Potential Implications of Insolvency for Directors

Here is a note of the issues that a director of an insolvent company or potentially insolvent company has to take into account. The relevant legislation is primarily contained in the Insolvency Act 1986 (the "Act").

Definition of Insolvency - Section 123 of the Act states that a company is "unable to pay its debts" (i.e. it is insolvent) when the company is unable to meet its debts as and when they fall due. This is commonly referred to as a "Cash Flow Insolvency"; or
the amount of the company's liabilities (including its actual and contingent liabilities) exceeds the value of its assets on a balance sheet basis. This is commonly referred to as a "Balance Sheet Insolvency".
Where a company is or is about to become insolvent its directors must act in the best interests of the company's creditors (as opposed to the company's shareholders) and there are certain corporate and personal consequences for those directors if they fail to do so.

The Corporate Consequences of Insolvency

Preference claim - A preference is a transaction which has the effect of placing a creditor in a better position if the company goes into liquidation than if the transaction had not occurred. If the transaction occurs within six months of the company's liquidation, the liquidator can apply to have it set aside but he must prove that the directors in entering into the transaction were influenced by a desire to produce the preferential effect. In the case of a transaction with a creditor who is a connected person (for example any of the company's shareholders, subsidiaries or directors) the period of six months is extended to two years and it is also presumed (unless the contrary can be proved) that there was a desire to prefer the creditor. A classic example of a preference is where the company repays its inter-company debts or director's loan accounts ahead of its other creditors shortly before its liquidation. However paying a creditor who has refused to make further supplies may not be a preference if the primary purpose of the payment was to secure supplies which could not be obtained elsewhere.

Transactions at an undervalue

A transaction at an undervalue occurs when a company disposes of its assets for significantly less than they are worth. Once again, a liquidator can apply to have the transaction set aside if it occurred within two years of the company's liquidation. A classic example of a transaction at undervalue is where the company transfers its business and/or assets to a creditor, director or another party for a nominal amount. If you are considering a transfer to say a current client or any other third party it is important to ensure market value is paid and/or the transfer insured against set aside.

Personal Consequences of Insolvent Liquidation

Wrongful Trading - Section 214 of the Act states that, if the directors (including any shadow directors - see below) of a company allow it to continue trading when they knew or ought to have known that there was "no reasonable prospect" of the company avoiding insolvent liquidation (see 1 above), they can be held personally liable for the debts incurred. A shadow director is a person, or entity, who has effective control over the company's board (i.e. the company's directors are accustomed to act in accordance with that person's instructions). The only potential defence available to the directors is to show that they took every possible step to minimise the potential loss to the company's creditors. It is not sufficient to show, for example, that the directors believed that the company's financial situation might improve because of market forces that are beyond their control [MC Bacon Limited [1990]].

The directors may be able to justify trading for a short period of time if they are:

Trying to sell the whole or part of the company's business and/or assets as a going concern; or
awaiting a decision regarding further funding (for example by the shareholders or by a venture capitalist).
In these circumstances the directors should: investigate whether the company's overheads and operating costs can be reduced; only pay the creditors that are crucial to the preservation of the business and assets (e.g. essential supplies, employees salaries, and judgment creditors who are about to or have taken "key" assets);
postpone all other payments; not incur any new liabilities (except for immediate payment in cash