Note: This Insight has been updated since originally published on March.24.2020 with the title "COVID-19 - Protecting Directors from personal liability during uncertain times".
We are amid a black-swan event that is bringing unprecedented levels of uncertainty to the world. As the UK Government announce new measures every day to support UK businesses, strategy and financial planning needs to change just as frequently. We discussed these measures and responses in our recent Government Assistance and Support for SMEs, Financing Related Considerations and Mind the Gap insights.
Companies that were otherwise solvent may have been thrust into financial distress as a result of COVID-19. In such circumstances, directors should be aware that their duty to act in the best interests of creditors becomes paramount to the duties of directors in order to promote the success of the company for the benefit of its shareholders.
If a company is unable to continue to trade and enters an insolvency process, an insolvency practitioner will review the prior conduct of the directors of the company and may seek to bring claims against the directors personally, to the extent they failed to mitigate losses to creditors. Some comfort may be derived from the UK Government's announcement to make certain changes to insolvency laws, in particular, to suspend legislation relating to wrongful trading backdated to 1 March 2020 (see the end of this note for a brief explanation of wrongful trading). The intention of such changes is to allow directors to continue to trade and to incur further credit (including under the Government's emergency funding initiatives) without facing personal liability under the wrongful trading regime.
Whilst this may provide some additional comfort to directors and prevent insolvency filings by directors, boards should continue to take the measures set out below to ensure they are acting appropriately during these extremely uncertain times.
Keep the interests of creditors at the forefront of any decisions
If a company is trading whilst in the "zone of insolvency" directors should consider whether their conduct is in the best interests of creditors (as a whole). In circumstances where directors continue to trade at a time where they knew, or ought to have known, that the company could not avoid an insolvent liquidation and failed to take every step with a view to minimising potential losses to the creditors of the company, the directors may be liable to make a contribution to the assets of the company under the current wrongful trading regime. The UK Government's announcement that it will postpone wrongful trading legislation may be significant during this time of increased uncertainty. The announcement will allow directors to continue to trade and to seek to rescue their company without the need to be concerned that if they do not put the company into an insolvency procedure, they could be guilty of wrongful trading.
Importantly, this should allow directors to incur further debt on an emergency basis, including obtaining access to the UK Government's Covid-19 Business Interruption Loan Scheme, Large Business Interruption Loan Scheme or Corporate Finance Facility introduced by the UK Government (or from other sources if available). Whilst this is helpful, directors should be cautious in incurring further indebtedness (including trade credit) and should continue to consider whether their actions are in the best interests of creditors as a whole.
Meet regularly to consider the financial position of the company
In current circumstances, the financial position of the company can change daily. Boards should therefore be encouraged to meet as frequently as is reasonable in the circumstances (even daily) to consider whether the company is able to continue to be capable of paying its debts as they fall due. Directors that are required to work from home in these difficult times could "meet" via videoconference or by telephone which would likely be permitted by the articles of association. Orrick has launched an innovative online meeting platform that should enable all companies to continue with shareholder meetings during the pandemic.
Keep minutes of board meetings
If the company is unable to avoid an insolvency, board minutes will provide evidence to an insolvency practitioner that the directors have acted appropriately, considering their duties and acting in the best interests of the creditors of the company. It is therefore essential to keep a comprehensive set of minutes for all board meetings.
Directors should try to avoid situations in which they have or may have an interest that may conflict with that of the company. An example of this may be with private equity firms where conflicts between the interests of the sponsor and the company may arise. Boards should therefore consider the company's corporate governance and ensure there is sufficient independence on the board.
Avoid antecedent transactions
Under the Insolvency Act 1986, a liquidator or administrator may seek to unwind certain transactions or bring claims where the directors' conduct was held to be contrary to insolvency legislation. Such antecedent transactions and/or conduct include (amongst other things):
misfeasance – if the director misapplies, misappropriates (directly or indirectly) or wrongly retains money or property of the company, or commits any misfeasance or breach of duty;
wrongful trading – if the company enters an insolvent liquidation and the director knew, or ought to have known, that there was no reasonable prospect of the company avoiding insolvent liquidation and did not take every step to minimise the potential loss to the company's creditors. The postponement of the wrongful trading legislation will be of some assistance to directors, but it will only be temporary and directors should continue to monitor whether continuing to trade is in the best interests of creditors;
fraudulent trading – if the company has gone into insolvent liquidation and the directors have knowingly taken part in carrying on the business with the intent of defrauding creditors.
transactions at an undervalue – a gift or transaction during the relevant period before the company went into an insolvency process where the company received no or inadequate consideration.
preferences – a transaction prior to the company going into insolvency that puts a creditor in a better position in the insolvency had that not been done, and the directors had a desire to prefer such creditor.
Directors should therefore consider carefully whether entering into particular transactions could result in liability if the company later enters an insolvency process. Examples, may include making payments to directors or connected parties including dividends or repayment of directors' loans; and
transactions defrauding creditors – a transaction at an undervalue with the intention of putting assets beyond the reach of the creditors of the company.
Consider the position of each group company separately
Directors who act on boards on different companies within the group must consider the position of each company separately. One company within the group may be insolvent, whilst other companies within a group are solvent. Directors should therefore consider whether any actions are in the best interests of each group company (and its creditors) separately. Many groups operate cash pooling arrangements and transfer cash around the group without much thought. However, in a distress situation, the directors should consider whether it is appropriate to pool cash or whether cash should be kept separate.
Instruct professional advisers
Seeking advice from legal and financial experts can assist in providing a defence to any potential claims by an insolvency practitioner if the company later enters an insolvency process. Advisers can also assist in identifying areas of risk where directors could potentially be in breach of their duties and provide guidance in dealing with circumstances that many directors may not have experienced.
A precis of Wrongful Trading
Under section 214 and section 246ZB of the Insolvency Act 1986, an administrator or liquidator may bring a claim against the directors of a company for wrongful trading. The wrongful trading provisions are intended to prevent directors from continuing to trade to the detriment of creditors where the directors knew, or ought to have known, that an insolvent liquidation or administration could not be avoided.
The wrongful trading provisions apply to any person who is or has been a director. The definition of director extends to non-executive directors, de facto or shadow directors and nominee directors. A director will be guilty of wrongful trading where the company is in administration or insolvent liquidation and:
the director knew, or ought to have concluded prior to the commencement of proceedings, that there was no reasonable prospect of the company avoiding an administration or insolvent liquidation; and
the director failed to take every step with a view to minimising the loss to the company's creditors, that the director ought to have taken.
The test for determining whether a director ought to have reached the conclusion that there was no reasonable prospect of avoiding insolvent administration or insolvent liquidation, and the steps that the director ought to have taken, is both objective and subjective. The court will consider what a reasonably diligent person having both: (i) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company; and (ii) the general knowledge, skill and experience that the director has.
In the event that a director is guilty of wrongful trading which resulted in a greater deficiency being suffered by the creditors of the company than would have been suffered had the director put the company into administration or liquidation at the point at which they knew, or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent liquidation or administration, the court will consider whether the directors took every step to minimise the potential loss to creditors. The court may order that the director makes a contribution to the assets of the company to compensate the creditors for such increased deficiency.
A director who is guilty of wrongful trading may also be disqualified to hold office of a director under the Company Directors Disqualification Act 1986 for a period of 2 to 15 years.
Although the UK Government has announced suspension of the wrongful trading provisions, the legislation has not yet been enacted and is not expected until at least 21 April 2020. Whilst we await the legislation, directors should continue to exercise caution when determining whether the company should continue to trade, and also to continue to incur further credit.