “balance sheet” basis for insolvency is used for the purposes of wrongful trading:

  • For the purposes of section 214, a company goes into insolvent liquidation if it goes into liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the winding up (section 214(6), IA 1986).
  • For the purposes of section 246ZB, a company goes into insolvent administration if it goes into administration at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the administration (section 246ZB(6)(a), IA 1986). 

Although the balance sheet basis for insolvency is the sole insolvency test used for the purposes of wrongful trading, the ability of the company to pay its debts as they fall due (the “cash-flow” test) is nevertheless of some relevance. This is because if a company cannot pay its debts as they fall due, a creditor may be entitled to wind the company up in a petition based on section 123(1)(e) of the IA 1986: compulsory liquidation will trigger a forced realisation of the company’s assets, and the circumstances of a sale in such circumstances will often realise proceeds significantly below the directors’ expectations: the liquidation may therefore give rise to a balance sheet insolvency: the directors should keep such valuation issues in mind as they consider their positions.

Who can bring an application under sections 214 and 246ZB?

Sections 214 and 246ZB respectively contemplate that an application for an order requiring a director to contribute to the company’s assets (sections 214(1) and 246ZB(1), IA 1986) be made by either the liquidator or administrator.

A liquidator or administrator is however entitled under section 246ZD of the IA 1986 to assign the right of action (including the proceeds of an action) for wrongful trading. The most obvious circumstance in which a wrongful trading claim might be assigned is where a creditor wishes to pursue a claim that the liquidator or administrator does not wish to, or has no funds to, pursue. However, the powers of the court remain limited to the power to order a contribution to the company’s assets, and this may be a disincentive to a creditor from taking an assignment and pursuing a claim. 

Company Directors Disqualification Act 1986

Under the CDDA 1986, a court may make a disqualification order against a person that he shall not, without leave of the court, be a director of a company or in any way, whether directly or indirectly, be concerned or take part in the promotion, formation or management of a company for a specified period beginning with the date of the order.

”Director” is widely defined to include any person occupying the position of director, by whatever name called (section 22, CDDA 1986). 

Disqualification orders and insolvency

Upon the initiation of the Secretary of State, a disqualification order may be made by the court against a director or shadow director of a company that becomes insolvent, if his conduct as a director makes him unfit to be concerned in the management of a company (sections 6 and 7, CDDA 1986).

When assessing conduct, the court is entitled to judge a director unfit on the strength of his conduct regarding:

  • The insolvent company alone or taken together with the director’s conduct as director of any other company or companies (including overseas companies).
  • Any matter connected with or arising out of the insolvency of any such company (including an overseas company).

The minimum period of a disqualification order is two years and the maximum is 15 years. It is open to a disqualified director to apply to the court for leave to act as a director or manager of a company (sections 1(1)(a) and 17, CDDA 1986).

Duty to report on delinquent directors

Liquidators, administrators and administrative receivers are required to submit reports about directors (including shadow directors) to the Secretary of State if it appears to them that the conditions for disqualification are satisfied in relation to a person who is or has been a director of the company for which they have been appointed.  

Insolvency practitioners need to make difficult judgments, involving both commercial and legal considerations as to whether directors are unfit to be concerned in the management of a company and, in the case of shadow directors, whether they fall within that category or not.

The House of Lords has held that the powers of investigation conferred upon insolvency practitioners by section 236 of IA 1986 can be exercised solely or principally to obtain evidence for use in disqualification proceedings.

Factors in determining disqualification

In determining the question of unfitness, whether to make a disqualification order or the period of disqualification, the court shall have regard, in particular, to the matters set out in Schedule 1 to the CDDA 1986 (section 12C, CDDA 1986). These matters include:

  • Any misfeasance or breach of any fiduciary duty by the director in relation to a company (or an overseas company).
  • Any material breach of any legislative or other obligation which applies to the director as a result of being a director of a company (or an overseas company).
  • The frequency of any conduct of the director falling within the above two matters.

Sanctions for acting while disqualified

It is a criminal offence if a person acts in contravention of a disqualification order (section 13, CDDA 1986) and that person will be personally liable for all the relevant debts of the company he is managing (section 15, CDDA 1986). 

Disqualification Undertakings

Under section 1A of the CDDA 1986, the Secretary of State, instead of initiating disqualification proceedings, may accept a voluntary disqualification undertaking from a director to speed up the disqualification process. 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.

If a director agrees to give a voluntary disqualification undertaking, the Secretary of State has a discretion whether to accept the undertaking or apply to court for a disqualification order. Disqualification undertakings will only be accepted where it appears to the Secretary of State that it is expedient in the public interest to accept an undertaking instead of applying for, or proceeding with, a court application for a disqualification order.

A breach of the terms of the undertaking has the same criminal and civil consequences as a breach of a disqualification order.

Disqualification for fraudulent or wrongful trading

The court can make a disqualification order against a person if he has been found liable for fraudulent trading under section 213 of IA 1986 or wrongful trading under section 214 (see Wrongful trading) (section 10, CDDA 1986).

Section 10 of the CDDA 1986 does not include reference to fraudulent trading or wrongful trading pursued under sections 246ZA or 246ZB (respectively) of the IA 1986 in administration.

For further advice please contact our Restructuring and Insolvency team on 0345 20 73 72 8 or email info@thursfields.co.uk

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