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Covid-19: Guidance on insolvency for company directors

Posted: 01/04/2020


In a welcome announcement for company directors, Alok Sharma, the Business Secretary has confirmed that the wrongful trading provisions under the Insolvency Act 1986 (the “Act”) will be suspended for three months.

This announcement follows the Chancellor’s commitment to do “whatever it takes” to save businesses and workers and, as part of a raft of measures, to pay 80% of staff kept on by employers. Not only have such radical measures never before been attempted in the UK but it is likely that further measures will follow as the government takes unprecedented action to seek to mitigate the economic consequences of Covid-19. https://www.gov.uk/government/publications/guidance-to-employers-and-businesses-about-covid-19/covid-19-support-for-businesses.

Under the wrongful trading provisions (set out in s214 of the Act and dealt with in greater detail below), a company director may be ordered to pay compensation if a company goes into insolvent liquidation and the court concludes that the director knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation or administration. This has left directors with a difficult decision; whether to accept Government support and continue trading or risk potential personal liability if the company subsequently collapses.

Mr Sharma’s confirmation has provided welcome clarification of the position for directors. The changes will take retrospective effect from 1 March 2020 and last for three months (though the precise terms of the implementing legislation have yet be published). The government has confirmed that the changes may be extended if required. However, while the policy has been announced, it has not yet become law.

How this plays out in the weeks and months to come remains to be seen.At the creditors’ cost there is the potential for unscrupulous businesses to exploit the relaxation to continue to trade where they should not do so. It is not difficult to imagine these measures providing fertile territory for future litigation.

In the interim, in this summary briefing note flags some of the key legal points that any business - whether it be a small/medium sized company (SME), owner-managed, partnership or in the FTSE 250 - and their directors/senior managers should consider from an insolvency law risk perspective.

This is, however, only a summary checklist. For detailed advice please contact our specialist restructuring and insolvency team.

Insolvency

Where a business is insolvent or even when it is of doubtful solvency, its directors have a duty to consider the creditors’ interests above the interests of its members. Under section 123 of the Insolvency Act 1986 (1986 Act), a business will be considered insolvent by application of one or both tests for insolvency, known as the 'cash flow' test and the 'balance sheet test.

  • The cash flow test where the business is unable to pay its debts as they fall due.
  • The balance sheet test where it is proven to the satisfaction of the court that the value of the business' assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

In these turbulent times it is likely that at least one of these tests have been triggered. It is therefore important for the directors to understand that the duties and potential liabilities upon a director under the 1986 Act are widely construed and apply equally to de facto or shadow directors (ie an unappointed individual/ connected business whose instructions the directors are accustomed to follow).

Wrongful trading

As described above, the most common concern for directors faced with a potential insolvency is wrongful trading under section 214 of the 1986 Act. This is where a business has gone into insolvent liquidation and it can be shown that before the commencement of the winding-up the director knew or ought to have known that there was no reasonable prospect of the business avoiding insolvent liquidation. In such circumstances there is a risk that the director can be required by a court to make such contribution towards the debts or liabilities of the business.

The only defence open to a director is that he/she took every step with a view to minimising the potential loss to the creditors that he/she ought to have taken. However, this first assumes that he/she knew or ought to have known that there was no reasonable prospect that the business would avoid insolvent liquidation. The onus is on the director to prove this defence but it is up to the liquidator to prove the latter.

Note that this provision does not merely cover trading activity. Any kind of act or failure to act, unless it minimises losses to creditors, may attract liability under this section.
Simply resigning will not of itself relieve a director from liability if he/she was a director at a time when the liquidator can show that he/she knew or should have concluded that insolvent liquidation was inevitable. The director must take some further steps thereafter to protect his/her interests and those of creditors.

If, after that time the director cannot persuade the other directors to follow what they believe to be the correct course, they should express their views at a board meeting as soon as possible, preferably after producing a reasoned paper setting out their views for consideration by the directors at the board meeting.

If that fails to convince the other directors, the director should then either resign or make one further attempt to persuade the board by threatening to resign, and then resign if that fails to produce the desired effect.

No order will be made against a director if the court is satisfied that the director took every step with a view to minimising the potential loss to the Company's creditors that they ought to have taken in the circumstances. It is therefore crucial to make a careful contemporaneous written record of such steps and to seek professional advice and act in accordance with it. The relaxation of the wrongful trading provisions for an initial term of three months from 1 March 2020 will provide temporary respite, however we anticipate that the court will not look favourably on anyone considered to have abused these measures (and directors should ensure they can evidence the steps they have taken as described above). Moreover, while the wrongful trading provisions have been relaxed, there remain a series of alternative claims for which directors can be found liable (as described below).

Reviewable transactions

Certain transactions entered into by a company or an individual within a specified period before an insolvency may be set aside by the court on the application of an office holder (IP) such as an administrator or liquidator. These are collectively known as “reviewable transactions” and include transactions at an undervalue, preferences and transactions defrauding creditors.

Directors should be keenly aware of the potential for significant financial or criminal penalties if they are found to have acted in breach of the 1986 Act. These risks can also apply to the recipient of the unlawful benefit.

Transactions at an undervalue

A transaction at an undervalue is where say the company has entered into a transaction for no consideration (ie money or money’s worth in non-legal language) or for a sum which is significantly less than that received by the company). In such circumstances, the directors could potentially be liable.

Preferences

A preference is where say a company does anything, or allows anything to be done, which is intended to put one of its creditors or guarantors into a better position than they would have been in if that act had not been done. An example of this is the payment of one creditor in full while others remain unpaid.

Transaction defrauding a creditor

A transaction defrauding a creditor is where an individual enters into a transaction at an undervalue with the purpose of putting assets beyond the reach of a person who is making or may make a claim against them. In such circumstances, the court may make an order under section 423 of the 1986 Act to restore the position to that which it would have been if the transaction had not been entered into and to protect the interests of persons who are victims of the transaction.

There is no fixed period within which a transaction must have occurred nor is it necessary for the company to have begun any insolvency process for a transaction to be liable to be set aside under this section. It should also be noted that this remedy is not limited to liquidators and administrators but is available to any victim of the transaction as set out above.

Misfeasance

Misfeasance is a broadly defined offence under section 212 of the 1986 Act which provides for a remedy against directors who have misapplied, retained, become liable or accountable for any money or property of the business, or have been guilty of misfeasance, breach of fiduciary duty or any other duty in relation to the business.

As such, it covers a wide variety of wrongs including the improper payment of dividends, the application of monies for improper purposes, the application of monies contrary to the Companies Act 1985, and any unauthorised loans or payment of unauthorised remuneration to directors. The court may examine the conduct of such persons and compel them to repay or restore the money or the property with interest or to contribute money to the assets of the business by way of compensation

Fraudulent trading

If any business is carried on with the intent to defraud creditors or for any other fraudulent purpose, the liquidator can apply to the court under section 213 of the 1986 Act for a contribution from any person who was knowingly a party to the carrying on of the business in that manner.

This provision is not often invoked since it requires fraudulent conduct (ie a deliberate intention to carry out the intended conduct with a view to the other party acting to its detriment). However, where the directors allow a company to continue to trade and incur liabilities when they know there is no real prospect that these will be repaid, the directors are at risk under this provision.

It should also be noted that the provision is wider than the wrongful trading provision in that it applies to "any persons" - not just directors - who were knowingly parties to the carrying on of the business in question. There is also no defence of taking steps to minimise loss to creditors. Fraudulent trading also attracts a criminal penalty of up to seven years' imprisonment, an unlimited fine or both, as well as civil liability.
Summary of the key steps

  • A director may potentially be exposed to a claim for wrongful trading if the company goes into insolvent winding-up or administration and it can be shown that, before the commencement of the winding-up, the director knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation.
    No order will be made against a director if the court is satisfied that the director took every step with a view to minimising the potential loss to the company's creditors as they ought to have taken in the circumstances.
  • It is therefore crucial to take a careful contemporaneous written record of such steps, to seek professional advice and to act in accordance with it.
  • Where a company is facing insolvency, it needs to be very careful to ensure that any cash payments being made are business critical - that is, with a view to the business continuing for the benefit of the company including its creditors and members - rather than with any intention to prefer one creditor over another.
  • In such circumstances, a company also needs to engage carefully at an early stage in discussions with its stakeholders and, of course, its lenders and consider the terms of any charges with its bank(s) to consider whether the bank is able to appoint an administrator. It is a fairly standard term contained in the charge documentation - which should be checked by the directors - that a bank is able to appoint its own administrator in these circumstances. Therefore, keeping a bank onside is a key action to focus on.
  • The directors should also consider the terms of any Directors & Officers Insurance policy or other policies (and how they are affected by any exclusions relating to the Covid-19 virus); notify the relevant insurer in writing; and consider the terms of the policy to see whether legal fees and other losses are covered.
  • If a business is served with a statutory demand or threatened with a winding up petition, the directors should immediately seek specialist legal advice (see link to the specialist restructuring and insolvency team above). In many circumstances, the company is likely to be under an obligation to notify its bank, with the risk that the bank may freeze the company’s account. Swift specialist advice can help the directors to save the business and reduce the risk of claims.

The above is only a short summary of some of the key issues, however for more detailed advice please contact a member of the team.


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