The position of a director is not an easy one – you are a director whose company is struggling to cope with the prolonged economic downturn.  You have the monthly wage bill; rent due, and suppliers breathing down your neck with sales slipping.  What do you do?

Directors of UK companies need to navigate a legal minefield when deciding whether their company is fundamentally strong enough to survive. 2013 has already seen several high profile retail failures with Republic the latest high profile casualty following in the wake of HMV, Jessop’s, Blockbuster etc.  The substantive decision to carry on trading may depend on a range of factors such as interest rates, availability of funding, strength of the competition and domestic and foreign demand for the product.  The procedures directors follow in reaching an answer to this decision, is also key.

Directors generally have a duty to promote the success of the company.  However, if their company nears insolvency, this duty is modified by an obligation to have regard to the interests of creditors.  

As a general rule as a company’s financial position worsens, the interest of the company’s creditors should become of paramount importance.  The dual threat of personal liability and disqualification as a director, means that directors ignore the interests of creditors at their peril.

We set out below 10 practical tips for directors:

1.    Do not ignore the problem

The ostrich in the sand approach does not work when an individual puts a final reminder in a drawer.  It certainly should not be adopted if your company is in financial difficulty.   Recognising that the business is in difficulties and resolving to do something about it, is probably the most important stage in the process.

Taking action, sooner rather than later, could make the difference in saving the business in its current, or a revised, form.   Even if it cannot be saved, action at an earlier stage may reduce the risk of a director subsequently being personally liable for the debts of the company (known as wrongful trading and looked at in paragraph 3 below).

2.    Take proper advice  

Once a problem has been identified, directors should assess whether they need outside help.  If the company is in receipt of statutory demands or, events of default notices, it is fairly obvious that specialist legal/insolvency advice is needed.

However, even if the company has not reached the default stage, the board should still consider whether it has the necessary knowledge and skill sets to turn the company around.  Bringing in turnaround experts is an option which should be considered as they have a proven track record of saving companies.  

3.    Be aware of your risk/obligations – personal liability

Operating as a company can act as a shield to incurring liabilities yourself.  However this shield can be breached.  

Under UK insolvency law, a liquidator of a company can apply to the Court to seek contribution orders from directors and/or ex-directors.  The liquidator must show that before the commencement of the winding-up, the company carried on incurring liabilities when the defendant “knew, or ought to have concluded, that there was no reasonable prospect of the company avoiding an insolvent liquidation.”

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”.  Both defences are viewed from the standpoint of the reasonable director not a particular individual.  Lack of experience and/or knowledge may not save you!

Power to Disqualify Directors

Under UK law, a person who has been a director of an insolvent company and whose conduct makes him unfit to be concerned in the management of a company, may be disqualified for a period of between two to fifteen years.

Disqualification can irreparably tarnish the reputation of an individual and can impact your future career.  As above, a lack of knowledge of how serious the situation was or arguing that these responsibilities were delegated to others will not save you.  Ultimately, as a director the buck stops with you.

4.    Establish procedures and stick to them

Hindsight is always 20:20.  A decision, for example, taken by the Board to continue to trade may subsequently prove to have been wrong.  However if there is evidence to document the thought process behind it (board minutes, evidence of advice taken, consideration of creditors’ position etc), it is unlikely that the directors will be open to legal redress.  If the company is in financial difficulties, the directors should consider implementing procedures such as the:

(a)    expedite the collections of debts. Once rumours get out that a company is in trouble, it will become harder to collect;

(b)     review of such management accounts and all other relevant trading/financial information at regular minuted board meetings where directors are encouraged to raise any specific concerns;

(c)    formulation of specific areas of responsibility for each director;

(d)    review of the position of the company’s creditors; and

(e)    production of detailed, accurate and up-to-date management accounts.

Decisions taken at this troubled time are often fraught with legal difficulties.  For example, if it is decided that employee numbers should be cut, the redundancy process in the UK should be handled with great care.  Get it wrong and you are only adding to the company’s woes with unfair dismissal claims.  
Decisions to cancel orders should be checked to make sure that there are no penalty clauses being triggered.  It is also wise to check bank covenants to make sure you are not inadvertently triggering a breach by, say, quickly disposing of certain assets.

5.    Stay with the ship

As Captain Smith tragically proved on the Titanic, a Captain is supposed to go down with his ship.  Directors of troubled companies are supposed to have the interests of the creditor at the forefront of everything they do.  It is difficult to see how they can protect their creditors’ interests if they are out of office.

The main time when a resignation may be appropriate is if (i) a Board is refusing to acknowledge the problem or (ii) by a director resigning, it forces the spotlight onto the company and requires them to take action.  A subsequently appointed insolvency official  can review the conduct of former directors, so resignation does not get the director off the hook in any event.

6.    Consider the stakeholders in the business

To have any chance of survival it is imperative to keep key players, such as the bank/landlord/employees, on side.  Talk to them. 

Often, the bank will be far more sympathetic if it is involved in the process from the start rather than notified at the last minute of a problem.  Often it is a good idea to have one point of contact such as the finance director that is in regular discussions with the bank/landlord.

A landlord given notice of a future default may be prepared to agree a rent reduction/holiday to keep the tenant paying rent in the long term.

7.    Think the unthinkable

If the company is in difficulties every possible solution should be on the table (another reason why bringing in a turnaround expert is often a good idea).

Often there is no point in just looking to reduce cost at the edges.  The whole rationale of each business unit should be re-examined.  Every line of costs should be reviewed as well as consideration being given to proposals such as invoice discounting/factoring, stock reduction, out sourcing etc.  It was reported that French Connection had a wide ranging review of costs and appointed property agents to try and exit the leases in respect of 15 loss making stores.

It is also not just a case of trading (and continuing to run the risk of wrongful trading) or throwing in the towel by liquidating the company at the first sign of trouble.  A company voluntary arrangement or administration process should also be considered.

8.    Do not prefer

A liquidator has the ability to review the actions of a company for a period of up to two years prior to the insolvency (longer if there is evidence that steps were deliberately taken to put assets outside the reach of creditors).

It is surprising how often key assets such as IP are transferred out to connected companies or dividends/bonuses are paid, just as the company is about to fail.  If there is no commercial justification for such transactions, they will be looked at and may be subject to legal challenge.

9.    Consider the priority

If the company is in difficulties, the directors should have one eye on the payment order for creditors if the company goes into insolvency.  For example, if the bank has full security, there is more justification in meeting term loan repayments than paying in full unsecured creditors.  

The law acknowledges that the directors should be allowed to pay for proper advice.. However the intention behind payment orders may also be looked at.  For example, directors are often tempted to pay liabilities where they have given personal guarantees.  This decision could be attacked as a preference.

10.    Do not lose too much sleep!

In the US it is almost expected that a successful businessman will have one or two previous business failures on his CV.

The UK Government also does not want to see directors being sued or barred from future management of companies if there is a legitimate business failure.

As such, the insolvency service will generally only instigate disqualification proceedings when there is genuine evidence of negligence/fraudulent conduct.  Also liquidators will be reluctant to bring claims for wrongful trading unless they are in funds and there is evidence of conduct well below the required standard.

Thousands of shop workers have lost their jobs recently as a series of high street names collapsed into administration (La Senza, Jane Norman, b2Jeans, Barratt’s, Pumpkin Patch, JJB Sports etc), battered by a combination of weak demand and escalating costs. In the current climate, many further fashion businesses are likely to fail.  The question will always be whether the director approached the situation pragmatically and reasonably.

Paul Taylor is a partner in our Corporate department and advises clients on a broad range of business areas, including mergers and acquisitions, joint ventures, private equity, banking and insolvency.

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