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Commercial Update – Directors’ Duties and Insolvency

20 December 2019

Amy Cunliffe-Rowe

In our previous article about directors’ duties, we summarised the general duties of directors of private limited companies. This article focuses on directors’ duties when a company is, or is likely to become, insolvent.

When a company is solvent, directors owe their duties to the company’s shareholders. However, when a company is financially distressed and insolvency is likely, there is a shift in the directors’ duties from being owed to shareholders to being owed to creditors. The point at which there is a shift in directors’ duties is important because it marks a change in duties and liabilities, the breach of which can lead to personal liability. Pinning down exactly when the shift occurs, however, is not always easy because there is no precise point at which the line is crossed. This means it is important for directors to understand insolvency and to be aware of what the red flags are so that they can take action to reduce the risk of personal liability as soon as possible.

The two generally accepted tests for insolvency are, simply put, where:

  1. the value of a company’s assets is less than its liabilities, including current, future and prospective liabilities (the balance sheet test); and

 

  1. a company is unable to pay its debts, such as invoices from suppliers, inter-company debts or taxes, as they fall due. This test is deemed to be met where a company fails to comply with a statutory demand for a debt in excess of £750, or if a judgment debt remains unsatisfied (the cash flow test).

If a company meets either of the tests above, or if its directors are concerned that it is likely to, they should take immediate steps to seek advice. Directors are not ordinarily responsible for a company’s debts unless a court has made a finding of wrongful trading, fraudulent trading or misfeasance against a director, or if a director has been found liable for deceit but, if this is the case, it can be very costly indeed.

Practical steps directors can take to minimise their exposure to personal liability include:

  • closely monitoring the company’s finances so that any potential issues can be identified at an early stage;

  • holding regular board meetings and maintaining thorough records of decisions and reasoning;

  • putting in place effective credit control;

  • if any issues are identified, making sure, together with the board, that there is a reasonable prospect of the company being able to pay all debts as they fall due;

  • taking advice from an appropriate advisor about their responsibilities and any proposed transactions; and

  • ensuring that insurance is put in place and, if not, taking out directors and officers liability insurance.

 

The key thing is that directors are aware at all times of the company’s financial position so that they are able to take immediate action if its position deteriorates.

If you would like further advice in relation to this issue or further information about our compliance services please contact the Commercial team at 3HR.

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