The tests: There are generally two broad tests for ascertaining whether a company is insolvent. The first is referred to as a test for commercial solvency. The second is referred to as balance sheet solvency.
A company is deemed to be solvent on a commercial basis if it is able to meet its current debts as they fall due. It follows that a company is considered to be insolvent on a commercial basis if it is unable to meet its current debts as they fall due.
As to the balance sheet test, a company will be considered insolvent if the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
Directors’ duties where the company is in financial distress: Where a company is (a) insolvent, (b) of doubtful solvency, (c) on the verge of insolvency, or (d) on the verge of or likely to go into insolvent administration, and there is money owed to creditors which is at risk, the directors have to consider the interests of the creditors as paramount and take those into account when exercising their functions. It follows that a director’s general duties (as summarised above) change from a situation where they are owed principally to shareholders, to one where they are owed principally to creditors.
Perhaps the most critical consequence of this is the fact that there may come a time when it is in fact in the best interests of the creditors that company’s trading should cease, and some formal insolvency procedure should be entered into. Directors run significant personal risks if they do not bear this in mind and continue to trade a company which is in financial difficulty, in particular where it is later established that no reasonable director would have continued to trade.
The other critical point which must be made is that if a director acts in breach of their duties, they can potentially face severe penalties.
Potential personal liabilities: The Insolvency Act 1986 contains a number of provisions under which directors can be made personally liable. In short, they are:
- Misfeasance or breach of duty (Section 212 of the Insolvency Act 1986).
- Fraudulent trading (Section 213 of the Insolvency Act 1986).
- Wrongful trading (Section 214 of the Insolvency Act 1986).
Misfeasance or breach of duty
A director may have an order made against him requiring him to compensate the company for loss arising as a result of his misfeasance or breach of duty (Section 212).
The section can apply to an officer of the company (e.g. a director or secretary), a liquidator or former administrator of the company, or any other person that is concerned with or has previously taken part in or been concerned with the promotion, formation or management of the company.
Under the provision, if a director (a) has misapplied or retained, or become accountable for, any money or other property of the company or (b) has been guilty of any misfeasance or breach of any fiduciary or other duty (as to which, see above), a court may, if an application is made by the Official Receiver, the administrator or the liquidator, compel the director to repay any monies which are properly the company’s or, alternatively, compel the director to contribute such sum of money to the company’s assets by way of compensation as is necessary to make good the misfeasance or breach of duty.
In essence, the section provides a summary remedy against directors who have broken their common law duties (set out in the section above headed ‘Directors’ duties’).
A director who is knowingly a party to the carrying on of a business with intent to defraud creditors or for any fraudulent purpose commits both a criminal offence and, if the company goes into liquidation or administration, can face being personally liable to make a contribution to the company’s assets.
It is not enough to show that the company continued to run up debts when a director knew that it was insolvent; there has to be actual dishonesty involving real moral blame.
Conversely, if a director continues to trade the company actually knowing that the debts that it will continue to incur will have no prospect of being paid in the future, then this can amount to fraudulent trading.
Fraudulent trading proceedings are very rare, since the burden of proof, being criminal, is high. Instead, a liquidator or administrator is more likely to succeed if he brings wrongful trading proceedings, where the standard of proof is less strict.
The balance sheet test for insolvency is used when determining whether there has been wrongful trading.
A director will be ‘guilty’ of wrongful trading if (a) the company has gone into insolvent liquidation or administration and, (b) before that time the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration, and (c) that person was a director.
There is a caveat to liability arising in this way, which is that if, from the time that a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation/administration, the director took every step with a view to minimising the potential loss to the company’s creditors as the director ought to have taken.
The very real difficulty for directors considering whether they are trading wrongfully is that the standard by which they are assessed is objective. It is not linked directly to their particular skills and experience. Rather, the standard by which people are assessed is the standard of a reasonably diligent person having both (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by the actual director, and (b) the general knowledge, skill and experience of the actual director.
In other words, there is a minimum standard of knowledge, skill and experience which the law expects a director to have. If, in turn, the director’s actual knowledge, skill and experience exceeds the general standard, they will be assessed according to the higher standard.
There is no hard and fast rule, nor standard, by which an assessment can be made at any given time. A director can become liable for wrongful trading if, judged by the objective standard, there was a point in time when they knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation/administration, but they in any event continued to trade.
When that ‘point in time’ arises (if ever) is extremely difficult to assess. As guidance, however, we would advise directors to regularly ask themselves the following questions:
- Do you honestly believe that there is a reasonable prospect that the liabilities the company is about to incur will be paid in full at the time they fall due?
If not, then you should ensure that the company does not incur such liabilities.
- Having taken all reasonable steps to ascertain the relevant facts, is there a reasonable prospect that the company will avoid going into insolvent liquidation/administration?
If not, you should take every step that you ought to take with a view to minimising the potential loss to the company’s creditors. This will usually involve immediately taking advice from an insolvency practitioner as to the formal insolvency procedures that are available.
If a director is found ‘guilty’ of wrongful trading, then, on application to the court by the liquidator/administrator, they can be required to compensate the company for the loss that it has suffered. This does not mean that the director will become personally liable for all of the company’s debts. However, they can become liable for the difference between the company’s deficit at the time when they ought to have concluded that the company was insolvent and the time at which they in fact reached that conclusion (and took steps to put the company into a formal insolvency procedure).
It should be noted that, whereas this provision is contained within the Insolvency Act 1986 and applies in all liquidations and administrations, it is not always pursued by a liquidator/administrator (even if there are grounds for a claim). Further, if an action is pursued, it may be possible to take steps to compromise the claim before it reaches court.