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Keep the creditors happy

Company directors should be aware of the duties that fall upon them in hard times. By Glen Flannery

It is just over one year since the US sub-prime credit bubble burst. In the period since, the UK economy has taken a remarkable change in direction – the housing market in particular.

Faced with falling sales and increasingly stringent lending criteria, many major housebuilders have resorted to cutting supply-side payments to control cashflows, such as Taylor Wimpey, Barratt, Bellway and Bloor.

Others have needed more intensive care, such as Chase Midlands, which is in administration. As the economy causes a domino effect through the supply chain, many suppliers, subcontractors and others in the sector are also feeling the pinch.

Call the creditors

If you are a director of one of these companies you will have enough to think about, but if you want to protect yourself there is one additional thing that you should put near the top of your list – the company’s creditors.

When a company’s solvency is in question, the law requires the company’s directors to shift their attention from the company’s shareholders towards protecting the interests of its creditors.

It is generally accepted that this duty to creditors comes into play when the company is insolvent, on either a cashflow or a balance-sheet basis.

A company should be considered cashflow insolvent if it cannot pay its debts as they fall due or (following recent case law) if it is unlikely to be able to pay future debts. A company should be considered balance sheet-insolvent if its liabilities (including contingent and prospective ones such as guarantee liabilities and hire purchase obligations) exceed its realisable assets.

There is another point, typically further down the financial decline curve, where directors need to be even more cautious, because strictly defined statutory duties come into play – the wrongful trading provisions.

This is the point at which they know or ought to conclude that there is no reasonable prospect of the company avoiding an insolvent liquidation.

From this point, directors are under a positive statutory duty to take every step available to them to minimise potential loss to the company’s creditors.

If the company subsequently folds into a formal process such as administration or liquidation, the appointed insolvency practitioner is required to investigate and report on the directors’ conduct in the twilight period – that is, the period between the onset of insolvency and the start of the administration or liquidation.

If he/she discovers that the directors did not act in creditors’ best interests from the onset of insolvency, or that they traded wrongfully, the practitioner can bring claims against them personally, for the benefit of creditors.

More penalties

Additionally, the insolvency practitioner is required to report to BERR (the Department for Business Enterprise & Regulatory Reform), which can bring disqualification proceedings to prevent culpable directors from acting as directors for any period up to 15 years.

It is sometimes said that delinquent directors always get away with it. While this may be open to debate, it is worth remembering that many claims are not widely reported because they settle out of court and are made subject to confidentiality.

But they do happen where creditors left high and dry look for another pocket from which to be paid. As a practice, we are regularly required to prosecute and defend breach of duty claims against directors, claims which it is increasingly easy to bring, given innovations in litigation funding. As for BERR, published figures show that for 2007-8, there were 1,145 disqualifications.

Glen Flannery is a partner in Nabarro LLP’s banking finance & restructuring group


Every case will require something different, but there are some practical steps of general application which directors of financially troubled companies can follow to mitigate against personal claims.

  1. The first is to regularly review the company’s financial and trading position by reference to up-to-date accounts and projections, to assess whether the company is technically insolvent on either a cashflow or balance sheet basis (in which case creditors’ interests should prevail) or at the point of wrongful trading (in which case every possible step must be taken to minimise loss to creditors). For this it may be necessary to produce management accounts on a more frequent basis with professional help.

  2. Assuming insolvency, regular board meetings should be held to evaluate all options available to protect and, where possible, improve the position of creditors as a whole. This should include consideration of whether a formal insolvency process would assist or prejudice their position. Good records should be kept of board decisions and the rationale for making them in the interests of creditors. This will serve as defensive evidence, should a claim be brought.

  3. Where trading continues, new credit should not be incurred without proper regard to how it will be discharged. Where a restructuring/rescue is pursued, there should be a contingency plan in case it fails, with due consideration to when it should be implemented. Preferences and transactions at undervalue should be avoided.

  4. Additional protection can be achieved by taking professional advice from legal and financial advisers accustomed to advising directors of distressed companies – and following that advice. This is by no means exhaustive, but following these steps should greatly reduce the risk of personal claims and disqualification.