Considerations of a director in a distressed situation

Answer

As a corporate solicitor, you’ll advise companies throughout their life cycle, and at no time will the stakes be higher than when a company finds itself in financial distress. While the title ‘director’ may sound snazzy and might even come with an impressive salary, a director should always remember that they have a number of statutory and fiduciary duties to act in the best interests of the company and its stakeholders, a responsibility that becomes more complex in a distressed situation. The legal consequences of not meeting your statutory duties may result in financial penalties, disqualification from being able to act as a director in the future and, in a worse-case scenario, imprisonment. The case study below highlights the type of commercial considerations lawyers should have in mind when advising directors of companies facing financial distress.

Scenario

Mark and Amy are the two directors of a company that manufactures and sells hats, ‘Hats4U’. Hats4U owns factory premises, machinery and vans, and employs a full-time workforce of 10 people. A culmination of the increasing cost of materials, fuel costs for both the manufacture and transportation of the goods, as well as disappointing sales in the past 12 months has meant that the business is in financial distress. It’s struggling to meet its repayments under a bank loan taken out six months ago and a number of suppliers are seeking payment of overdue invoices. Hats4U’s main supplier of materials, ‘Hat Supplies’, is refusing to provide any more materials and is threatening legal action if all of its outstanding invoices are not settled within the next two weeks.

Statutory duties

When advising directors in this situation, the starting point and primary consideration must always be: what are the duties owed to the company in law?

Under the Companies Act 2006, there are seven general duties of a director owed to the company, set out at sections 170 to 177. This includes a duty to exercise reasonable care, skill and diligence and a duty to promote the success of the company for the benefit of the members as a whole. In relation to the latter, when a company is insolvent, or of doubtful solvency, the ordinary duties owed to the company by the directors are supplemented by rules designed to protect the position of the company’s creditors, including a duty to consider the interests of the company’s creditors. The underlying rationale for this shift in duties is that in an insolvent situation the assets of the company are often not sufficient to pay off all creditors before any amounts are returned to shareholders. As such, in times of distress, it’s in fact the creditors of the company that hold the economic interest in a company rather than the shareholders.

Insolvency

Mark and Amy’s first priority should be to consider whether Hats4U is solvent or insolvent. A company is considered insolvent if it’s unable to pay its debts as they fall due, or if its liabilities exceed its assets. This is set out in the Insolvency Act 1986 (the Insolvency Act). There are two main tests for insolvency:

• Cash flow test: a company is considered insolvent if it cannot pay its debts as they fall due. This means that if a company receives a demand for payment, it must be able to pay that demand immediately. If it cannot, it may be deemed insolvent.
• Balance sheet test: a company is also considered insolvent if its total liabilities exceed its total assets, meaning that the company's net worth is negative. This balance sheet test assesses whether the company's financial position is sound, based on the value of its assets compared to its liabilities.

In this scenario, Hats4U owns its factory premises. Let us assume that this is worth £500,000 and that Hats4U has total liabilities (long-term and short-term debt) of £450,000. Therefore, Hats4U is currently solvent under the balance sheet test. However, Hats4U has overdue loan repayments and invoices totalling £150,000, but it only has a total of £100,000 in its bank. The company is therefore cash flow insolvent presently.

Both tests are important for determining a company's overall solvency, and Hats4U is in a precarious financial position. Technically, the law doesn’t outright prevent a company from trading under these circumstances, but there are several important considerations for Mark and Amy to keep in mind.

Financial health assessment

Mark and Amy should be reviewing the company’s financial position regularly to determine whether the business is solvent and to assess its prospects of avoiding insolvent liquidation or insolvent administration. If the business has a finance team, it should be tasked with reviewing cash flow projections and liabilities on a daily basis if appropriate. It may be advisable here to appoint an external restructuring advisor/insolvency practitioner to help the board address these issues.

Directors should be fully aware that the duty to appropriately consider the interests of the company’s creditors as a whole (as noted above) is engaged as soon as (and on the earlier of) Mark and Amy know, or ought to have knowledge, that the company is either insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable. An early determination of the company’s solvency or otherwise is imperative to comply with this duty.

Practical steps

In order to demonstrate that they’re meeting their duties, and as a result mitigate any potential liability they may face as directors of a company of doubtful solvency, Mark and Amy should use the financial health assessment to consider carefully whether the business is viable. If they believe it is, they should:

• undertake a full business review, ideally with the assistance of an external advisor as mentioned above;
• put in place a sensible and constructive programme to reduce the expenditure of increased income, ensure adequate cash flow, restore the company to profitable trading;
• convene frequent board meetings at which they receive an updated budget and cash flow forecast and a full, accurate, up-to-date picture of the company’s trading and financial position;
• continue to take appropriate outside professional advice and suitable remedial measures; and
• ensure that (to the extent that’s possible) they agree on what needs to be done and ensure all recommendations for remedial action made by them as directors, together with any points of disagreement are fully recorded.

It may be that in order to dispose of unprofitable or marginal parts of the business that Mark and Amy need to consider reducing their workforce of ten people by dismissing staff who are surplus to the company’s needs.

Can Hats4U continue to accept/encourage customer deposits?

Best practice is to receive confirmation from appropriate advisors that the chosen strategy has a reasonable chance of preventing insolvent liquidation. Mark and Amy must ensure that such advice is based on accurate and up-to-date information in their possession. These steps should be taken so that in the event of the company having to enter a formal insolvency process Mark and Amy aren’t sanctioned for wrongful trading (which is discussed further below).

Should Hats4U tell major creditors?

Yes – major creditors such as the bank (loan provider) and Hat Supplies should be kept informed of Hats4U’s situation. This is especially important when a strategy developed to effect a turnaround in the business and to avoid the formal insolvency process requires creditor support. All dealings with creditors must be on an open and honest basis.

In this scenario, let us assume that as part of Mark and Amy’s strategy to turn around the business, they decide to settle all of Hat Supplies outstanding invoices, but no other creditors.

Can Mark or Amy resign if they don’t like what is going on?

The onus is on individual directors to make their opinions known to the other board members. If, for example, Mark has concerns about a strategy that involves Hats4U borrowing more money but Amy doesn’t share his concerns, Mark should take no part in incurring further debts. If Amy continues to ignore his views on the subject, he should resign. It must be noted, however, that Mark could still be held personally liable, and as touched on below, liable to make a contribution.

Absent the above situation, it’s rarely appropriate for a director to resign. A director should act in a way as to minimise loss to creditors.

The formal insolvency process

There are any number of reasons why a business may fail: ranging from poor management to simply and unavoidably becoming a victim of market conditions (for example covid-19). When a company is insolvent and the situation cannot be saved, it must enter into a formal insolvency process, typically an administration or liquidation. A liquidator or an administrator (an insolvency office holder) will be appointed and among other duties, will undertake a review of the actions taken by the directors of the company.

In the event that an insolvency office holder is appointed over Hats4U, they could commence proceedings in the name of the company for any breach of fiduciary or other duty by Mark or Amy. If successful, they could be made to repay any monies or return any property or make a contribution to the company’s assets. Mark and Amy could also face being disqualified from acting as a director for a period of between two and 15 years.

Liability for wrongful trading

Under section 214 of the Insolvency Act, if Mark and Amy knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation/administration but continued to trade without taking step to avoid loss to creditors, they could be liable for the offence of wrongful trading.

Potential liability for wrongful trading is an area of particular concern for directors. Directors need to ensure that they’re able to demonstrate that they were keeping the cash and solvency position constantly under review and were making practical decisions intended to minimise losses to creditors.

What steps should Mark and Amy take to protect their personal positions?

It’s essential that whatever actions directors take, either collectively or individually, are in the interests of their company, and that creditors are fully documented with supporting reasons and the advice received before those decisions were made. In this way, Mark and Amy can create a paper trail evidencing the reasonableness of their actions. Directors should ensure that all deliberations of the board are reflected fully in meetings and minutes (which should be readily available to be reviewed and advised on by the company’s advisors). This ensures that any future insolvency office holder can see what attempts Mark and Amy made to protect the company’s creditors and also provides evidence of why a particular strategy was chosen.

Sunay Radia is a partner and Andrew West is an associate at McDermott Will & Emery UK LLP.