It feels to me sometimes as if I am living in a B movie right now but I settled for a less racy title than I might have done. “Twilight” is in fact a technical insolvency expression (see below) and these are certainly uncharted times.
In my last blog, I considered the balancing act directors must perform under Section 172 of the Companies Act in respect of a variety of competing interests and how that can become even more difficult in challenging times. Given the speed at which the crisis sparked by Covid-19 is developing, it is perhaps worth examining separately what Section 172 has to tell us about directors’ duties in an insolvency context. Section 172 (3) provides that “The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.”
These “circumstances” broadly speaking exist where a company either is insolvent or is likely to become insolvent. This point is also known as the twilight zone and is when the nature of a director’s duties change with the focus shifting to the need to act in the best interests of the company’s creditors and to maximise the value of the assets of the company in the interests of those creditors. There is a well-established and comprehensive insolvency regime in the UK governed by the Insolvency Act 1986 and a host of associated legislation. I don’t intend to summarise that here but set out below instead some practical tips with a focus on directors’ duties.
The first challenge can be in knowing precisely when a company is likely to become insolvent. While courts are likely to be sympathetic to directors who make good faith judgments about the competing interests of creditors, they are much less likely to look favourably on board decisions based on incomplete or inaccurate management information. It is essential that accurate books and records including up to date management accounts exist and are maintained and updated.
Secondly, accurate management information must be considered appropriately by the board. Much will depend on the nature and size of the company and the seriousness of any cash flow issues which may exist. It may for example be sensible to appoint a sub-committee of the board to meet even on a daily basis with regular updates to the board as a whole. Such an approach would be consistent with the well-recognised English law principle that although directors may delegate executive functions they cannot delegate their supervisory duties.
Thirdly, an understanding of the various different insolvency mechanisms and their potential effect would be highly desirable. For example the consequences for creditors of administration may be very different from a voluntary arrangement or voluntary winding up let alone compulsory liquidation. Seeking professional advice on this issue from lawyers and accountants may be prudent even before the point at which insolvency is likely since it will allow for better informed decision making.
Fourthly, the duty on directors may involve weighing up a series of competing interest among creditors. Most typically, the interests of secured creditors may not be aligned with those of the company’s unsecured creditors but even individual creditors’ interests may diverge. Timing here is also key. The usual advantages of administration which enable a business or part of it to be sold off or rescued may be less applicable if no market or potential buyers exist in a crisis such as this.
Fifthly, directors need to be wary of taking steps aimed at avoiding or delaying insolvency which, though successful, attract potential liability. There is a duty under section 239 of the Insolvency Act to avoid allowing the company to enter into any transactions outside the ordinary course of business if they would either have the effect of preferring any particular creditor over others or diminish the net assets of the company available to its creditors. The question as to what constitutes the “ordinary course of business” is an open one in the current crisis.
Finally, directors should carefully document and/or minute their decision-making process. It is worth remembering that if a company is unfortunate enough to go insolvent the liquidator is under a statutory duty to investigate the causes of the insolvency and in that context they are almost certain to want to examine and understand the board’s decision making process.
Conclusion
Following the practical steps identified above may help directors to mount a robust defence in the event that they face a post insolvency claim or investigation. The importance, in that event, of having access to good Directors’ and Officers’ insurance to fund such a defence is a subject about which I have written before here. In a subsequent blog I will consider some of the weapons in the insolvency practitioner’s arsenal of which directors would also do well to be aware. To finish on a brighter note, I think in the future when courts are inevitably asked to examine how competently directors performed their duties in these extraordinary times they will be careful not to apply hindsight and will judge based on what was known or could reasonably have been found out now rather than by reference to outcomes.
