In 2015, director disqualification compensation orders were put into place and can lead to personal claims against directors who find themselves disqualified from acting. It’s crucial for company officers that are faced with a claim to seek professional legal advice to prevent making expensive blunders.
Failure to gain legal advice on a compensation claim could lead to a director agreeing to their disqualification and then facing a large damage claim.
The liability of directors in regards to their conduct while managing a company was significantly altered by the Small Business Enterprise and Employment Act 2015, which went into effect on March 26, 2015.
This is especially true in the event of insolvency. These modifications are significant and might have a significant impact on directors.
How do director disqualification compensation orders work?
In director disqualification proceedings, compensation orders are a technique used to hold directors personally liable for damages suffered by the company as a result of their malfeasance. In addition to a disqualification order, which bars the person from serving as a director of a corporation for a predetermined amount of time, a court may also issue these orders.
The purpose of compensation orders is to make up for losses experienced by shareholders and creditors as a result of the director’s actions. The amount of compensation that is mandated is based on the losses incurred by the corporation and its stakeholders, and if required, it can be enforced in court.
Therefore, where the Company is thrown into insolvency, the protection of limited liability is greatly diminished, and this article aims to address the risk to Directors being made.
1. Which directors are covered by these changes?
Directors of insolvent companies against whom disqualification has been or will be brought by the Secretary of State or the Official Receiver may request compensation orders. The criminal courts have the authority to impose disqualification orders on directors in cases of significant criminal proceedings, particularly when there are fraud allegations.
If a disqualification order has been issued by a criminal court under the Company Directors Disqualification Act of 1986, these directors may also need to defend themselves against compensation order proceedings.
2. When did this new procedure start?
The new regime established by the Small Business, Enterprise and Employment Act 2015 (Commencement No. 2 and Transitional Provisions) Regulations 2015 went into effect on October 1, 2015.
3. What limitation period applies to the bringing of compensation order application?
According to the law, directors of insolvent corporations are subject to director disqualification proceedings for an extended length of time. This is due to the fact that the Secretary of State may request a compensation order at any time during the two years starting on the day when a director disqualification order is made or a disqualification undertaking is accepted.
The statute of limitations for these actions has also been extended to three years starting from the date of insolvency. Importantly, the disqualification order or disqualification undertaking‘s execution date determines the start date for the limitation period rather than the disqualification itself (which is typically 21 days from the issuance of the disqualification order or undertaking).
It is possible that a director could be faced with disqualification proceedings just before the end of the 3 year period for such proceedings. If the director decides to defend against these proceedings, the case could potentially continue through the courts for a period of up to 2 years or more
- if at trial a director disqualification order is made, a further period of 2 years will apply from the date of that director disqualification order
- during this time a director disqualification compensation order application may be issued (with the consequential time spent dealing with the litigation proceedings thereafter, if defended).
Even though it is a relatively simple process, a director disqualification compensation order application may take up to a year to resolve. A director of an insolvent corporation could therefore be at risk in the aforementioned scenario for up to 8 years following the date of insolvency.
However, in some exceptional cases, a director who has been suspended for a shorter period of time (such as two to four years) may be released from the disqualification order or undertaking prior to the issuance of a compensation order.
4. Why give a director disqualification undertaking?
The Secretary of State can seek director disqualification compensation orders regardless of whether the original disqualification proceedings were contested or not.
- in England and Wales most directors are disqualified by way of a voluntary undertaking.
- this is typically offered by directors in order to avoid the legal fees associated with director disqualification proceedings, which can last for two to three years and result in substantial legal fees with no guarantee of victory.
Since it has not been viable to pursue such procedures on a “no win no fee” basis, directors who desire to defend civil litigation proceedings, including most forms of claims or defences, have had fewer legal options.
5. Effect of a director disqualification compensation order?
Signing an directors disqualification order without legal representation can have drastic effects on a company officer for a number of years. This is due to the fact that, after the undertaking has been signed and entered into, the director will continue to bear the burden of being aware that they could face compensation proceedings for a further two years.
Some points to consider if a director is considering signing a disqualification undertaking:
- If the director believes that signing the undertaking will help them avoid legal costs, they may end up having to pay substantially more as a result of losses to the company caused by their misconduct. This removes the cost benefit of signing the undertaking.
- The most common type of director disqualification offense is trading to the detriment of HMRC, and the government is increasingly using compensation orders to recover such losses.
- There have been instances of the government attempting to recover sums through proceedings for breaches of fiduciary duties or wrongful trading, which were previously the domain of appointed liquidators.
6. Are there are alternatives to litigated director disqualification compensation order proceedings?
Alternatives to litigated director disqualification compensation order proceedings can be done by way of a negotiated compensation undertaking.
Some points to consider when deciding whether to sign a compensation undertaking:
- Signing the undertaking will help the director avoid legal costs and minimise their expenditure.
- However, it may be more advantageous to spend the money on defending the original disqualification proceedings. This is because such expenditure may be considerably less and can often be recovered from the Secretary of State in successfully defended disqualification proceedings.
A director should think about including or negotiating the inclusion of a disqualification compensation undertaking as part of their disqualification undertaking if they decide not to defend disqualification proceedings.
This is because a director has far less negotiating leverage and is almost guaranteed to receive a disqualification compensation order once they have signed a disqualification undertaking.
Before signing a disqualification undertaking, directors are strongly advised to consult with a solicitor. This is especially important in view of recent legislative developments and the associated financial concerns.
7. How much will I have to pay under a director disqualification compensation order or undertaking?
The amount you will have to pay under a director disqualification compensation order or undertaking is specified by Section 15B of the Company Directors Disqualification Act 1986.
Some things to keep in mind about compensation orders and undertakings:
- These require a director to pay an amount to the Secretary of State that reflects the loss caused by their actions or inaction. This includes passive or non-executive directors.
- The amount of the compensation will be based on the nature of the conduct that led to the finding of unfitness in the disqualification proceedings.
The order or undertaking may be larger if the original disqualification proceedings involved fraud or other serious conduct. In most cases, the company will have traded to the detriment of a creditor, such as HMRC, resulting in a tax loss during that period of trading.
- These can often amount to hundreds of thousands of pounds, and the government is using this legislation to try to recover losses from directors, even if the company is small or medium-sized.
- For unsecured creditors, these orders and undertakings can provide an additional source of payment in the event that the company has no assets and there are no litigation claims against directors or third parties. This can result in a dividend being paid to creditors out of the liquidation.
The debt resulting from a director disqualification compensation order or undertaking under the legislative changes may be discharged in bankruptcy, however it is not ideal.
8. What are the options available?
Avoiding misconduct and insolvency is the greatest approach to avoid the dangers and repercussions of director disqualification procedures.
Directors shall cooperate with the Secretary of State, the Official Receiver and any liquidator or administrator appointed in the event that any of the foregoing has already occurred.
When considering how to respond to an investigation that could result in a finding of misconduct, directors should consider the following:
- The costs and benefits of accepting a disqualification undertaking.
- If disqualification itself would not be too disruptive, it may be worthwhile to try to negotiate both a disqualification and a disqualification compensation undertaking.
A director may be able to request permission from the court to continue serving as a director of particular companies under Section 17 of the Company Directors Disqualification Act 1986 if their disqualification would result in too much harm.
The only alternative left is to contest the disqualification claim if this is not a viable option because the disqualification is not requested or the Secretary of State will not negotiate a satisfactory disqualification compensation agreement.
9. What are the choices available once a director has signed a disqualification compensation undertaking?
The Small Business Enterprise and Employment Act 2015 introduced a new Section 15C to the Company Directors Disqualification Act 1986, which allows a director to apply to the court to vary the amount of compensation payable under a compensation undertaking or to seek revocation of the undertaking.
This is similar to the provision in Section 8A of the Act, which allows a director subject to a disqualification undertaking to seek a reduction of the disqualification period.
- A reduction can only be sought for a compensation undertaking, since an order made in court on the basis of detailed evidence is considered to be more reliable than a negotiated disqualification undertaking.
- It is not possible to apply for a reduction in respect of a disqualification compensation order made by the court, but there is a right to appeal the order within 21 days of its issuance.
The criteria that must be followed under the Small Business Enterprise and Employment Act 2015 in order for a director to request a decrease in the amount of a disqualification compensation undertaking are not specified in the law. The Secretary of State will probably reject such a request.
Legal fees associated with filing this application could be non-recoverable, and they could also result in legal fees owed by the director to the Secretary of State. Therefore, before determining whether to proceed with the application, it could be required to perform a cost-benefit analysis.
Such requests are probably only going to be made when a considerable reduction is requested from a disqualifying compensation undertaking that is for a sizable sum. In this field, the case law is continually emerging.
10. What should I focus on when I receive a letter from the insolvency service?
The main issues to address when I receive a letter from the insolvency service is that we strongly advise that before signing a disqualification undertaking, directors consult with legal counsel. However, it is not unusual for people to sign these commitments without seeking legal counsel.
Usually, the director doesn’t become aware of the necessity for corrective action until much later, when they start to experience the effects of the project. By this time, it is frequently a matter of limiting the harm caused by information that the director or a third party committed to paper but which later proved to be inaccurate.
Some situations in which a director’s disqualification can have unintended consequences:
- A director may face other types of proceedings that partially rely on their disqualification and the resulting impact on their credibility in court.
- A liquidator may bring a claim against a director after the director has been disqualified, using the disqualification to discredit the director.
Similar problems could occur with compensation obligations, though directors are probably more cautious in signing these personal debt-creating contracts. It will be very challenging to defend against compensation claims if a director has already signed an undertaking to abstain from acting in that capacity (although not impossible, although the argument will likely focus on the amount of compensation, not the underlying liability).
The law does give you the option to ask a judge to evaluate the sum you and the director agreed upon before you sign a director compensation agreement. This is probably only going to be approved in situations where the director was coerced into signing the disqualifying commitment or there were extenuating circumstances.
Despite the fact that this area of the law is still evolving, many people may find that asking for a variation or cancellation of a director disqualification compensation undertaking is preferable to declaring bankruptcy or liquidating personal assets to pay the debt owed under the undertaking.
In conclusion, the government is now using director disqualification compensation orders to demand repayment of losses from directors of insolvent businesses. The limitation period for disqualification proceedings is increased to three years from the date of insolvency, and these orders may be requested at any time within the first two years following the granting of a disqualification order or undertaking.
Trading to the detriment of HMRC is the most frequent disqualification offence, and losses resulting from this form of misconduct are frequently recovered by compensation orders. Directors should get legal representative to fully understand the risks and repercussions before agreeing to a disqualification commitment. Directors have the opportunity to request a reduction or cancellation of a disqualification or compensation undertaking, but doing so may result in legal fees and necessitate a cost-benefit assessment.
With over three decades of experience in the business and turnaround sector, Steve Jones is one of the founders of Business Insolvency Helpline. With specialist knowledge of Insolvency, Liquidations, Administration, Pre-packs, CVA, MVL, Restructuring Advice and Company investment.