As businesses and companies in the UK face an uncertain few weeks and months with unprecedented pressures, it can be easy for directors to panic and not know where to turn.
To assist in decision-making, we give a reminder of the law in this area, and some signposts for those seeking help.
In this briefing, we give a short reminder of statutory duties owed by UK directors under the Companies Act 2006, the potential risks of continuing to trade while possibly insolvent, and actions that should be taken in order to mitigate those risks.
While companies are solvent, directors each owe duties to it. In particular, under section 172 Companies Act 2006, they must promote the success of the company for the benefit of its members as a whole. In discharging this duty, section 172 of the Act gives a non-exhaustive list of matters that directors must have regard to, such as long term consequences of decisions, the interests of the company’s employees, and the need to foster the company’s business relationships with suppliers, customers and others. At times like these, directors have to tread a careful path between taking measures to ensure the company’s survival, such as conserving cash flow, while determining how to deal with other priorities such as paying suppliers and employees. In general terms, the directors may decide to pay dividends if the company is solvent and has sufficient realised profits, but in taking that decision they should consider all the section 172 factors, especially if payment of dividends to shareholders may increase pressures on cash flow.
The emphasis changes if the company is insolvent or is approaching insolvency. If a company becomes insolvent, or is at risk of insolvency, directors must put the interests of creditors as a whole before those of the company. Section 172(3) of the Act states that in those circumstances, directors should consider or act in the interests of creditors, and case law suggests that this duty to creditors is triggered once there is a real, not remote, risk of insolvency. The precise details of what factors directors should take into account to discharge those duties will vary from case to case. They should seek professional advice if in any doubt.
When will a company be deemed to be insolvent?
- There are two alternative tests. Applying the “cash flow” test, a company is likely to be insolvent on this basis if it cannot pay its debts as they fall due. Applying the “balance sheet” test, a company is likely to be deemed to be balance sheet insolvent if its liabilities (taking into account its contingent and prospective liabilities) exceed its assets. If directors think their company may be insolvent on either test, duties are owed primarily to creditors as a whole.
- Case law is helpful in advising on the practical application of both tests, but is beyond the scope of this note. In any event, the application of the tests in such unprecedented times has not yet been tested, and it will no doubt develop as this period of economic turbulence continues.
What are the consequences if a company continues trading while it is technically insolvent?
- Directors can be liable for wrongful trading where they continued trading at a time when they knew (or should have concluded) that there was no reasonable prospect of the company avoiding an insolvent liquidation and they failed to take every step a reasonably diligent person could be expected to take to minimise loss to creditors. Fraudulent trading occurs if it appears that any business of the company has been carried on with intent to defraud creditors or for any fraudulent purpose. It can be sufficient to show that a company continued to carry on business and to incur debts at a time when there was, to the knowledge of the directors, no reasonable prospect of those debts being paid. Fraudulent trading is also a criminal offence, punishable by a fine or imprisonment.
Take particular care if a group of companies is involved
- A director who is the director of several companies within a group owes his or her duties to each particular company. When a group is poor financial health, conflicts may develop. For example, allowing group funding practices to continue which may have made sense in a time of financial health (such as diverting cash from one company to another via a group cash pooling mechanism) may be open to attack in an insolvency, if an insolvent company is thereby deprived of assets. A director could be liable for breach of duty for allowing such a practice to continue.
What can directors do to mitigate the risk?
- Review the ongoing financial position of the company in the light of the crisis
- Keep a written record of all board meeting decisions
- Seek advice from insolvency practitioners and lawyers, and proactively engage with the company’s funders
- Ensure they can justify their actions in deciding to continue trading.
The good news is that the Government has recently announced a package of measures for struggling businesses, with more in the pipeline, in an attempt to minimise the impact of COVID-19 (see recent government guidance). The question, however, is the extent to which such a package will actually help struggling businesses in the short term and allow companies to survive and get back on their feet once the crisis has passed. By way of further guidance, see guidance for startups in Europe issued by Sifted and our recent briefing for employers. Our banking team has also issued a briefing on issues for corporate borrowers and their funders to consider at this time.
Please contact our corporate or restructuring & insolvency teams, or your usual contacts at the firm, and we will be happy to help.