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Financial difficulty and insolvency: An introduction

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Financial difficulty and insolvency . This guide looks at the legal position of directors...

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Financial difficulty and insolvency.

This guide looks at the legal position of directors when a company is in financial trouble or insolvent.

Those who flout the rules and fail in their duty to creditors and shareholders can be ordered to contribute to the company's assets and, in the worst cases, be prosecuted for fraudulent trading.

This guide provides an overview of the kind of action (or inaction) that increases the risks of personal liability, but it is not an exhaustive study of the law. Advice will need to be sought in all circumstances.

Legal duties

The general duties of directors are examined in more detail in our series of guides on Director's duties. Below, we highlight those most relevant in insolvency-related cases.

  • To consider the interests of creditors above those of members. When a company is clearly solvent, directors must act in the interests of the shareholders in general. When a company is insolvent, or possibly even when it is of doubtful solvency, the position changes: creditors come first.
  • Not to act for any personal or additional purpose. All directors should separate their own personal interest (as shareholder, executive, creditor etc.) from the company’s interests. Their duty is to act in the interests of the company. This will mean following the principles outlined in Actions that minimise the risks of liability, below.
  • To take steps to avoid loss to creditors.Under insolvency legislation, a director will be personally liable for wrongful trading if a liquidator can show that they knew or ought to have concluded there was no reasonable prospect of avoiding liquidation but continued to do business as “normal”. Liability will not arise if the director can show (to the court’s satisfaction) that they took every possible step to minimise the potential loss to the company’s creditors. They must be seen to have actively tried to do this.

A director should never allow a company to accept credit if in their view there is no reasonable expectation of the creditor being paid at, or shortly after, the time when the debt becomes due. Anyone knowingly party to a transaction in such circumstances could be ordered by the court to make contributions to a company’s assets, and be guilty of the criminal offence of fraudulent trading.

  • Not to enter into transactions at an undervalue or make preferences. Insolvency legislation permits an administrator or liquidator of a company to apply to a court to set aside or vary transactions at an undervalue as well as preferences entered into within a specified period before insolvency proceedings began. (Transactions at an undervalue and preferences are defined below.) In setting a transaction aside, a court will make an order to restore the position to what it would have been had the transaction not taken place. This may result in personal liability for the directors of the company and disqualification proceedings against any director responsible for the transaction concerned.

Actions that minimise the risks of liability

It's important not only that the steps explained below are carried out, but also that they are seen to be carried out: the behaviour of directors may be carefully scrutinised by a future liquidator or administrator. Actions taken in the interests of a company and its creditors should be methodically documented and explained. All meetings must be minuted. Directors must give reasons for their decisions and cite the advice they have taken. Directors who can show that they acted in good faith on the advice of suitably qualified professionals will be more likely to avoid wrongful trading allegations – even if the liquidator believes the advice they were given was wrong.

Monitoring the financial position of the company

A director should regularly review the company’s financial position in order to assess whether the company is solvent and to determine its prospects of avoiding insolvent liquidation. This will generally involve the preparation of regular statements of affairs and cashflow projections and other current financial information – in collaboration with auditors and other advisers as necessary.

Directors should establish a procedure for the finance director to keep the board informed of the performance and prospects of the company. This will generally involve frequent board meetings.

The directors should be satisfied that, taking into account their duties to creditors, shareholders and employees, the company may properly continue to trade. Each director should carefully consider the company’s ability to pay before arranging for the receipt of any further goods or services on credit, and the board should regularly review the company’s financial position. These reviews should be fully minuted.

Individual directors should raise any concerns over solvency with other members of the board. If their fears are not heeded, they should repeat them and take steps to protect their own position. (See the paragraph on resignation in our Wrongful trading FAQ)

If directors believe the minutes of a board meeting do not properly reflect the views they put forward, they should ask for correction, and failing that, write to the chairman (copying the letter to other board members) re-stating their position. It’s important for there to be a written record of what a dissenting director said, and when, whether it appears in the official board minutes or elsewhere.

When going through a difficult period, directors must regularly ask whether their company fails the “solvency test”. A company will be regarded as insolvent when it is unable to pay its debts or the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

A company is deemed to be unable to pay its debts if:

  • a creditor owed more than £750 has served a statutory demand at the company’s registered office and the debt has not been paid for three weeks thereafter;
  • execution of a judgment or other court order remains unsatisfied after a visit from a bailiff or sheriff’s officer.

If a company is part of a group, it is important for the directors to think of it as a separate legal entity, even where the treasury function is shared. The financial position of each company in the group has to be evaluated separately. This may require a review of facility letters, security, guarantees, joint venture documentation, joint obligations and similar documentation in order to determine the nature and extent of the financial position of each subsidiary.

Taking advice

Directors of a company in financial difficulties often face a dilemma. It seems that they are expected to be neither unduly rash nor unduly cowardly.

Causing a company to cease to trade or putting it into administration or liquidation, or calling in an administrative receiver (see: Insolvency procedures, an OUT-LAW guide) prematurely can be as damaging to the interests of the creditors as allowing a company to carry on trading against all odds.

Directors must act responsibly, resisting, on the one hand, their natural tendency to be over-optimistic or to refuse to accept defeat and, on the other hand, the temptation to succumb to despair without considering the options available. Their analysis of the company’s performance and prospects should be based on up-to-date financial information and should almost certainly involve consultation with professional legal and financial advisers. Advisers can offer a range of ‘restructuring options’, including finding a buyer to maximise the value of the business’s assets. (See: Accelerated M&A and 'pre-packaged' administration, below.)

Accurate, complete and up-to-date information and access to financial and legal advice from appropriately qualified professionals will significantly strengthen a director’s position in the event of a court hearing. They would, for example, be vital in justifying a director’s actions if faced with a claim for wrongful trading. (See: Personal liabilities for financial difficulty and insolvency, an OUT-LAW guide.)

A court will be reluctant to substitute its own commercial judgment for that of a director unless it considers that no reasonable director could have concluded the action taken was in the interests of the company. In cases where directors have taken the advice of properly qualified, competent professionals, judges are unlikely to claim they know better.

In some circumstances, there may be a conflict of interest between subsidiary and parent or between fellow subsidiaries, requiring separate legal and/or financial advice; for example, where it is proposed to use the assets of a doubtfully solvent subsidiary to secure the parent’s indebtedness.

Directors may need to seek advice individually on how to minimise the personal risks involved in the management of a company that is approaching insolvency. (See: Personal liabilities for financial difficulty and insolvency, an OUT-LAW guide.)

Formulating a viable strategy

If the company’s performance and prospects demand it, a board should formulate a strategy for restoring a company to a healthy financial position and avoiding formal insolvency proceedings. In general terms, the action plan may involve one or a number of the following:

  • alternative trading strategies;
  • disposals;
  • maximising existing asset values;
  • cutting overheads;
  • delaying capital investment;
  • further bank finance (possibly with a grant of security);
  • converting debt to equity, converting short-term debt to long-term debt, or raising new equity;
  • an informal arrangement with major creditors or voluntary arrangement;
  • arranging alternative sources of funding from other financiers, particularly where the bank is unlikely to advance further money.

The chosen strategy must have the support of the board (the full board if possible). In addition, its viability must be reviewed by appropriate advisers and its implementation constantly monitored.

At the very least, directors should review the strategy at each board meeting and have grounds for concluding that there is a reasonable prospect of avoiding insolvent liquidation.

They should reconsider the factors that underlay the development of the strategy and confirm whether in their view they are still valid. A board might have committed the company to cutting overheads, delaying capital investment, relocating premises, selling part of the business or procuring fresh equity. At each meeting, the board will need to review whether the strategy is being implemented as envisaged and whether the underlying assumptions (for example, as to the value of properties) are still reasonable.

The valuations used should be realistic. The accounting principles upon which assets are valued for the purposes of the annual statutory accounts might not be appropriate. The realisable value of any asset will, of course, depend upon all the circumstances in which the asset is being sold. Discussions with a company’s auditors may be helpful on this point.

All decisions made and the reasons for them should be recorded in the minutes, as should any advice taken.

Holding regular meetings

Board meetings and other, more informal, meetings should be held at regular scheduled intervals. All directors should endeavour to be present in person or by phone/conference facility. Detailed minutes should be kept of all meetings and circulated in a timely manner. Additional meetings should be called as and when new significant events occur. Briefing papers should be circulated before such meetings to promote informed discussion. Absent directors should be told as soon as possible of critical decisions taken at board meetings.

Involving all directors

Undoubtedly, the involvement of the finance director and any members of  the management team responsible for credit control and assessing the current and future financial performance of a company will be key. Depending on the nature of a recovery strategy, input from sales, marketing and production executives may also assume a greater importance.

In most cases, however, it will be the non-executive directors who are best placed to assess whether a company is able to continue trading and, in particular, whether it can justify incurring fresh liabilities. Non-executives bring objectivity, experience and financial independence to the board. Where a company’s prospects for survival are uncertain, their involvement will ensure that the interests of creditors and shareholders are not overlooked and will facilitate discussions with banks and other lenders.

Keeping major creditors informed

It is important that the distribution of information to creditors’ groups is handled in an orderly way. Information to be released to creditors should be discussed with and, in some circumstances, presented by, the company’s advisers. Where a strategy to be implemented requires creditors’ support (principally that of the lending banks), a careful and clear presentation is required.

If a company’s shares are publicly traded, directors will have to consider the problems associated with the release of price-sensitive information.

Making announcements

The FSA’s Disclosure and Transparency Rules oblige directors to make certain announcements to avoid the creation of a false market in the company’s shares. Similar rules apply in the case of AIM companies. Bad news, in other words, cannot be kept hidden.

Announcing that a dividend might not be paid on a listed preference share, or that a company is in discussion with its bankers, will obviously have a marked effect on creditor confidence, and directors will need to consult their advisers about the timing of announcements.

They must, however, never lose sight of the fact that they can be guilty of a criminal offence if they:

  • make any statement, promise or forecast they know to be materially misleading, false or deceptive;
  • recklessly make (dishonestly or otherwise) any statement, promise or forecast that is materially misleading, false or deceptive;
  • dishonestly conceal any material facts.

In each of these cases, directors will be guilty if they deliberately induced another person to deal in securities in a company on the basis of false information – or they were careless about what they said and its effect on investor behaviour. (See our series of guides on The FSA and Securities Regulation.)

Accelerated M&A and 'pre-packaged' administration

Currently, where a company is in financial trouble and its bankers and stakeholders are not prepared to fund for the long term, the directors will often be advised to consider an accelerated M&A strategy as the best means to achieve a better realisation for the creditors. This involves the fast-track marketing of the business by accountants and corporate advisers. Data rooms are set up for due diligence, and the M&A process (which would normally take months) is truncated to weeks or, in some cases, days.

Often, the outcome is that a buyer is found for the business but not one prepared to take the company with all its liabilities. The buyer therefore negotiates to acquire the assets of the business, leaving the rest behind. Once that deal is agreed, the company is put into administration. An insolvency practitioner is appointed, who then completes the sale (often helped by their previous involvement in the negotiations).

These transactions, known as ‘pre-packaged’ administrations, will usually achieve a better result for creditors, and better protection for directors. They should only be entered into, however, with the benefit of professional legal advice.