Directors in the Twilight Zone

Directors of limited companies have a primary duty under section 172 of the Companies Act 2006 to promote the success of the Company. In respect of conventional limited liability companies, this usually means making sufficient profit acting in the shareholders best interests to exclusion of most other groups or categories all stakeholder in the company.

One crucial point for all company directors, and indeed shadow directors, to be aware of is that when their company reaches a point where it is insolvent and unlikely to avoid an insolvent liquidation or otherwise then directors duties shift and they must then act in the best interests of the creditors of the company rather than its shareholders.

The above has always been the historic position in case law that has evolved over the years. The Companies Act 2006, which supports The Insolvency Act 1986, puts this in the statutory form.

If a director breaches such a duty to the creditors he’s breaching not only his fiduciary duties but also rendering himself or herself liable to insolvency proceedings by the liquidator for misfeasance and all wrongful trading and possibly fraudulent trading. There is also the possibility of directors disqualification proceedings by the Insolvency Service.

The twilight zone is not addressed by legislation but has been addressed by case law over the years. It defines the final period of the company’s trading before and insolvency appointment of one form or another. From a legal perspective it is often quite difficult to precisely identify when a company has become insolvent thereby triggering the above duties. In reality, a sensible director will know when his or her company is facing financial difficulties that could possibly result in the company being placed into one of the forms of insolvency being a corporate voluntary arrangement, a creditors voluntary liquidation, a compulsory liquidation or administration.

There are various reasons why a company could be entering the twilight. Indeed it could be just one reason, such as the catastrophic loss of a major customer. Other causes are poor cash flow management, adverse trading conditions, management failings, loss of key staff and so forth. This list is not exhaustive.

A sensible director should seek advice from a specialist solicitor and or  licensed insolvency practitioner as soon as he or she suspects that the company may have entered into the twilight zone. Seeking such advice is generally seen by the courts as a sensible step for the director to have taken and therefore goes to his or her credit in the face of an action against them by a liquidator or administrator.

Liquidators and administrators are given considerable powers and remedies to seek recovery of any assets distributed by the director(s) when transferred as an undervalue and or as a preference. If assets are distributed by director on an arm’s length basis for proper consideration then the director is unlikely to have contravened the relevant statutory provisions. It may well be appropriate for a director to obtain advice from a specialist solicitor or licensed insolvency practitioner in relation to proposed transactions.

The majority of the duties imposed by The Companies Act 2006 relate to how directors act in order to protect third parties and in particular creditors. One specific point to make is that the courts take a particularly dim view of directors using the benefit of limited liability to prevent HMRC from being paid what is due to them

Director has a duty to manage each and every situation and also be able to justify decisions at a later stage should matters deteriorate into a formal insolvency appointment. However it should be remembered that companies are often insolvent, particularly at the beginning of trading, so it is a matter of managing it on the way forward and having a realistic strategy for the company’s future success which in turn will determine the viability of any plans and the justification for any decision to continue trading.

The director should also bear in mind at all times that where the company is insolvent and it is only possible to perceive that the situation will get worse then the companies directors have to pay very close attention to the detail and be most careful when making decisions which could ultimately lead to them bearing personal liability for some of the indebtedness of the company to third party creditors.

One thing not to is simply ignore the situation. Another mistake sometimes made by directors is to think that they know best and there was little or no point in seeking independent professional advice.

The circumstances leading to a company being in the twilight zone are too numerous to list and it is for the director is to be aware as to when such events have happened or are happening thereby altering their responsibilities from shareholders to the creditors.

A properly run company would have made provisions for entry into the twilight zone, especially if it is audited regularly, and that may include relevant insurance policies such as key man and credit so as to hopefully mitigate any potential risks.

If in doubt, seek advice.

To ask a question, please contact Richard Curtin, Head of Insolvency & Restructuring: [email protected]  or 0207 822 2222