When a company experiences financial distress, directors have specific legal duties and responsibilities aimed at protecting the interests of creditors and mitigating potential personal liabilities.
Warning Signs
What should directors look out for? The two tests for insolvency are as follows:
- Cash flow test - A company will be deemed insolvent if it is proved to the satisfaction of the Court that it cannot pay its debts as they fall due.
- Balance sheet test – This test considers the actual realisable value of a company’s assets (not just book values) against its liabilities, which are to include contingent and prospective liabilities.
In accordance with recent case law, it is held that the cash flow test and balance sheet test should be conducted as part of a single exercise to determine whether a company is unable to pay its debts.
Directors should be mindful of the above and ensure they are aware of any risks to the company’s solvency.
Duties
What should directors do if the company is at risk of becoming insolvent?
- Shift in Duties – Creditors’ interests become paramount
- Under section 172(3) of the Companies Act 2006, if the company is facing financial difficulty or on the verge of insolvency, the directors must prioritise the interests of creditors over those of shareholders.
- This duty is reinforced by common law (e.g. BTI 2014 LLC v Sequana SA [2022] UKSC 25), confirming that creditor interests must be considered once insolvency is probable.
- However, treat creditors fairly
- Directors must not favour one creditor over another unless legally required (e.g. secured creditors).
- Preferential payments to certain creditors could be reversed by an insolvency practitioner.
- Duty to Avoid Wrongful Trading (Insolvency Act 1986, s. 214)
- Directors must not allow the company to continue trading if they know, or should know, there is no reasonable prospect of avoiding insolvent liquidation or administration.
- If they do, they may be held personally liable for worsening the company’s financial position.
- Duty to Avoid Fraudulent Trading (Insolvency Act 1986, s. 213)
- If a director continues business with the intent to defraud creditors or for any fraudulent purpose, they may face civil and criminal liability.
- Duty to Keep Proper Financial Records (Companies Act 2006, s. 386)
- Proper documentation is essential to demonstrate responsible decision-making.
- Poor record-keeping can lead to allegations of misfeasance or wrongful trading.
- Duty to Consider Insolvency Options Promptly
- Directors should seek professional advice early (e.g., from an insolvency practitioner).
- They may need to consider placing the company into:
- Administration
- Company Voluntary Arrangement (CVA)
- Liquidation
Legal Consequences
What are the possible legal consequences for directors if they fail to identify and address (or ignore) their duties?
If directors fail to fulfil their duties, they may face serious consequences including:
Reputational Damage – Legal actions and disqualifications can harm a director’s ability to serve on future company boards.
Personal Liability for Debts – If wrongful trading is proven, directors may be required to contribute personally to company debts.
Director Disqualification – The Insolvency Service can ban directors for up to 15 years if misconduct is found.
Fraudulent Trading Charges – If a director knowingly acts dishonestly or with intent to defraud creditors, they may face criminal charges.
Protection for Directors
What steps should be taken by directors to comply and minimise possible liabilities?
Hold regular board meetings to assess the company’s financial position.
- Document decisions and advice received to show directors acted responsibly.
- Conduct regular contingency planning to understand the options available for the company and to prepare for each available scenario.
- Refer back to their duties and ensure they are familiar with their responsibility
- Engage early with key stakeholders (key creditors, employees, regulators, etc).
- Engage early with professional advisers (solicitors, accountants, insolvency practitioners).
- Cease trading if there is no reasonable prospect of avoiding insolvency.
Here at KR8 Advisory, we have extensive experience working with directors to navigate periods of financial distress including:
- Providing advice on a director’s duties
- Running cash flow analysis and financial modelling
- Conducting an analysis of available options, both solvent and insolvent
- Taking formal insolvency appointments, if required
If you find yourself in a period of financial distress, don’t wait. Contact a member of our team who can provide the right advice and help get you on the right path.
