Though incorporation can shield shareholders from liabilities, the directors (who are often the shareholders as well) face a series of challenges in the event of financial difficulties that can, if advice is not sought early, result in personal liability.
Where a company is or is about to become insolvent its directors must act in the best interests of the company's creditors (as opposed to the company's shareholders) and there are certain corporate and personal consequences for those directors if they fail to do so.
Under common law directors it may be held that there be contribution by the directors by way of compensation where there has been a breach of their duty that is owed to the company (misfeasance). Trading while insolvent can also trigger several provisions under the Insolvency Act 1986 which may have the effect of making directors of a company personally liable to contribute to the assets of a company.
Furthermore, a person can be a director without bearing the title and can be held personally liable for debts. Thus, a shadow director is defined as ´a person in accordance with whose directions or instructions the directors of the company are accustomed to act´.
The relevant insolvency legislation is primarily contained in the Insolvency Act 1986. The relevant provisions of the Insolvency Act 1986 include:
Wrongful trading occurs when the directors of a company have continued to trade a company past the point when they:
- "knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation"; and
- they did not take "every step with a view to minimising the potential loss to the company’s creditors".
Penalty: The directors have to make a contribution, without limit from personal funds, as the court sees fit. This is to enable compensation, not to punish those concerned. The Court has wide discretion over the contribution.
Fraudulent trading is the carrying on of the business of a company with the intention to defraud creditors. Any director who knowingly allows a company to continue trading with the intent to defraud its creditors or any other person can be held personally liable to pay compensation. Insolvency at the time of the trading is not a requirement to establish fraudulent trading.
Penalty: The directors have to make a contribution, without limit from personal funds, as the court sees fit. This is to enable compensation and also to punish those concerned.
Where a person or company transfers assets or pays a debt to a creditor shortly before going into bankruptcy or liquidation, that payment or transfer can be set aside on the application of the liquidator or trustee in bankruptcy as an unfair preference.The effect of a successful application to have a transaction set aside means inevitably the creditor which received the payment or assets has to return it to the liquidator.
A classic example of a preference is where the company repays its inter-company debts or director's loan accounts ahead of its other creditors shortly before its liquidation.
A transaction at an undervalue occurs when a company or person, who subsequently goes into liquidation or bankruptcy, disposes of assets for significantly less than they are worth. A liquidator can apply to have the transaction set aside for the benefit of the debtor's creditors. Under ordinary principles of contract law, the courts will not generally look into the adequacy of the consideration provided by either side. However, if a company is in real peril of going into liquidation, transactions which are seriously commercially disadvantageous to the company can be unwound, so as to prevent prejudice to the creditors of the company.
A classic example of a transaction at undervalue is where the company transfers its business and/or assets to a creditor, director or another party for a nominal amount.
The relevant period for a transaction at an undervalue or unfair preference to be proved is:
- 2 years, if the person with whom the company entered into the transaction with is a "connected person", or
- 6 months, in all other cases.
In an action for wrongful trading, fraudulent trading, transaction at an undervalue and preferences there is also the likelihood of a directors disqualification. A disqualification order will run for a minimum of two and a maximum of fifteen years. A person who is subject to a disqualification order may not:
- Be a director of a company without leave of the court
- Be concerned or take part in any way in the promotion, formation, or management of a company without leave of the court
Recommendations
To assist directors in dealing with a potential crisis the following guidelines should be followed:
- Avoid incurring further credit unless you believe that the company can pay for the goods or services ordered
- If assets are disposed of ensure that market value is achieved
- Do not seek to pay one creditor in priority to another
- Do not continue to trade whilst the company was insolvent
- Always keep proper accounting records, pay taxes on time and submit forms to Companies House on time.
We also recommend that, as a matter of good practice, every board of directors:
- Minute carefully the particular responsibility of each board member
- Ensure that appropriate management information is provided to it at regular intervals, and that action is taken where necessary
- Record at least in outline the information presented to it, any action it resolved to take as a result, and the director or directors responsible for implementing the action
- Seek proper professional advice on all material matters not within the general knowledge, skill, and experience of the company’s own directors and senior staff
- Those who are not directors of a company but nevertheless have a close business connection with it should satisfy themselves that their relations with the company do not make them shadow directors.
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