The number of UK companies in critical financial distress increased by over 25% in the fourth quarter of 2023, compared to the previous quarter, impacting more than 47,000 businesses.[1] Given high interest rates and inflation, it’s likely a number of those businesses will enter insolvency this year. In the current climate, it is therefore important that directors are familiar with their duties and how these may change if their company is facing financial difficulties.
The directors of a company owe various duties, first and foremost to the company itself. The duties owed to the company are generally accepted as duties owed to the company’s members, as they are the ones who stand to lose out in the event of a breach. Historically, those duties have been based on the decisions of the courts. However, following the introduction of the Companies Act 2006 (CA 2006), many of these duties were placed on a statutory footing. In particular, a number of duties owed by directors are codified in sections 171 to 177 CA 2006.
It is important to note that registered directors are not the only people who may owe directors’ duties. Duties are also owed by those who perform the role of director (albeit without that title) and those in accordance with whose instruction the directors are accustomed to act. No distinction is drawn between executive and non-executive directors.
There are a whole range of duties owed by directors to their company. However, two of the key ones we see being litigated are as follows:
When assessing whether a director has complied with this duty, regard will be had to the level of skill and expertise you would expect someone in the director’s position to have. It is not a defence for a director to claim they did the best they could, but lacked the necessary skills. Therefore, directors should be careful to ensure they possess the necessary skills and experience before taking up the position and/or should seek appropriate support (e.g. from professional advisors) to ensure they can meet the standard expected of them.
Any additional skills or experience possessed by a director will also be relevant in assessing compliance with this duty. Therefore, if, for example, a director has a background as a trained accountant or lawyer they will be expected to meet a higher standard in areas where that experience is relevant. Accordingly, directors should be careful to ensure they utilise any additional skills and experience they have, instead of simply pleading ignorance.
There are two limbs to the duty to avoid conflicts. One limb concerns dealings by the director with the company, for example, the director buying an asset from the company. The other limb concerns taking up opportunities at the potential expense of the company, for example a director buying some land after discovering that it was up for sale in the course of their role as a director.
It is worth noting here that a director may seek authorisation from the members of the company before taking any action in accordance with the terms of the company’s constitution. Where authorisation can be obtained, this should be done in advance of any dealings and should be properly documented.
The duties owed by directors are generally owed to the company itself (i.e. to the members). However, in circumstances where the company is facing financial problems, these duties can migrate and regard must be had to the position of the company’s creditors, either instead of or as well as the company. In BTI v Sequana, the Supreme Court considered in detail when a duty to creditors will arise. In short, as a company gets closer to insolvency (either on a cashflow or balance sheet basis) greater weight must be given to the interests of the company’s creditors. The rationale for this is that once a company is insolvent there is technically no longer any value in the company for members and therefore it is only the creditors who stand to benefit or lose out as a result of the decisions made by directors.
Insolvency is also significant in relation to directors’ duties as, once a company has entered a formal insolvency procedure (e.g. administration or liquidation), the office holder (IP) appointed will review the conduct of the directors in the period leading up to the IP’s appointment. In the event that directors’ conduct is found to be lacking the required standard, the IP may either seek to pursue a claim for the recovery of damages, or provide a report to the Insolvency Service which could result in disqualification proceedings being pursued by the Secretary of State.
As the financial outlook of a company deteriorates, its directors should also consider potential liability under the wrongful trading regime. Whilst not a duty in a strict sense, wrongful trading imposes personal liability on a director in the event of a breach, and accordingly, it is prudent for directors to consider the position. A director may be liable for wrongful trading if they allowed the company to carry on trading beyond the point where they knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation or administration (the ‘reasonable prospects’ test). Directors of companies facing financial difficulties should, therefore, as a matter of course, consider the reasonable prospects test at regular intervals, and again on the occurrence of any event likely to change the financial outlook of the company, in order to assess whether reasonable prospects remain. If there is any doubt in this regard, professional insolvency advice should be sought as soon as possible.
As the possibility of insolvency increases, directors should consider both the interests of creditors and the reasonable prospects test regularly. Any decisions taken, along with the reasoning behind them, should be carefully documented and directors should seriously consider whether it is appropriate to take professional advice.
Whilst the above article provides an overview of some key issues and useful tips to address them, it does not cover all of the issues which may arise, along with many of the various complexities arising as a result. If you have any queries relating to the content of this article or directors’ duties more generally, please contact Emily Reeve or Hamish Scott.
[1] According to a report by Begbies Traynor.
