This article addresses the personal liability and risks associated with fiduciary duties and wrongful trading because these are the key areas of responsibility and risk that need to be understood.
Fiduciary duties
Directors must act with 'utmost good faith' in what they reasonably consider to be the best interests of the company.
They must act honestly, diligently and for a proper purpose and not allow their personal interests to conflict. They also owe a duty of skill and care.
Wrongful trading
The law here can be simply put: wrongful trading is when a director allows the company to continue trading and taking credit from suppliers when no-one could reasonably have thought that it could avoid insolvent liquidation.
If a director does so he can be made personally liable for those additional liabilities. In practical terms this means:
- it is wise to take independent professional advice as soon as it becomes apparent that the company might be on the brink of insolvency
- ensuring that directors are regularly given up-to-date financial information, such as a weekly cash flow
- being careful not to take goods or services on credit if the financial position of the company is very uncertain
- ensuring that the basis for any decision to continue trading is carefully documented and minuted by the board of directors
- considering the possible use of one of the insolvency procedures
If a company goes into an insolvency procedure, its directors will be required to fill out a detailed form. This will seek to establish what financial information the board had to hand, and on what basis they acted as they did. If decisions have been documented formally, the records will help the directors to answer the questions on this form and avoid disqualification proceedings.
You can read more about insolvency procedures.
Disqualification
The Department for Business, Enterprise and Regulatory Reform has the power to bring proceedings to disqualify a person from acting as a director. Breach of fiduciary duty or allowing a company to trade wrongfully can lead to disqualification.
Preferences and salary payments
When a company is in financial difficulties, the directors should not deal more favourably (or prefer) one creditor in a group.
Paying employee salaries when other suppliers are not being paid may seem to go against this rule. However, the key issue will be why the payment is being made. If salary payments are made, not with the intention of preferring the employees, but because the future viability of the business depends on employee support and confidence, then payment can almost certainly be made provided the board reasonably believes the company can survive.
You can read more about preferential payments during insolvency.
Self-dealing by directors
In some circumstances, directors may choose to buy assets from a company in financial difficulty in order to provide a cash injection.
Or they might loan the company money taking security against the company's assets.
Care should be taken before doing this.
First, the transaction should be on arms' length terms, and if not, could be set aside on the basis of a transaction at an undervalue if the company goes into insolvent liquidation.
Second, it is likely that formal shareholder approval will be needed. It would usually be a reserved matter in the shareholders agreement. Failure to obtain that approval will again leave the transaction vulnerable to be set aside by a liquidator.
Phoenix companies
A pheonix company is one that has become insolvent, been liquidated, and then been re-registered by one or more of the directors.
If a company has gone into insolvent liquidation, a director of that company will commit a criminal offence if his new company uses the same or a similar name for the next 5 years.
This is to prevent the owners (or the directors) from acting fraudulently or negligently, liquidating the company, and restarting the same illegal or fraudulent operation under the same name and brand.
There are exceptions to this prohibition. In particular, it is possible to use the same name if substantially all of a company's assets have been bought from an administrator or liquidation, and creditors have been circularised so they are aware of the director's connection with the failed business.
False accounting
The onset of financial difficulties may be a temptation to present the financial position of a company more favourably than should be the case (e.g. by over-valuing stock or recognising income too early). Great care must be taken that window dressing does not become false accounting. This is a criminal offence.
Fraudulent trading
Directors who allow a company to trade dishonestly with an intent to defraud creditors, will commit the criminal offence of fraudulent trading.
Resignation
A director who is not happy with the way in which a company is being run may need to consider resigning his directorship. Care must be taken, however. In circumstances where a key director resigns without having first initiated one of the insolvency procedures, that director may be judged to have failed to meet his or her obligations in that position.