One of the most stressful situations that a company director can face is their business becoming insolvent.
With the worry of fighting to keep the organisation from falling into administration or being wound up, it is easy to forget that directors’ duties remain applicable.
In fact, the risks and responsibilities increase when a company is in financial strife. This article explains everything you need to know about complying with directors’ duties when your company is insolvent.
The overriding duty
A company is considered insolvent if it cannot pay its debts.
There are two tests for insolvency:
- Cash-flow – the company cannot pay its creditors by the due date, or
- Balance sheet – the value of a company’s assets is less than its liabilities.
A company is also deemed unable to pay its debts, and therefore insolvent, if:
- a creditor who is owed more than £750 has served a formal demand for an undisputed sum at the company’s registered office, and the debt has not been paid for three weeks; or
- a judgement or other court order has not yet been paid.
When a company is solvent, directors have an overriding duty to act to promote the success of the company.
In the case of insolvency, a director must act in the best interests of the company’s creditors.
Mismanagement of an insolvent company
Limited liability companies are separate legal entities, meaning that directors are not personally liable for a company’s debts or contractual obligations in ordinary circumstances.
However, if the company is mismanaged during insolvency, this principle does not necessarily apply.
There are three ways a director can find themselves in a world of trouble if their company becomes insolvent:
Wrongful trading
Wrongful trading is an easy mistake for a director to make. It is defined as continuing to trade when there is no chance of avoiding liquidation. It often happens that directors commit wrongful trading inadvertently while trying to save the company by continuing to trade past the point where they should.
The court will not make an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid falling into administration or liquidation, the director took every step they ought to have taken in order to minimise any loss to creditors.
Because of the enormous amount of work involved in proving wrongful trading (the administrator or liquidator must provide evidence of wrongful trading and creditor loss), the risk of being personally liable for wrongful trading is low; however, for your personal and professional reputation, it is always best to avoid such an accusation. If you are unsure of whether your company can avoid administration or liquidation, talk with an experienced Company Law Solicitor and your accountant, who will advise you on when to stop trading.
Fraudulent trading
Fraudulent trading is a criminal offence. It occurs when directors manage an insolvent company with the intent of defrauding creditors. Examples of fraudulent trading include;
- You are paying large bonuses or directors’ salaries that you know the company cannot afford.
- Continuing to use lines of credit from suppliers when you know cannot be repaid.
- Taking orders from customers which cannot be fulfilled.
- Falsifying financial statements to make the company appear profitable.
- Using company funds and assets for personal gains instead of business purposes.
Unlike wrongful trading, fraudulent trading must involve intentional or reckless dishonesty.
As mentioned above, fraudulent trading is a crime, and you can go to prison and face a significant fine if you are convicted. You can also be personally liable for creditors’ losses.
Misfeasance
Directors who breach duties they owe (for example, by misusing company property) can be personally liable for misfeasance, and a court can order a director to repay misused money to the company.
Are directors monitored during a company’s insolvency?
The liquidator or administrator overseeing the insolvency must submit a report concerning the company directors to the Insolvency Service within three months of the company’s insolvency.
The report must cover the past three years of trading.
The Insolvency Service will examine the report and decide whether further investigations are warranted.
An application can be made to the Court to disqualify a director for up to 15 years. A disqualified director must not act as a company director or be involved with forming, marketing, or running a new company.
If you are facing disqualification, you can voluntarily disqualify yourself, saving considerable time, expense, and stress. However, it is crucial to get legal advice before taking this step.
Wrapping up
If your company has or is about to become insolvent, it is crucial you receive professional advice from an experienced Corporate Law Solicitor to ensure you do not breach your directors’ duties and risk becoming personally liable for company and creditor losses.
To discuss any points raised in this article, please call us on +44 (0) 203972 8469 or email us at mail@eldwicklaw.com.
Note: The points in this article reflect the law in place at the time of writing, 27 March 2024. This article does not constitute legal advice. For further information, please contact our London office.
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