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The issues of insolvency for fashion businesses and the duties of directors

View profile for Paul Taylor
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Every year, Fox Williams LLP is called upon to advise boards and individual directors of fashion clients as to legal issues arising when a company is on the brink of insolvency.

Directors are responsible for the day to day running of the company’s business. This was set out as 7 duties which the law imposes on directors for the first time in the Companies Act 2006 as follows:

  • to act within the company's constitution and only exercise powers for a proper purpose;
  • to act in good faith to promote the success of the company;
  • to exercise independent judgment (this does not restrict a director seeking informed advice);
  • to exercise reasonable care, skill and diligence;
  • to avoid conflicts of interest;
  • not to accept benefits from third parties;
  • to declare interests in proposed transactions or arrangements with the company.

When a company is solvent, these duties are owed to the shareholders. As a general rule, as a company’s financial position worsens, the interests of the company’s creditors become of paramount importance. Under UK law, an individual director has the dual threat of (a) potential personal liability for future debts, and (b) disqualification as a director, to make sure the interest of the creditors are at the forefront of their thinking!

Personal liability can arise under a number of fronts:

  1. “Wrongful trading”

If a company is nearing insolvency, the directors should only continue to trade and take on liabilities if there is a reasonable prospect of avoiding insolvency.

There are two main defences:

First, the liquidator has to show that the company was insolvent, or became insolvent, at the time of the alleged wrongful trading. There is no prescribed or unequivocal test of a company's solvency. Directors would be expected not only to consider the net asset position but also the ability of the company to settle its reasonably foreseeable liabilities out of its expected cash flow.

Second, a statutory defence is provided if it can be shown to the Court that the director "took every step with a view to minimising the potential losses to the company's creditors as soon as he knew, or ought to have concluded, that insolvent liquidation was unavoidable".

Directors are judged individually, rather than as a board, and it is imperative that regular board meetings are held; there’s a clear divisions of responsibility; regular updates of financial information, clear justification for continuing to trade etc. A resignation from the board will not necessarily save the director from liability. The law also applies to ex-directors. In addition a liquidator will not look kindly on a director who resigns when the ship is deemed to be sinking.

(b)  Breach of duty

The Companies Act 2006 also contains provisions which apply to derivative claims (for this purpose, claims instigated by a shareholder on behalf of the company). One of the main substantive changes introduced by the Companies Act 2006 was to prescribe a wider range of circumstances in which a derivative action may be brought by a shareholder against a director. For example:

  • A derivative action is expressly available for breach of duty of directors (see duties above), even if the director has not benefited personally from the breach.
  • It is not necessary for the shareholder to show that those directors, who carried out the wrongdoing, control the majority of the company's shares.

The shareholder is required to make an initial case for permission to bring/continue a derivative claim and the court is required to consider the issue on the basis of the evidence filed by the shareholder, without requiring evidence from the defendant. The courts must dismiss the application if the applicant cannot establish an initial case.

  1. Other risks of Personal Liability

For example, directors can be made personally liable for national insurance contributions due by the company. They can also be fined for breaches of legislation such as failure to file accounts/confirmation statements etc. If such documents are not filed on time, outside suppliers/customers may also get very nervous and stop dealing with the company.

Power to Disqualify Directors - Company Directors' Disqualification Act

Also if a company does go into insolvency, the liquidator has a duty to report to the Insolvency Service re the actions of the directors (and directors in office over the two years prior to the insolvency). Those whose conduct make them unfit to be considered in the management of a UK company, can face disqualification orders of between 2 and 15 years.

In recent times the courts have attempted to offer guidelines as regards the definition of "unfit" conduct. The courts have outlined directors' duties generally:

  • Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company's business to enable them properly to discharge their duties as directors.
  • Whilst directors are entitled (subject to the articles of association of the company) to delegate particular functions to those below them in the management chain, and to trust their competence and integrity to a reasonable extent, the exercise of the power of delegation does not absolve a director from the duty to supervise the discharge of delegated functions.
  • The extent of the duty and the question whether it has been discharged must depend on the facts of each particular case, including the director's role in the management of the company.

It has been decided that it was not necessary to show that the person in question was unfit to be concerned in the management of any company in any role. If the person's conduct in his actual management role in the company showed incompetence to the requisite degree then a finding of unfitness should be made.

Directors with concerns about their company going into insolvency are well advised to take proper professional advice as soon as their concerns occur.