Financially Distressed Companies – Issues for Directors
When a company is trading well and things are on-the-up directors often pay less attention to their Companies Act duties. However, when the company is trading badly and potential insolvency looms what issues then arise? This note identifies some of those issues and when a director should act on them.
Trouble Ahead?
Under company law a company is insolvent if it is unable to pay its debts as they fall due. However, the company law issues that directors must be alive to come into play ahead of the point of insolvency during a period often referred to as the “Twilight Zone”. The “Twilight Zone” is the period of time during which the company’s financial stability is compromised to the extent that insolvency is a very real threat or unavoidable.
In the “Twilight Zone” a director’s duties to the company’s creditors come into sharp focus. It is critical that directors identify early that their company is in the “Twilight Zone” and act swiftly. If they fail to do so, in a subsequent winding up the directors might find themselves in the crosshairs for failing to identify impending insolvency.
In the “Twilight Zone” directors may trade out of the company’s financial difficulty while ensuring that sufficient assets are retained to discharge the company’s liabilities. However, as noted below there is an attendant risk with trading in those circumstances.
There is also the option of sourcing external funding. However, directors must be careful to ensure that any such funding is on terms that do not simply heap further difficulty on the company’s already difficult financial position.
Insolvency Offences
In the “Twilight Zone” and when a company is actually legally insolvent, the directors run the risk of committing certain offences which can impose personal liability on them in respect of the company’s liabilities.
Reckless Trading
This offence applies in the context of a winding up or an examinership. The offence’s key element is that the director was knowingly party to the carrying on of the business in a reckless manner. Recklessness is an objective test, but its assessment is tempered by subjectivity due to the presence of “knowingly” in the offence.
A director shall be deemed reckless if: (a) having regard to general knowledge, skill and experience that may reasonably be expected … s/he knew or ought to have known that … his/her or the company’s actions … would give rise to loss for creditors; or (b) debt is knowingly contracted and the director did not honestly believe on reasonable grounds that the company would be able to pay the debt when it fell due for payment as well as all the company’s other debts.
It is essential that a director treads carefully when trading in the “Twilight Zone” as a claim for reckless trading can be brought by creditors (provided they have suffered a loss), contributories (provided they have suffered a loss), a liquidator, an examiner or a receiver.
Failure to Keep Accounting Records
A director failing to take reasonable steps to secure compliance with the Companies Act requirement to keep adequate company accounting records and books, or who has by his or her intentional act been the cause of any default in that regard is guilty of a Companies Act category 2 offence (the second most serious class of offence).
That category 2 offence is raised to a category 1 offence (the most serious class of offence) if the company is wound up and unable to pay its debts and the breach of the requirement to keep adequate company accounting records and books: (i) contributed to the company’s inability to pay its debts; (ii) resulted in substantial uncertainty as to the company’s assets and liabilities; or (iii) substantially impeded the company’s orderly winding up.
Accordingly, in the “Twilight Zone” the requirement to keep adequate accounting records and books is accentuated and becomes even more acute.
Fraudulent Trading – Civil Offence
The key ingredient to this offence is that the director is knowingly a party to the carrying on of the company’s business with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose. The test is subjective as it requires actual knowledge and intent on the director’s part that creditors will not be paid. It is that subjectivity that makes the offence hard to prove. However, there have been successful cases brought against directors. The consequences for committing the civil offence of fraudulent trading can include personal responsibility (without limitation) on the director’s part for all or any part of the company’s liabilities.
Fraudulent Trading – Criminal Offence
The same subjective test applies in respect of the criminal offence of fraudulent trading as it does in respect of the civil offence of fraudulent trading. However, the criminal standard of beyond reasonable doubt must be proved in order for the conviction to succeed. The criminal offence of fraudulent trading is a Companies Act category 1 offence (the most serious class of offence). Conviction can bring significant fines and/or a term of imprisonment.
Fraudulent Preference
Fraudulent preference is the wrongful favouring of one creditor over others by an insolvent company. Any such payment by a company is invalid. It can be difficult for a liquidator to challenge a payment on the grounds of fraudulent preference. For example, payment of a creditor who has simply been diligent about pursuing its debt is not a fraudulent preference.
A company liquidator can engage in a six month look back period for the purpose of setting aside a fraudulent preference. Where the person receiving the payment is a company director or a connected person, a liquidator can look back for a period of two years for the purpose of setting aside a fraudulent preference.
Misfeasance
The offence of misfeasance applies in course of winding up. If a court is satisfied that: (a) any person who has taken part in the formation or promotion of the company; or (b) any past or present officer, has misapplied or retained or become liable or accountable for any company money or property, or has been guilty of any misfeasance or other breach of duty or trust in relation to the company, a court can order repayment by that person of the money or property or any part of it or contribution by that person of such compensatory sum to the company as the court thinks just.
Be Wary
While a director may not doubt his or her own ability to ride out a financial storm, he or she must be mindful of the company’s creditors should the company enter the “Twilight Zone”. There are defenses available to the above-mentioned offences. However, the attendant criminal and civil sanctions, the risk of personal liability for the company’s debts and the potential for restriction or disqualification should focus a director’s mind in ensuring creditors’ interests come to the fore when a company faces financial difficulty.