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Directors’ duties

The initial cause of the credit crunch was the collapse of the US sub-prime market and its knock-on effect has brought an end to cheap and available credit in the UK and raised the spectre of recession.

The decade-long consumer boom is over and the UK is left with a personal debt mountain of over £1.39trn, with individuals owing an average of £33,000.

A squeeze on credit has hit individuals and companies and the residential property market has slowed to a 30-year low. Allied to these problems are inflationary pressures on fuel, utilities and commodities.

The downturn will come as a shock to many after a decade of continuous growth but those with longer memories will recall how cycles of economic growth have inevitably led to recession. Businesses must adapt to changing conditions.

Business directors are subject to a barrage of obligations. Within this legally complex world of increasing regulation and scrutiny, a director must tread a careful path. Failure to fulfil duties can lead to civil and even criminal sanction, personal liability and disqualification as a director.

Case law has developed to the extent that directors cannot defend their actions on the basis that they held a genuine belief that the prosperity of the company could be restored by trading through difficulties.

A more objective standard is applied and directors will be punished if they have not acted with proper regard for the interest of creditors.

A director’s overriding duty can be distilled as the basic responsibility to act in good faith in a way likely to promote the success of the company for the benefit of its members. However, if insolvency of the company arises or becomes a possibility, the directors must have primary regard to the interest of creditors.

It is a difficult balance. The Insolvency Act 1986 imposes a duty on directors to take every step expected to be taken to minimise any loss to creditors from the moment a company cannot avoid insolvent liquidation. This does not necessarily mean that a director should cease trading as soon as a company becomes insolvent. Such a step may have disastrous consequences, causing additional loss to the creditors. For example, it may increase employee claims, destroy the goodwill of the business, leave client positions exposed and incur additional liabilities.

The directors should give careful thought to actions which may turn round the business, head off cashflow difficulties and return it to profitability. Steps to be considered may include:

  • Disposing of surplus assets.

  • Changing working methods or practices to increase efficiency.

  • Eliminating unprofitable products or service lines.

  • Introducing additional equity or loan capital.

  • Seeking to reach informal agreements with creditors.

  • Seeking a sale or merger with third parties which have the resources to assist. It is increasingly common to pursue an accelerated merger and acquisition strategy before formal insolvency proceedings.

    Finally, the management should consider whether the structure and personnel of the existing board are best placed to bring a turn-round of the business.

    Turning round a business requires a significant amount of time and effort. Perhaps new blood is needed. Those who have built the business and led it in a certain way might not be best placed to effect a change. Different skills sets are required.

    In continuing to trade and trying to turn round a business, directors need to have regard to the proceedings that could be taken against them in circumstances where the company eventually enters into an insolvency process. Steps that should be taken to avoid potential personal liability may include:

  • Undertaking a full and frank evaluation with fellow directors, questioning whether the business remains viable and documenting the conclusions.

  • Identifying steps to be taken to turn round the fortunes of the business and drafting a business rescue plan which is agreed by all.

  • Evidence that a rescue plan has been implemented and followed while remaining flexible and being prepared to adapt it in light of changing circumstances.

  • Ensuring that accounts are kept orderly and up to date.

  • Ensuring the board meets regularly and receives full information on the state of the company’s trading. If it appears to be facing insolvency, the regularity of such meetings must be increased significantly.

  • Ensuring that creditors are regularly informed – and certainly not misled – regarding the company’s situation. If possible, enlisting the support of key creditors in the continued operation of the company.

  • Keeping careful records and minutes of any decisions taken and remedial action to be pursued.

  • Obtaining advice from specialist legal and accountancy professionals. Guidance from the Department for Business, Enterprise & Regulatory Reform accompanying the new Companies Act instructs directors to get advice from an insolvency professional when in financial difficulty.

    Directors must be aware of the personal liabilities that can arise and the steps that can be taken to safeguard a company, its creditors and themselves. A three-step process should be taken:

    1: Stop

    Think about whether your business is strong enough to withstand a recessionary period.

    2: LOOK

    Review all areas of your business. Are there steps that can be taken to improve its financial strength and avoid insolvency?

    3: listen

    If the company is potentially heading into insolvency, seek out the advice of professionals.

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