Guidance for Directors

The Duties of Directors of Troubled Companies

Anyone who fulfils the role of a director in these days of increased regulation and a much sharper focus on corporate governance will be aware that the duties and responsibilities they bear are onerous. This is never more true than for a company struggling with difficult cash flow and trading conditions. The wish to preserve the business has to be balanced against the risks of failure and the ensuing criticisms and penalties that may result. So how should directors act to best protect themselves?

It is sometimes said that “throwing in the towel” is the safest option, although resigning does not release directors from liabilities or protect them against criticism. However, it is undoubtedly true that directors trading on a company in difficulties or perhaps even technically insolvent must be continually aware of their responsibilities and ensure they follow a sound methodology in taking the business decisions they face.

The General Duties of Directors

Directors have duties and responsibilities to the company and these include:

A fiduciary duty to use their powers for proper purpose and act in the best interests of the company and the shareholders as a whole.
A duty to act with proper care, skill and diligence in carrying out their functions as directors having regard to their own level of knowledge, skill and experience.
A duty to acquire and maintain a full understanding of the business, its current position and circumstances.

Companies in difficulties may be technically insolvent or prospectively insolvent and in such circumstances, the primary duty is owed not to the shareholders but to all the creditors of the company.

The Risks Directors Run

Continuing to trade a company which subsequently fails can lead to disqualification from acting as a director and an action for wrongful trading. A successful wrongful trading action will lead to the director personally contributing to the company’s deficiency.

The law also expects directors in such circumstances to protect their creditors and the Checklist for Directors sets out the main areas where directors’ conduct will be reviewed.

Continuing to Trade

The key issue for directors is whether they can continue to seek a turnaround in their company’s fortunes. To understand the thought process they should use it is helpful to look at the concept of wrongful trading.

This enables a liquidator of a failed company to look back and ask whether the directors of that company continued to trade when they knew or ought to have known that there was no prospect of their company avoiding liquidation. It should be noted that by asking what directors “ought to have known” the law is applying an objective test having regard to the skills and experience expected of directors fulfilling similar functions.

In determining whether or not there was a “reasonable prospect” of avoiding liquidation, the test is comparing the directors’ actions against those of a reasonably diligent person, having both the general knowledge, skill and experience that could reasonably be expected of a person carrying out the same functions as are carried out by that director for that company and the general knowledge, skill and experience that the particular director possesses.

Thus, professionally qualified directors will be judged by a higher standard than others. Conversely, directors will not escape liability by arguing that their specific role meant it was reasonable for them not to have a knowledge of the overall position of the company.

Non-executive directors, part time directors, de facto directors and people on whose instructions the directors are accustomed to act have the same duties and responsibilities as all other directors. A person joining the board to assist a turnaround will still be treated as a normal director.

If accused of wrongful trading, directors are able to mount a defence and that is that on becoming aware of there being no reasonable prospect of avoiding insolvent liquidation, they took every step that a reasonably diligent person would have taken in attempting to minimise the potential loss for creditors.

So How Can Directors Best Protect Themselves?

The following critical procedures are those we would always recommend be followed for a company facing an uncertain future, even if the tests for wrongful trading have not been triggered.

The need to have a clear strategy for the company going forward supported by the appropriate documentation, such as budgets and cash flows, indicating that there is a reasonable prospect of a turnaround of the company’s fortunes being achieved.
If this turnaround requires change within the business such as a new line of financing or a sale of a whole or part of the business, then have clear documentation of the decisions taken and the actions pursued by the board in order to effect those changes.
The board should consult with professional advisers about the viability of the company.
Hold regular directors’ meetings to review the situation and evidence the decisions taken by way of minutes
Ensure that all members of the board have regular access to up to date financial information.
It is very clear that directors cannot evade responsibility either by leaving decisions to others or by resigning.

Will I Be Safe?

In the event that the rescue strategy is unsuccessful and the company fails, the conduct of the directors will be looked at and a brief resume of the matters that will be reviewed is set out in the Checklist for Directors.

Case law on directors’ disqualification over the last few years has shown that judges are usually unwilling to second guess commercial decisions taken by boards of directors who have followed the procedures set out above and who are able to demonstrate that in continuing to trade they did so acting reasonably and with a clear focus on their responsibilities to the company’s creditors.

Conclusion

Many companies have to operate at some time in their corporate life within the “danger zone” but with clear, realistic strategies and objectives and a well organised and documented approach, the board of directors of such a company should be able to demonstrate, even in the case of ultimate failure, that they have properly discharged their duties and responsibilities. In a group structure it will be necessary for each board of directors to consider separately the position of each company.

Whilst this guidance note is designed to alert directors to their duties and the approaches to take to issues they face, it cannot be construed as legal advice. We recommend that a board of directors take legal advice on their specific circumstances and we are always very happy to meet with Directors for an initial consultation on a free of charge basis.

If you would like further information, please feel free contact us.