April 2nd, 2020 / Insight posted in Articles, Coronavirus, Legal, Operations

Coronavirus: Directors’ duties and the risk of wrongful trading

This analysis looks at directors’ duties, particularly concerning wrongful trading, in the context of companies facing financial difficulties as a result of Coronavirus.

Introduction

The impact of Coronavirus is unprecedented and is already creating significant health, social and economic challenges across the world, not least the UK.

The UK government has ordered the closure of pubs, restaurants, gyms, schools and shops unless deemed exempt as key suppliers. As such, the economy is effectively hibernating. Furthermore, the government has introduced travel restrictions and social distancing measures which will negatively affect the global economy. Directors will be concerned as to their conduct during this pandemic.

It has long been established that directors owe a fiduciary duty to the company and its shareholders but when the company is insolvent, this duty switches to its creditors and directors will feel increased scrutiny should the company fail.

Potential wrongful trading

The liability will arise where a director knew, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into insolvent liquidation and failed to take every possible step to minimise the potential loss to the company’s creditors. In ascertaining the potential level of liability, consideration will be given to a person having both the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same function as is carried out by the director (an objective test) and the general knowledge, skill and experience which the relevant director actually has (a subjective test).

It is important to note that directors may be liable for wrongful trading even though their business is not actually trading, but losses are increasing. This is particularly relevant in the leisure and hospitality sector where establishments are closed due to the Coronavirus but some fixed costs continue to accrue.

On 28 March 2020, the UK government announced changes to the insolvency regime. This was in particular the temporary suspension of wrongful trading provisions for directors to remove the threat of personal liability during the pandemic, with retrospective effect from 1 March 2020, currently lasting for three months, although this may be extended.

Directors’ duties

The Companies Act 2006 (CA 2006) codifies most, but not all, of the duties imposed on directors by case law and equitable principles. There are seven general statutory duties, of which three are most relevant to companies in financial difficulties:

  • the duty to promote the success of the company for the benefit of its members as a whole
  • the duty to exercise independent judgment, and
  • the duty to exercise reasonable care, skill and diligence.

Duties when in financial difficulty

When a company is financially distressed and formal insolvency proceedings become more likely, the directors’ duty to promote the company’s success (ie to act in the interests of the members as a whole) is replaced by a duty to act in the interests of the company’s creditors as a whole (ie to preserve the value in the company in order to maximise the return to creditors). This is known as the twilight zone.

Because of recent events, the prospects of avoiding insolvent liquidation have increased. If the company was already distressed before this event, it may be that the directors were already within the twilight zone. That puts directors’ behaviour in the mitigation period, including ensuring they take every step to minimise losses to creditors.

The amendment to the Insolvency Act appears therefore to remove a director’s potential personal liability for losses in circumstances when, from 1 March 2020, they knew or ought to have known that the company should enter into a formal insolvency process. As a result, this should allow directors of companies that have been directly affected by the economic effects of the Coronavirus pandemic to continue trading.

However, a blanket suspension of wrongful trading could risk abuse and may cause directors to bury their head in the sand if they feel they are protected by the temporary suspension. The provisions are there for a reason: to protect creditors. It should be noted that directors were always protected if they acted reasonably.

Indeed, the temporary suspension of wrongful trading should not be interpreted as a suspension of fiduciary duties. Directors will need to remember that they act in the best interest of the company’s creditors if they are trading while insolvent and the duty to cease trading remains a fiduciary duty.

Potential preference payments

As with wrongful trading, preference payments may become a bigger risk to directors in the current climate.

A preference is a transaction which places a creditor in a better position when a company goes into liquidation than if the transaction had not occurred. If the transaction occurs within six months of the company’s liquidation, the liquidator can apply to have it set aside but must prove that the directors were influenced by a desire to produce the preferential effect. In the case of a transaction with a creditor who is a connected person (for example, any of the company’s shareholders, subsidiaries or directors), the period of six months is extended to two years. It is also presumed (unless the contrary can be proved) that there was a desire to prefer the creditor.

Indeed, the desire to pay connected creditors ahead of others may be incredibly strong as directors face uncertainty and potential insolvency in these difficult times. With the new government measures, HMRC has effectively deferred the collection of their debts to ease company cash flow but that does not mean they will not become due.

Current climate

Today’s current trading climate is unprecedented and, with the assistance measures introduced by the UK government, it may be possible for a company to hibernate and trade through.

The government has introduced a number of measures to assist directors in the UK, such as:

  • the Coronavirus business interruption loan scheme (CBILS). Under the scheme, lenders can offer facilities of up to £5 million to smaller businesses, where 80% of the loan is guaranteed.
  • a new lending facility from the Bank of England to help support liquidity among larger firms, helping them bridge Coronavirus disruption to their cash flows through loans.
  • a Coronavirus job retention scheme.
  • the ability to furlough employees.
  • deferring VAT and income tax payments to HMRC.
  • a statutory sick pay relief package for SMEs.
  • a 12-month business rates holiday for all retail, hospitality and leisure businesses in England.
  • HMRC’s time-to-pay scheme, and
  • small business grant funding.

However, while the CBILS may provide much needed funding for a company in the short term, directors should proceed with caution and obtain professional advice. Ultimately, this is a commercial lend (loan/overdraft/invoice finance/asset finance) and will have to be repaid to the lender, albeit with the borrowing interest funded by the government for the first 12 months. The loan sits on the company’s balance sheet which may affect its solvency and indeed credit rating.

Furthermore, the lenders will more than likely seek personal guarantees from the company’s directors. Lenders may not seek a charge on any main property owned by the directors, however, if the worst happens and the company is placed into some form of insolvency in the future, the directors’ personal assets are available (via bankruptcy) for the lender, should company assets be insufficient to pay the lender in full. Indeed, any personal guarantee could be mitigated if s obtain a personal guarantee insurance product.

As such, any directors seeking funding to trade through this period should seek professional advice, as there may be alternative options, which stop short of placing personal assets on the line.

Maintaining vigilance

While the government has relaxed wrongful trading provisions, they have stayed silent on other parts of the Insolvency Act, so directors may be personally liable for other offences. These could include general misfeasance, preference payments (as described above) and transactions at undervalue. Those involved in the running of a company should continue to seek professional advice if they are concerned about the viability of their business and on their personal obligations in these unprecedented times.