Over Taylor Biggs

This in many cases has been caused by cashflow issues and the lack of overdraft and other bank facilities. This has meant that companies who would not ordinarily consider themselves to be insolvent, may in fact be on the brink of insolvency, not so much because they do not have assets which exceed their liabilities, but because they cannot pay their debts as they fall due, potentially as a result of poor cashflow.

Is the Company solvent?

Directors who are considering whether or not their company is still solvent in the "financial sense" will need to consider whether or not the company is able to pay its debts as they fall due and whether or not its assets outweigh its liabilities (including any contingent or prospective liabilities).  If the company fails to satisfy either of those two tests, then the company is financially insolvent.  The company is not "in insolvency" in the legal sense of the word until it or a third party initiates a formal insolvency procedure.

What should a director of a company close to insolvency consider?

A company faced with financial difficulties has a number of options to pursue, depending on what it aims to achieve, how serious its financial position is and how co-operative its creditors are willing to be.  The company's directors are under various duties to act properly and responsibly in relation to the company, which includes reacting to its financial situation appropriately.  Directors are also under a specific duty to minimise potential loss to the company's creditors in the event of insolvency and, in particular, it should be noted that the directors' duties under the Companies Act 2006 will shift from being to promote the success of the company for the benefit of its members as a whole and instead will be focused towards protecting the creditors of the company.

In the event of a company entering into an insolvency procedure, the directors' conduct prior to the insolvency will be carefully looked at by an insolvency practitioner.

Directors who do not take any steps and ignore the situation can incur potential personal liability (see below) and disqualification for not taking appropriate action.  A disqualification order preventing a person from acting as a director can be imposed by the court for a period of between 2 to 15 years.

There are a number of things that a director of a potentially insolvent company should consider when trying to find a solution to the company's financial problems. Some of the more legalistic things are set out below with a brief commentary and points the director could consider:

• Should the company cease trading?

Directors should as soon as the company enters into a position where it may be financially insolvent obtain professional advice in relation to any major decision taken by the company.  This could include accounting, legal and specific insolvency advice from relevant professionals.  For example, in may be thought that in rationalising the business of the company certain assets should be sold, or divisions of the business sold, or alternatively employees of the company should be made redundant.  It is important when disposing of any form of assets of the company that the disposal is done at market value and on arm's length terms to avoid there being any suggestion of any undervalue transaction or any form of preference or fraud on creditors. 

• Have the directors' actions given rise to any criminal liabilities?

Criminal liabilities will arise if prior to or during the company's insolvency company property was dealt with in certain ways as specified by insolvency legalisation. For example, disposing of company property (other than in the usual course of business) which was obtained on credit and has not be paid for or taking property knowing it was obtained on credit and not paid for. If found guilty a director will be liable to a fine and/or imprisonment.

• Could the directors' actions have rendered them liable to contribute to the company's assets or any of its debts?

A director can be held liable for wrongful trading if:

(i)   the company is in insolvent liquidation;

(ii)   before the company went into liquidation, the directors knew, or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation;

(iii) he/she was a director at the time; and

(iv) he/she did not take every step he/she should have done to minimise the loss to the company's creditors.

Any action for wrongful trading is normally brought by a liquidator.

When the directors decide to place the company into insolvent liquidation a statutory duty arises which require directors to take every step which a reasonably diligent person would take to minimise potential loss to the company's creditors. After the company has entered insolvent liquidation if the court finds that the director failed to comply with this duty he/she can be ordered to contribute to the company's assets.

If any business of the company was carried on with the intent to defraud creditors the liquidator can apply to the court seeking an order for those who were knowingly parties to the fraud to contribute to the company's assets.

• Is the company under any particular contractual liability to notify others of its insolvency, and/or do other parties have particular rights when the company becomes insolvent?

For example do any of the company's contracts contain provisions which with allow a contracting party to terminate the contract in the event of insolvency?

Directors should review all of their major contracts and, in particular, their funding contracts to monitor compliance with any covenants and, in particular, financial covenants and other terms in relation to the financial position of the company so that they are aware of the result of a potential breach of any such covenants.  In assessing whether a company is unable to pay its debts as they fall due and/or its liabilities exceed its assets, all contingent and prospective liabilities must be taken into account.  The directors can then approach any relevant third party to try to obtain a variation of any such agreements or a waiver of any breaches.

• What obligations does the company have towards its employees?

If any employees are to be made redundant, then appropriate legal employment advice should be taken before the redundancy process is commenced so as to have an understanding of the likely redundancy costs and also the likelihood of claims for unfair or wrongful dismissal.

• Should any directors resign?

It is no defence to simply resign.  Directors must take every step to minimise potential losses to creditors.  If they conclude that the company cannot continue to trade, they must implement one of the insolvency procedures, such as liquidation or administration.  If the other directors disagree with this approach, it is important for the personal protection of the relevant director to ensure that this is carefully minuted.  All directors should keep copies of the board minutes for their own records.  Resigning as a director is a last resort and it is important that any director who does resign is seen to have taken all steps possible to minimise potential losses to creditors to avoid (or at least minimise) personal liability.

The following are some suggested practical steps that the directors may also wish to consider taking:-

• It is important to hold regular board meetings so that the directors can keep all of the other directors up to date on the current position of the company.  It is particularly important that all directors (including non-executive directors) should be present at any such board meetings so that they are aware of the company's financial status.  It is not a defence for a director to simply not turn up for board meetings and take no part in the running of the company.  This will not absolve the director from any liability for, amongst other things, wrongful trading and breaches of their directors' duties. 
• The directors of the company should ensure that all board minutes of any meeting are circulated immediately after a meeting.  The minutes will be evidence of whether or not steps were taken by the directors to minimise the potential loss to the company's creditors for the purposes of avoiding liability for wrongful trading.  These are obviously key evidential documents and it is important that the minutes are clear and comprehensive as they will provide vital evidence if the liquidator of the company seeks to bring an action for wrongful trading against any of the directors.  Bear in mind that the minutes will be capable of being produced to the court.
• A list of all possible sources of funding for the company should be drawn up.  A board meeting should then be called of all of the directors to consider the board's overall attitude to pursuing any source of funding from any of the proposed sources. 
• The legislation in connection with wrongful trading requires the directors to identify the point in time at which the company no longer had any reasonable prospect of avoiding insolvent liquidation.  Once that point is reached, the directors then have to place the company into some form of voluntary (or involuntary) liquidation in order to avoid any liability for wrongful trading.  If all sources of funding are considered and discarded it will be at that point that the directors know that there is little, if any, chance of the company avoiding an insolvent liquidation. 
• A timetable by when financial milestones, such as new funding levels for the company, must be met should be prepared.  Once again, this supports the concept and assists the directors with defining where there is no reasonable prospect of the company avoiding insolvent liquidation.  It is important that the timetable is adhered to in order to support the contentions that the directors have taken all necessary steps to minimise potential loss for the company's creditors. 
• The company should not incur any substantial new liabilities.  This is commonsense but it is important that liabilities are not incurred without any form of guaranteed funding source being in place before such liability is incurred. 
• Although it is a reasonably obvious statement, simply letting judgments be entered into against the company, or people threatening to serve winding up petitions, should be a key marker that the company is struggling financially and it is important that if any judgments or the like are served on the company, all of the directors are notified.  This gives the directors the opportunity to be kept financially aware of the current solvency position of the company.
• If any directors can foresee any problems or wish to discuss matters, it is important that they call a board meeting and actually raise those problems with the rest of the board.  This must be done as soon as a director is aware of those matters so that the board can take immediate legal or financial or other advice as appropriate.  It is very important that a director (even if he/she disagrees with the other directors) should have their points listened to carefully and noted in the board minutes.  This can provide evidence for any director who disagrees with the actions of his fellow directors to support any contention that the relevant director took all steps to minimise losses to creditors.

We hope the above article is helpful but if any further advice is required in this regard, please do not hesitate to contact Karl Taylor at first instance.

This briefing note is not intended to be a comprehensive guide and does not cover every aspect of the topic and is not intended to provide legal or other advice.

September 2009