A Guide To The Potential Liability of Directors of Insolvent Companies
SECTIONS 127 AND FOLLOWING OF THE INSOLVENCY ACT 1986
The Insolvency Act 1986 (“IA”) as amended contains provisions designed to assist the pari passu (i.e. equal, by category) distribution of the company’s property to its creditors. Key provisions relating to a liquidator’s ability to recover company property from directors are as follows (a broadly similar regime operates in the case of company administrations).
Effect of the petition on the directors’ powers of management
The winding up of a company is generally deemed to commence at the time of issuing the winding up petition, and not on the subsequent making of the court order to wind up (section 127 IA). The purpose here is to prevent directors from disposing of company property to the prejudice of creditors. Dispositions of the company’s property, whether in the course of carrying on business or otherwise (and unless subsequently validated by the court) will generally be void if a winding up order is made. If the property is not recovered, the directors may be personally liable to reimburse the insolvent estate.
Effect of making the winding up order
A compulsory winding up order has the effect of terminating the appointment of directors and their powers as directors.
Liquidator’s powers of investigation
Liquidators have powers to require directors to provide information. This is not only to assist them to get in the assets of the estate and identify liabilities but also to identify the causes of the failure of the company and, if considered appropriate, to pass evidence to the Secretary of State or prosecuting authorities, with a view to disqualification or criminal proceedings.
Thus, directors and other specified persons are under a duty, on notice, to provide a statement of affairs. There are civil and criminal consequences for default. Directors may also be obliged to produce accounts for up to the three previous years and information concerning the promotion, formation, dealings, affairs and property of the company.
Directors and former directors, whether resident in the jurisdiction or abroad, can also be required to attend court for public examination.
It is the responsibility of the liquidator to take the company’s property into their possession or control. The directors and certain other third parties are under a duty to cooperate with the liquidator and must therefore hand over the company’s books, papers and records.
The liquidator can apply to the court to require the attendance of any person within the jurisdiction known or suspected to have in his possession any property of the company or who is supposed to be indebted to the company, or any person who the court considers capable of giving information concerning the business dealings, affairs or property of the company, and to produce any records in their possession or control relating to such matters (s. 236 IA). In making such an application, the liquidator will be acting as agent of the company, such that a legal adviser of the company prior to the winding up is unlikely to be able to resist on the grounds of privilege.
Directors’ Liabilities in Insolvency Proceedings
Liquidators have the power to bring proceedings in the name of the company against directors for breach of fiduciary and other duties, to recover company property in their possession or control, or to recover debts owed to the company. Remedies are available for the following actions of directors:-
Wrongful Trading when insolvent liquidation is unavoidable – The court is given power to order a person to make a contribution to the company’s assets if (a) the company has gone into insolvent liquidation, (b) at some time the person knew or ought to have known that insolvent liquidation could not be avoided, (c) at that time, the person was a director and (d) the court is not satisfied that after that time the person took every step with a view to minimising the potential loss to the company’s creditors as they ought to have done (s.214 IA). Whether a director ought to have known that insolvent liquidation could not be avoided is treated as a question of objective fact. However, the question is not to be approached with the benefit of hindsight. The cases in which directors have been held liable are typically those in which they closed their eyes to the reality of the company’s position, or failed to maintain accounting records compliant with UK legislation.
Even persons who are “sleeping” directors are subject to the above test, which in effect requires reasonable diligence.
Fraudulent Trading –This provision may be invoked in similar circumstances to the above, save that establishing the liability of the director is more onerous for the liquidator, who must satisfy the court that the individual concerned was knowingly a party to carrying on the business of the company with intent to defraud creditors, or for any other fraudulent purpose (s.213 IA). A finding of actual dishonesty is required.
Unlike the provision for Wrongful Trading, the provision for Fraudulent Trading was not temporarily suspended during the covid pandemic.
Transactions at an undervalue – Under this provision, the liquidator may apply to the court for an order where the company, within two years of the onset of insolvency and at a time when the company was unable to pay its debts, entered into a transaction with any person at an undervalue (ss.238-41 IA). There is a presumption of inability to pay debts where the transaction was with a ‘connected person’. However, the court may not make such an order if it is satisfied that the company entered into the transaction in good faith for the purpose of carrying on its business and at the time there were reasonable grounds for believing that the transaction would benefit the company. An example of this might be selling a property at less than its full value to raise working capital.
The finding that a company was unable to pay its debts at some earlier time than its entry into liquidation has additional consequences for directors. They will have been required to take account of the interests of creditors at that earlier stage (s.172 Companies Act 2006) and may not have the effective protection of a resolution of the members ratifying their conduct.
Preferences – Under this provision, the liquidator may apply to the court for an order where the company has, within two years prior to the onset of insolvency in the case of a connected creditor, or six months in the case of other creditors, done anything which has the effect of putting that creditor into a better position in the event of insolvency than they would have been in if the action had not been taken (s.239 IA). However, the court may only make such an order if the company was, in so acting, influenced by a desire to produce this effect. This is presumed in the case of connected persons, other than employees.
Public policy to facilitate the pursuit of claims for the benefit of unsecured creditors – Where there is a floating charge relating to property of a company in liquidation and the liquidator brings a claim under any of the provisions mentioned above, or assigns (i.e. sells) a claim of such a nature, the proceeds of the claim or assignment are not to be treated as part of the net assets available to satisfy the claims of holders of debentures secured by floating charges (IA s.176 ZB). In terms of calculating the level of contribution to be made, the starting point is to ask whether, as a result of the director’s wrongful act, there was an increase or reduction in the net deficiency of the company as regards unsecured creditors – Re Ralls Builders Ltd (2016).
The “misfeasance” provision – Under this provision, if, in the course of a winding up, it appears that a person who is, or has been, an officer of the company has misapplied or become accountable for any money or other property of the company, or been guilty of any misfeasance in the nature of a breach of trust, or negligence or other breach of any duty in relation to the company, the court may, on the application of the liquidator, a creditor or a contributory examine into the conduct of the person and compel them to restore the property with interest or contribute to the company’s assets by way of compensation (s.212 IA). Misfeasance applications can potentially be available where the complaint is that there was a failure to have regard to the interests of creditors.
There is the possibility of pursuing this remedy on a shortened procedural basis. Liquidators may assign this power to anyone willing to pursue the claim.
Transactions defrauding creditors – Rather than assisting the pari passu distribution of the company’s property, the purpose of this provision (under s.423 IA) is to protect creditors from fraud. Upon an application by a liquidator or a victim of the transaction, the court may set aside the transaction or otherwise protect the interests of the victim, where it is satisfied that a purpose of the transaction was to put assets beyond the reach, or otherwise to prejudice, the interests of the victim. Rather than the shorter time periods in the case of the remedies referred to above, the time periods under the Limitation Act 1980 apply.
If a director causes the company to dispose of property in circumstances to which s.423 applies, it is likely that they will have breached their duties to the company and will be liable to compensate for any loss.
For more information contact Wendy Miles, Chris Earl-Anderson or William Sturge at Lovetts.