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Director's personal liability and insolvency

publication date: Apr 4, 2008
 | 
author/source: Ben Hopps
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Once the prospect looms that the company may fail and that the directors may be called upon to fulfill obligations under personal guarantees, it becomes more difficult for directors to make rational judgments with regard to the business they are running. The most difficult decision for any director is whether the company should stop trading and, if so, when. 

In a question and answer session, Solicitor Ben Hopps looks at a situation from the point of view of a fictional company director. 

Q. When is a company insolvent? 
A. There is no precise legal definition of insolvency and it is still a largely a matter of judgment. It is therefore arguable as to the exact moment when a company becomes insolvent. A company is normally regarded as insolvent on two counts: a) When its liabilities exceed its assets, after taking into account its contingent and prospective liabilities. b) When it is unable to meet its liabilities as they fall due. 

Q. So when should I act? 
A. In view of the problem in determining precisely when a company is insolvent, directors should seek advice and be extremely careful about the liabilities their company incurs once they are aware that financial problems exist. It is at this time that directors, particularly those controlling and possibly owning smaller family businesses, often fail to appreciate fully the alternative courses of action open to them, and the consequences of these both for the company and for themselves. 

Q. So what are those options and how do they protect me? 
A. These may be broadly summarised as follows: 
a) To take corrective action within the existing company with the aim of alleviating the company’s cash shortage. However, very often there is little room for manoeuvre as the bank overdraft facility is fully extended and creditors may be pressing for payment, while debtors can be slow to settle their accounts. 
b) It may be possible to arrange a sale or merger with a third party with greater financial resources to assist the company over its difficulties. 
c) If the cash position is so critical that continued trading is no longer possible, then the directors will have to either come to an informal or voluntary arrangement with creditors in an attempt to resolve the company’s difficulties; or take steps to arrange for the appointment of an administrative receiver, an administrator or a liquidator and follow the appropriate formal insolvency procedure. 

Q. What steps can I take now to “future proof” the problems? 
A. A very common feature of companies that experience financial difficulties is that the accounting records are poorly maintained, with the result that the financial information available to management is inadequate. Accurate and up to date accounting records are never more vital and necessary then when a company is running out of money. This cannot be emphasised too strongly. Without accurate financial data neither the directors, nor their advisers, can hope to make the right decisions: whether it be the elimination of loss-making activities or products, an injection of funds to correct a shortage of working capital, or a concerted effort to reduce stocks and trade debtors in order to improve the company’s cash flow. Although up to date information will not of itself necessarily alter the ultimate decision, its presence allows alternative options to be considered, thus giving the directors the opportunity to determine the company’s future, rather than having a solution imposed from without. Short term profit forecasts and cash flow projections must be reviewed so that the benefit of future trading can be evaluated, together with the likely outcome of any company reorganisation or refinancing proposals. 

Q. When would I be likely to be liable if I continue trading in the face of financial difficulties? 
A. If there is a real risk that creditors may not be paid and trade is allowed to continue, however well-intentioned the decision may have been, any bills incurred during this period not subsequently paid may be held to be the personal responsibility of the directors. The directors’ duty is to preserve the status quo for the benefit of creditors and shareholders until the company’s future is determined. The directors should take advice as to whether trading should continue, and whether plans for the future are realistic. If it is possible to formulate a rescue plan which is regarded as achievable, then it will probably be important to inform creditors, as far as possible, of the company’s financial position and of the intentions for the settlement of outstanding accounts. Directors may in fact be surprised by the creditors’ sympathetic response, and very often creditors will be receptive to sensible deferred payment terms, providing current purchases are paid for either in cash or on normal credit terms. 

Q. How can I maximize the likelihood of a creditors agreement occurring? 
A. This is more likely to be the case if the proposals are presented and supported by an insolvency practitioner. Throughout this period the directors must have regard to the potential penalties of being found guilty of either wrongful trading or of trading fraudulently whilst insolvent. Although efforts will be concentrated on the resolution of the short term cash flow difficulties, the directors must not forget to consider the viability of their company in the longer term. If the decision is made that the company should continue to trade, there must be clear evidence of a real prospect that all creditors will ultimately be paid. If there is no such prospect, then apart from the possible conversion of work in progress into finished stock (assuming that the finished stock can be sold for a price that will cover the cost of completion), trading may well have to cease immediately. 

Ben Hopps Ben Hopps is a Solicitor in the commercial litigation team at Sykes Anderson LLP.