When faced with the possibility of a business becoming insolvent, it is crucial for directors to promptly take action and seek professional advice.
This proactive approach offers two potential paths: (a) implementing a strategic turnaround plan, or (b) initiating a formal insolvency process.
Failure to seek timely advice can expose directors to personal claims. Insolvency practitioners, who are often appointed as office holders, are obligated under the Statement of Insolvency Practice 2 to thoroughly investigate the circumstances surrounding the insolvency.
Such investigations can result in claims being made against directors in accordance with the Insolvency Act 1986. We understand that directors of insolvent businesses may have several pressing questions on their minds.
To address these concerns, we have compiled a list of frequently asked questions. Should you have any remaining queries or require further clarification, please don’t hesitate to reach out to a member of our experienced insolvency team.
Who is a director?
The role of a director encompasses individuals in various capacities, regardless of their official title or designation.
Executive directors are individuals who carry out executive functions within the business and are typically employees of the company. They play an active role in the day-to-day operations and decision-making processes.
On the other hand, non-executive directors do not usually hold an employment status but contribute their expertise and time to advise and guide the business. They provide valuable insights and support based on their specialized knowledge.
When a person is validly appointed as a director in accordance with the company’s regulations and legal requirements, they are known as a de jure director. This designation ensures that their directorship is legally recognized.
In contrast, a de facto director refers to someone who acts as a director without having been formally appointed or in cases where the appointment is not valid. Despite lacking an official appointment, they still assume the responsibilities and perform the duties of a director.
There are shadow directors who are individuals providing directions or instructions to the validly appointed directors. For someone to be considered a shadow director, the board must actively follow and comply with the instructions provided by that person. It’s important to note that mere advice, direction, or guidance on its own does not typically establish a shadow director relationship.
Understanding these different roles and distinctions is crucial in comprehending the dynamics and responsibilities associated with being a director within an organization
What are the general duties owed by a director?
Under the Companies Act 2006, directors are bound by several general duties that they owe to the company. These duties are as follows:
- Duty to act within powers: Directors must act in accordance with the company’s constitution (usually outlined in the articles of association) and exercise their powers only for the purposes for which they are conferred.
- Duty to promote the success of the company: Directors must act in a way that they believe, in good faith, will promote the success of the company for the benefit of its shareholders. They should consider various factors, such as the long-term consequences, employees’ interests, business relationships, and the impact on the community and environment.
- Duty to exercise independent judgment: Directors must exercise their powers independently and make decisions in the best interests of the company, without being unduly influenced or subordinating their judgment to the wishes of others.
- Duty to exercise reasonable care, skill, and diligence: Directors are expected to exercise the care, skill, and diligence that a reasonably diligent person with their knowledge, skill, and experience would apply in similar circumstances. This duty includes both an objective test (general expectations) and a subjective test (the director’s individual knowledge and experience).
- Duty to avoid conflicts of interest: Directors must avoid situations in which their personal interests conflict, or may possibly conflict, with the interests of the company. If such a conflict arises, directors must disclose the nature and extent of their interest to the other directors.
- Duty not to accept benefits from third parties: Directors must not accept benefits, whether directly or indirectly, from third parties that are conferred upon them due to their position as directors or based on their actions or inactions as directors.
- Duty to declare an interest in a proposed transaction or arrangement: If a director has a direct or indirect interest in a proposed transaction or arrangement with the company, they must disclose the nature and extent of their interest to the other directors.
It’s important to note that a company’s articles of association can impose additional duties on directors, as well as prescribe or limit their powers
Who are the duties owed to?
Directors owe their duties primarily to the company itself, rather than directly to the shareholders or creditors. However, the nature of these duties can differ depending on the financial status of the company.
In a solvent company, directors are obligated to act in the best interests of the shareholders. This means making decisions and taking actions that are likely to promote the success and overall well-being of the company, ultimately benefiting its shareholders.
Conversely, when a company becomes insolvent, the directors’ duty undergoes a shift. At this stage, their primary obligation is to act in the best interests of the creditors of the company. This entails making decisions that prioritize the repayment of debts and the preservation of the creditors’ interests, as the company’s financial viability may be at risk.
It’s important to note that directors must exercise sound judgment and fulfill their duties throughout both solvent and insolvent periods. However, the focus of their duty shifts from the shareholders to the creditors when the company faces insolvency.
By recognizing the specific obligations owed to the company, shareholders, and creditors in different financial scenarios, directors can navigate their responsibilities effectively and make informed decisions aligned with the best interests of the relevant stakeholders.
When do the duties start and stop?
The duties of a director commence from the date of their appointment and generally extend until the date of their resignation. However, certain duties continue to apply even after the director has resigned. These ongoing duties include:
- Duty to avoid conflicts of interest: The duty to avoid conflicts of interest extends beyond the resignation date. It encompasses situations where a director seeks to exploit any property, information, or opportunity that they became aware of during their tenure prior to resignation. Directors must continue to act in the best interests of the company and avoid any actions that could be deemed conflicting or detrimental to the company’s interests.
- Duty not to accept benefits from third parties: Similarly, the duty not to accept benefits from third parties remains applicable post-resignation. It covers actions or omissions that occurred during the director’s tenure prior to resignation. Directors should refrain from accepting any benefits offered to them due to their position as a director or as a result of their actions or inactions during their time in office.
Even after resigning, directors must adhere to these ongoing duties to maintain the integrity of their actions and safeguard the interests of the company.
It is important for directors to be aware of their responsibilities during their tenure and understand the extent to which certain duties continue to apply beyond their resignation. This ensures that they fulfill their obligations and act in accordance with the highest standards of corporate governance.
What is the test to show that a company is Insolvent?
Insolvency is generally determined based on two straightforward tests provided by statute:
- Cash flow test: This test examines whether a company is capable of paying its debts when they become due. If a company is unable to meet its financial obligations as they arise, it indicates insolvency under the cash flow test. This test focuses on the company’s ability to maintain sufficient cash flow to settle its debts in a timely manner.
- Balance sheet test: The balance sheet test assesses the value of a company’s assets in relation to its liabilities, considering both current and future obligations. If the total value of a company’s assets is lower than the amount of its liabilities, including contingent and prospective liabilities, the company is deemed insolvent under the balance sheet test. This test takes into account the company’s overall financial position and its ability to meet its obligations with available assets.
These tests provide objective criteria to determine whether a company is insolvent. Meeting either the cash flow test or the balance sheet test indicates a company’s inability to fulfill its financial obligations, signaling insolvency.
It’s important for directors to be aware of these tests and monitor the financial health of the company
Do the duties remain the same when a company is insolvent?
Yes, when a company becomes insolvent, the duties of a director remain owed to the company, but the director’s focus and priorities shift to include the interests of the company’s creditors as a paramount concern. In such circumstances, directors have a duty to consider the creditors’ interests alongside those of the company.
This means that directors must act diligently and responsibly to maximize the recovery for creditors, rather than solely focusing on the interests of the shareholders. They should make decisions and take actions that are in the best interests of both the company and its creditors, considering the financial position and obligations of the company.
Directors should exercise care, skill, and diligence to minimize potential losses to creditors and avoid actions that could unduly prejudice their interests. This may involve exploring options such as initiating a formal insolvency process, restructuring debts, or engaging in negotiations with creditors to achieve a fair and equitable outcome
Should a director authorise payment of some debts but not others?
The approach taken by directors in prioritizing creditors during insolvency proceedings should be based on the specific facts and circumstances of each case. While general principles apply, the unique factors involved must be considered.
When a company is insolvent and is likely to enter into formal insolvency proceedings, it is generally advisable for directors to refrain from favoring certain creditors over others, unless doing so is in the best interests of all the creditors as a whole. This ensures fairness and equity in the distribution of the company’s assets among its creditors.
There may be specific circumstances where it is permissible to make payments to key suppliers to enable the company’s ongoing trading. This is done to ensure the continuity of vital supplies and maintain essential operations during the insolvency process. However, it is crucial to exercise caution and seek professional advice to ensure compliance with applicable laws and regulations.
Directors should be aware that making payments to specific creditors while leaving others unpaid can potentially be subject to claims as preference payments and/or misfeasance. These actions may be viewed as violating the principle of equal distribution on a pari passu basis among the company’s creditors.
Should a director sell company assets at a less than market value to help with cash flow?
The approach to selling company assets during insolvency proceedings should be evaluated based on the specific facts and circumstances of each case. While general principles apply, the unique factors involved must be considered.
When a company is insolvent and is expected to enter formal insolvency, it is generally advisable for directors to refrain from selling company assets at less than their market value. Such transactions, where assets are sold for less than their fair market value, can be subject to challenge as transactions at an undervalue or misfeasance.
Transactions at an undervalue refer to situations where assets are disposed of at a price significantly below their true market worth. Engaging in such transactions can potentially hinder the ability to distribute the true value of the assets among the company’s creditors. As a result, these transactions may be subject to challenge during the insolvency process.
Misfeasance refers to instances where a director has acted in a manner that results in harm or detriment to the company or its creditors. Selling assets at a price below their market value can potentially be seen as a misfeasance if it is deemed detrimental to the interests of the company’s stakeholders.
It is important for directors to exercise caution and seek professional advice when considering the sale of company assets during insolvency. By adhering to fair market valuations and ensuring transparency in asset transactions, directors can help protect the interests of the company and its creditors.
Should a director allow a company to continue trading if they know, or believe, that the company will not be able to pay all of its debts?
If a director reasonably believes or has evidence to suggest that a company is unable to meet its debts and will likely require some form of formal insolvency, it is crucial for the director to promptly seek advice and not allow the company to continue trading.
In cases of insolvency, the primary consideration should be the well-being of the company’s creditors, as continued trading may impact the funds available for distribution among them
When should a director seek professional advice in an insolvency situation?
Once a director becomes aware that a company is unable to fulfill its debts or is facing insolvency, it is crucial to seek advice promptly to enhance the possibility of a successful turnaround through restructuring. Alternatively, entering formal insolvency at an early stage can help minimise losses to creditors.
In cases of insolvency, the primary focus should be on safeguarding the interests of the company’s creditors. Directors should demonstrate the proactive measures they have taken to protect the creditors’ position and mitigate potential financial harm.
Can anyone else see the advice received?
Yes, if the company has covered the cost of obtaining advice, that advice is considered company property. As a result, it becomes accessible to all directors and, subsequently, any appointed insolvency practitioner in the event of the company entering formal insolvency.
On the other hand, if a director has sought personal legal advice for which they have personally paid, such advice is protected by privilege and will not be accessible to others unless the director expressly waives that privilege. However, it’s important to note that this privilege does not extend to advice provided by an insolvency practitioner.
What are the options available if the Company is insolvent
The following provides an overview of the main options available, commonly referred to as formal insolvency procedures:
Creditors Voluntary Liquidation:
This process is initiated by the company’s shareholders and overseen by a liquidator. The company is placed into liquidation, its assets are realized, and the proceeds are distributed to shareholders and creditors. Ultimately, the company is dissolved at the conclusion of the liquidation.
Also known as winding up, this process commences with the filing of a winding up petition at court. Such a petition may be filed by the company itself, a director, a shareholder, or a creditor. If the court determines that the company cannot meet its debts as they become due or is otherwise insolvent, a winding up order is issued, and the company enters compulsory liquidation. A liquidator manages the process and realizes the company’s assets for distribution to its creditors.
Administration is typically initiated by the company, its directors, or a floating charge holder. Creditors may also apply for an administration order. An insolvency practitioner is appointed as an administrator to assume control over the company’s business and assets. The goal is to achieve one of the statutory objectives of administration, such as reorganizing the company or realizing its assets. Administration provides the company with the protection of a statutory moratorium, preventing creditors from taking legal action to enforce their claims.
In receivership, an appointed individual known as a receiver takes control of a specific company asset. The receiver then sells the asset on behalf of the company. Various types of receivers exist, with fixed charge receivers appointed by holders of fixed charges, while administrative receivers are appointed by holders of floating charges.
Company Voluntary Arrangement:
A company voluntary arrangement (CVA) involves the company reaching an agreement with its creditors to repay a portion of the outstanding debts. An insolvency practitioner acts as a nominee during the proposal stage and as a supervisor once the arrangement is agreed upon. The arrangement requires the approval of the necessary majority of creditors through a decision procedure, though not all creditors need to consent. The CVA can include future or contingent liabilities and binds all unsecured creditors upon acceptance.
These formal insolvency options provide companies with different paths to address their financial difficulties, depending on the specific circumstances and goals of the business. Seeking professional advice and guidance is essential when considering any of these procedures
What alternatives are there to formal insolvency?
Aside from formal insolvency procedures, there are alternative options available to companies facing financial difficulties:
A company has the option to engage in discussions with its creditors to negotiate an informal repayment arrangement or establish new terms of payment. This allows for the spreading of payments over a timeframe that aligns with the company’s financial capabilities.
Seek External Finance:
Companies can explore the possibility of securing external financing to overcome a challenging trading period. By obtaining additional funds, provided that the repayment terms are manageable, the company can address its immediate financial constraints.
Sale of the Company:
A company has the opportunity to be sold as a going concern to an external third party. This option involves transferring the company’s operations, assets, and liabilities to a new owner who will continue its operations, potentially bringing in fresh investment and revitalizing the business.
These alternatives provide companies with flexible approaches to address financial difficulties without initiating formal insolvency proceedings
What happens after the company enters in to formal insolvency?
The outcome will vary depending on the specific formal insolvency process adopted by the company.
In the case of liquidation, an insolvency practitioner is typically appointed, although it may remain under the jurisdiction of the official receiver. The appointed insolvency practitioner will conduct an investigation into the company’s affairs, assess potential claims, including the recovery of book debts, and oversee the sale of company assets. The proceeds from these realizations are then distributed equally among the creditors in accordance with the principle of pari passu.
During administration, an insolvency practitioner assumes control of the company’s business and assets. Their objective is to achieve one of the statutory purposes of administration, which could involve restructuring the business, realizing assets, or facilitating a more favorable outcome for the company and its creditors.
In the case of a company voluntary arrangement, an insolvency practitioner acts as the supervisor of the arrangement. Their role is to ensure that the company adheres to the specific terms and conditions outlined in the arrangement. The supervisor oversees the implementation of the arrangement and works to ensure that the agreed-upon provisions are met.
Each formal insolvency process involves the involvement of an insolvency practitioner who plays a distinct role in overseeing and managing the affairs of the company in accordance with the objectives and requirements of the specific procedure. Their appointment is vital to ensuring the fair treatment of creditors and the effective execution of the chosen insolvency process
What is the effect of formal insolvency on the powers of the director?
The impact on a director’s powers will vary depending on the type of formal insolvency process the company enters into.
- In compulsory liquidation, once the company enters this process, the director loses all authority to act on behalf of the company or manage its affairs. These powers are terminated on the date of compulsory liquidation.
- In the event of voluntary liquidation (whether initiated by members or creditors), the director’s powers are relinquished on the date of voluntary liquidation. Any attempt by a director to exercise powers beyond these dates is considered void.
- When a company enters administration, a director must obtain the administrator’s consent before exercising any management powers. The administrator assumes control over the company’s operations and assets, and the director’s ability to make decisions or take actions is contingent upon the administrator’s approval.
It is important for directors to be aware of the limitations placed on their powers during formal insolvency processes. Compliance with the specific requirements and guidelines of each procedure is crucial to ensure legal validity and avoid potential legal challenges.
Can a director be personally liable for the company’s debts?
Yes, a director can potentially face personal liability for the company’s debts. The specific circumstances and applicable laws will determine the extent of liability in each case. There are various claims that can be brought by different stakeholders, and the outcome will depend on the unique facts involved.
For more information on the specific claims that can be made by insolvency practitioners, please refer to the details provided in the section ‘Claims made by insolvency practitioners.
Can a director be disqualified?
Certainly, a director can be subject to disqualification. A court has the authority to issue a disqualification order, which prohibits an individual from acting as a director or being involved in the promotion, formation, or management of a company without court permission. The duration of the disqualification period is determined by the court, with a minimum of two years and a maximum of fifteen years.
Disqualification proceedings are typically initiated by the Secretary of State upon referral by an insolvency practitioner. These proceedings aim to establish that a director’s conduct renders them unfit to be involved in the management of a company.
If you find yourself facing disqualification proceedings, it is crucial to seek advice at an early stage. Doing so can potentially help in avoiding disqualification altogether, limiting the duration of disqualification, or entering into an undertaking not to act as a director. It may also be possible to negotiate conditions that allow an individual to continue acting as a director under specific terms.
In conclusion, directors of companies facing insolvency are entrusted with crucial responsibilities to act in the best interests of the company and its creditors. Understanding the legal framework, duties, and potential consequences is paramount in making informed decisions during such challenging times.
Seeking professional advice and support from experienced insolvency practitioners can provide invaluable guidance and help directors navigate the complexities of insolvency proceedings. If you require further assistance or have specific questions, we encourage you to complete our online enquiry form and connect with our knowledgeable team for personalized assistance tailored to your situation.
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.