Insolvency and financial difficulty: An introduction
This article is based on UK law.
Directors’ duties
[The general duties of directors are examined in more
detail in the section on Director's
duties. Below, we highlight those most relevant in
insolvency-related cases.]
- To consider the interests of creditors above those of
members. When a company is clearly solvent, directors must
act in the interests of the shareholders in general. When a company
is insolvent, or possibly even when it is of doubtful solvency, the
position changes.
- Not to act for any personal or additional
purpose. All directors should separate their own personal
interest (as shareholder, executive, creditor etc.) from the
company’s interests. Their duty is to act in the interests of the
company. This will mean following the principles outlined in
below.
- To take steps to avoid loss to creditors.Under
insolvency legislation, a director will be personally liable for
wrongful trading if a liquidator can show that they knew or
ought to have concluded there was no reasonable prospect of
avoiding liquidation but continued to do business as
“normal”. Liability will not arise if the director can show (to the
court’s satisfaction) that they took every possible step to
minimise the potential loss to the company’s creditors. They must
be seen to have actively tried to do this.
A director should never allow a company to accept credit if in
their view there is no reasonable expectation of the creditor being
paid at, or shortly after, the time when the debt becomes due.
Anyone knowingly party to a transaction in such circumstances could
be ordered by the court to make contributions to a company’s
assets, and be guilty of the criminal offence of fraudulent
trading.
- Not to enter into transactions at an undervalue or make
preferences. Insolvency legislation permits an
administrator or liquidator of a company to apply to a court to set
aside or vary transactions at an undervalue as well as preferences
entered into within a specified period before insolvency
proceedings began. In setting a transaction aside, a court will
make an order to restore the position to what it would have been
had the transaction not taken place. This may result in personal
liability for the directors of the company and disqualification
proceedings against any director responsible for the transaction
concerned.
Actions that minimise the risks of liability
It is important not only that the steps explained below are
carried out, but also that they are seen to be carried out: the
behaviour of directors may be carefully scrutinised by a future
liquidator or administrator. Actions taken in the interests of a
company and its creditors should be methodically documented and
explained. All meetings must be minuted. Directors must give
reasons for their decisions and cite the advice they have
taken.
Directors who can show that they acted in good faith on the
advice of suitably qualified professionals will be more likely to
avoid wrongful trading allegations – even if the liquidator
believes the advice they were given was wrong.
Monitoring the financial position of the company
A director should regularly review the company’s financial
position in order to assess whether the company is solvent and to
determine its prospects of avoiding insolvent liquidation. This
will generally involve the preparation of regular statements of
affairs and cashflow projections and other current financial
information – in collaboration with auditors and other advisers as
necessary.
Directors should establish a procedure for the finance director
to keep the board informed of the performance and prospects of the
company. This will generally involve frequent board meetings.
The directors should be satisfied that, taking into account
their duties to creditors, shareholders and employees, the company
may properly continue to trade. Each director should carefully
consider the company’s ability to pay before arranging for the
receipt of any further goods or services on credit, and the board
should regularly review the company’s financial position. These
reviews should be fully minuted.
Individual directors should raise any concerns over solvency
with other members of the board. If their fears are not heeded,
they should repeat them and take steps to protect their own
position.
When going through a difficult period, directors must regularly
ask whether their company fails the “solvency
test”. A company will be regarded as insolvent when it is
unable to pay its debts or the value of its assets is less than the
amount of its liabilities, taking into account its contingent and
prospective liabilities.
A company is deemed to be unable to pay its debts if:
- a creditor owed more than £750 has served a statutory demand at
the company’s registered office and the debt has not been paid for
three weeks thereafter;
- execution of a judgment or other court order remains
unsatisfied after a visit from a bailiff or sheriff’s officer. If a
company is part of a group, it is important for the directors to
think of it as a separate legal entity, even where the treasury
function is shared. The financial position of each company in the
group has to be evaluated separately. This may require a review of
facility letters, security, guarantees, joint venture
documentation, joint obligations and similar documentation in order
to determine the nature and extent of the financial position of
each subsidiary.
Taking advice
Directors of a company in financial difficulties often face a
dilemma. It seems that they are expected to be neither unduly rash
nor unduly cowardly.
Causing a company to cease to trade or putting it into
administration or liquidation, or calling in an administrative
receiver prematurely can be as damaging to the interests of
the creditors as allowing a company to carry on trading against all
odds.
Directors must act responsibly, resisting, on the one hand,
their natural tendency to be overoptimistic or to refuse to accept
defeat and, on the other hand, the temptation to succumb to despair
without considering the options available. Their analysis of the
company’s performance and prospects should be based on up-to-date
financial information and should almost certainly involve
consultation with professional legal and financial advisers.
It may be essential to involve the company’s
auditors in discussions on the financial position of the
company. In addition, specific people may need to be appointed to
deal with discussions with the company’s bankers and other major
creditors.
Lawyers will help determine whether a proposed transaction could
be vulnerable as a preference or for some other reason, or is
otherwise inappropriate. A company might need to retain an
insolvency practitioner to advise on the
strategies available.
Existing advisers can be involved in discussions and in the
development of strategy – but only if they are qualified to advise
in cases of financial difficulty.
Accurate, complete and up-to-date information and access to
financial and legal advice from appropriately qualified
professionals will significantly strengthen a director’s position.
They would, for example, be vital in justifying a director’s
actions if faced with a claim for wrongful trading.
A court will be reluctant to substitute its own commercial
judgment for that of a director unless it considers that no
reasonable director could have concluded the action taken was in
the interests of the company. In cases where directors have taken
the advice of properly qualified, competent professionals, judges
are unlikely to claim they know better.
In some circumstances, there may be a conflict of interest
between subsidiary and parent or between fellow subsidiaries,
requiring separate legal and/or financial advice; for example,
where it is proposed to use the assets of a doubtfully solvent
subsidiary to secure the parent’s indebtedness.
Directors may need to seek advice individually on how to
minimise the personal risks involved in the management of a company
that is approaching insolvency.
Formulating a viable strategy
If the company’s performance and prospects demand it, a board
should formulate a strategy for restoring a company to a healthy
financial position and avoiding formal insolvency proceedings. In
general terms, the action plan may involve one or a number of the
following:
- alternative trading strategies;
- disposals;
- maximising existing asset values;
- cutting overheads;
- delaying capital investment;
- further bank finance (possibly with a grant of security);
- converting debt to equity, converting short-term debt to
long-term debt, or raising new equity;
- an informal arrangement with major creditors or voluntary
arrangement.
The chosen strategy must have the support of the board (the full
board if possible). In addition, its viability must be reviewed by
appropriate advisers and its implementation constantly
monitored.
At the very least, directors should review the strategy at each
board meeting and have grounds for concluding that there is a
reasonable prospect of avoiding insolvent liquidation. They should
reconsider the factors that underlay the development of the
strategy and confirm whether in their view they are still valid. A
board might have committed the company to cutting overheads,
delaying capital investment, relocating premises, selling part of
the business or procuring fresh equity. At each meeting, the board
will need to review whether the strategy is being implemented as
envisaged and whether the underlying assumptions (for example, as
to the value of properties) are still reasonable.
The valuations used should be realistic. The accounting
principles upon which assets are valued for the purposes of the
annual statutory accounts might not be appropriate. The realisable
value of any asset will, of course, depend upon all the
circumstances in which the asset is being sold. Discussions with a
company’s auditors may be helpful on this point.
All decisions made and the reasons for them should be recorded
in the minutes, as should any advice taken.
Holding regular meetings
Board meetings and other, more informal, meetings should be held
at regular scheduled intervals. All directors should endeavour to
be present in person or by phone/conference facility. Detailed
minutes should be kept of all meetings and circulated in a timely
manner. Additional meetings should be called as and when new
significant events occur. Briefing papers should be circulated
before such meetings to promote informed discussion. Absent
directors should be told as soon as possible of critical decisions
taken at board meetings.
Involving all directors
Undoubtedly, the involvement of the finance director and any
members of the management team responsible for credit control
and assessing the current and future financial performance of a
company will be key. Depending on the nature of a recovery
strategy, input from sales, marketing and production executives may
also assume a greater importance.
In most cases, however, it will be the non-executive directors
who are best placed to assess whether a company is able to continue
trading and, in particular, whether it can justify incurring fresh
liabilities. Non-executives bring objectivity, experience and
financial independence to the board. Where a company’s prospects
for survival are uncertain, their involvement will ensure that the
interests of creditors and shareholders are not overlooked and will
facilitate discussions with banks and other lenders.
Keeping major creditors informed
It is important that the distribution of information to
creditors’ groups is handled in an orderly way. Information to be
released to creditors should be discussed with and, in some
circumstances, presented by, the company’s advisers. Where a
strategy to be implemented requires creditors’ support (principally
that of the lending banks), a careful and clear presentation is
required.
If a company’s shares are publicly traded, directors will have
to consider the problems associated with the release of
price-sensitive information.
Reviewing financial obligations
A board should ensure that the finance director and company
secretary are aware of the need continually to review:
- the maintenance of capital, as imposed by statute;
- any borrowing restrictions imposed by the company’s articles of
association;
- any financial covenants in the company’s loan
documentation;
- any regulatory requirements affecting the company.
Appropriate action must be taken if there is any possibility of
a breach.
Making announcements
If the company’s shares are listed on the London Stock Exchange,
the FSA’s Disclosure and Transparency Rules will be relevant. These
impose certain obligations on the release of information.
When a company’s financial situation deteriorates, certain
announcements have to be made to avoid the creation of a false
market in the company’s shares. Announcing that a dividend might
not be paid on a listed preference share, or that a company is in
discussion with its bankers, will obviously have a marked effect on
creditor confidence. Therefore, directors will need to consult
their advisers about the timing of announcements.
In addition, directors must be aware that they can be guilty of
a criminal offence if they:
- make any statement, promise or forecast they know to be
materially misleading, false or deceptive;
- recklessly make (dishonestly or otherwise) any statement,
promise or forecast that is materially misleading, false or
deceptive;
- dishonestly conceal any material facts.
In each of these cases, directors will be guilty if they
deliberately induced another person to deal in securities in a
company on the basis of false information – or they were careless
about what they said and its effect on investor behaviour.
