Directors Duties in relation to Insolvent Companies

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By David Arundel, partner at Clarion Solicitors.

We are, as the Government keeps reminding us, in the middle of "difficult times". Most people would in fact simply say that we are in the midst of a global economic crisis, precipitated by the credit crunch and that the UK economy is in recession. As a result, many previously profitable companies are teetering on the brink of insolvency.

Interim directors brought in to assist those companies will therefore find themselves facing a number of challenges. The Interim director may have been brought in specifically to assist with the company's financial difficulties, or he may to his surprise find himself faced with that problem, either way he will need to proceed carefully.

So what duties does the director have? Directors' duties generally have recently been codified by the Companies Act 2006. If the company is solvent, then perhaps the most important of the duties is the duty to promote the success of the company. To fulfil that duty the director must consider the likely consequences of any decision which he might make in the long term: the interests of the company's employees, suppliers, customers and others; the impact of the company's operations on the community and the environment and the need to act fairly between the members of the company.

The director must also exercise independent judgement, exercise reasonable care, skill and diligence and avoid conflicts of interest. The full list is longer but these are perhaps the most important of the recently codified duties.

However, where a company is insolvent then the duties change. In these circumstances a director's duty to the creditors overrides all other duties. The company's assets must be managed to give priority to the creditors. These principles have been set out repeatedly in the case law and in the insolvency legislation, the starting point for which is the Insolvency Act 1986. If the company is insolvent then the director's duty is owed to all creditors, not just one or more specific creditors. The directors cannot dispose of any of the assets of the company or make any payments to shareholders, if provision for the interests of the creditors has not been made. If the company is indeed insolvent then in reality such provision will not be possible and therefore those types of payment should not be made.

A failure by the directors to obey that overriding duty can give rise to a number of claims against them by an insolvency practitioner acting as liquidator or administrator, if the company does go into some kind of formal insolvency procedure. The officeholder may bring a claim against the director(s) for misfeasance which essentially are claims for breach of duty. The duties can be those owed to the creditors, but also those owed more generally to the company, as listed above.

The insolvency legislation also provides for possible claims by an officeholder against directors who have been guilty of wrongful trading. Many directors fall foul of this provision of the Insolvency Act because they believe (unrealistically) that the company can trade out of it's difficulties. The legislation provides that once a director concludes there is no reasonable prospect of the company avoiding insolvent liquidation, the directors then have a duty to take every step which a reasonably intelligent person would take to minimise the potential loss to the company's creditors. The test is a mixture of the objective and subjective. So a director must act as a reasonably diligent person would, but such a person is imposed with the actual skill, knowledge and experience of the director in question. It therefore seems to me that Interim directors who are engaged for their vast experience, knowledge and skill might in fact be subject to a higher duty than a director running a very small business who has only ever been involved in that particular company.

Directors should also be alive to the risks of falling foul of other provisions in the insolvency legislation including carrying out transactions at undervalue or allowing payments to creditors which constitute preferences. Office holders can pursue these monetary claims against directors to increase the assets of the insolvent company. Interim directors are less likely to fall foul of such claims, but care must be taken in particular in relation to payments which might constitute preferences, ie paying one creditor in preference to another one, or putting one creditor in a better position than he would be in if the particular arrangement was not put in place.

Directors of all types, interim and permanent should seek advice from an Insolvency Practitioner or an Insolvency Lawyer if they are in any doubt at all as to the solvency or insolvency of the company.

This step is useful for two reasons. Firstly the insolvency professional can give practical advice and assistance together with an objective view upon the company's position. Secondly, the very fact that a director or a board of directors has taken professional advice may form a defence to any of the claims which are set out above, for example wrongful trading.

Faced with an insolvent company, directors cannot necessarily just resign – there is a duty to take positive steps to resolve the situation even if those steps are simply to put the company into the hands of an insolvency practitioner.

The duties owed by Interim directors are no different to those owed by other directors and so Interims may find themselves unexpectedly sorting out the problems created by other, permanent directors in any given company. One advantage, as I have alluded to above, is that the Interim can cast an objective eye over the financial position of the company and its prospects for the future. An Interim can also put new ideas to the board.

Having said that, the objective view formed by an Interim may be a decision that the company is indeed insolvent, cannot continue to trade and therefore needs to take professional advice from an insolvency practitioner or an insolvency lawyer. No director should shy away from reaching that conclusion and taking the appropriate steps.

You can contact David at Clarion Solicitors here

Tel: 0113 222 3248
Email: d.arundel@clarionsolicitors.com
Address: Britannia Chambers, 4 Oxford Place, Leeds, LS1 3AX
Website: www.clarionsolicitors.com

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