The world economy is in a fragile state. China, with its zero-coronavirus (COVID-19) policy, continues to prioritise domestic healthcare over its role as the capital of global production. This has led to unprecedented deglobalisation of supply chains, while increasing geopolitical tensions have placed further strain on the interdependencies of the US and Chinese economies.
Meanwhile, the war in Ukraine has precipitated an energy crisis in Europe, propelling inflation to its highest level since the 1980s. Monetary policy is stepping in with interest rate rises to counter these inflationary pressures, stretching companies with already stressed balance sheets, some of which had become accustomed to the era of low interest rates that came out of the financial crisis.
Against this deteriorating backdrop, company directors must navigate an increasingly intricate web of obligations, duties and regulation. Some are old and others will be new to even seasoned directors. But in times of stress where there may be a real concern about the financial health, solvency or viability of the company, directors must take a step back and look at the wider picture, keeping in mind how the decisions they take will impact the company they serve and their personal position.
Key issues facing directors of distressed companies
The creditor duty. English law imposes a duty on company directors requiring them to act in good faith to promote the success of the company for the benefit of its members (shareholders). However, as insolvency approaches, directors also have a duty to consider the interests of creditors. In legal terminology, this is referred to as the creditor duty.
In October 2022, the UK Supreme Court confirmed the existence of the creditor duty and provided clarification on when it will arise. Despite this confirmation, pinpointing the moment in time when the creditor duty is engaged is not straightforward and requires ongoing monitoring of a company's financial position and analysis by boards and their advisers.
When is the creditor duty engaged? The creditor duty is engaged when a company is or is likely to become insolvent. Once engaged, directors must start to consider the interests of shareholders and creditors. If the company's solvency deteriorates, the directors must pay more attention to the interests of creditors. If an insolvency process, such as an insolvent administration or insolvent liquidation becomes inevitable, then directors must treat the interests of creditors as paramount.
Wrongful trading. Wrongful trading liability can arise when a director continues to trade a business when there is no reasonable prospect of avoiding an insolvency process. It applies to current and former directors. When directors know (or ought to conclude) that an insolvency is inevitable, they must take every step to minimise losses to creditors. Directors found to have committed wrongful trading can be disqualified and held personally liable for the losses suffered by creditors.
In June 2020, in response to the pandemic and economic uncertainty, the UK government suspended liability for wrongful trading. This suspension has now been lifted. Directors once again need to navigate this risk among what are predicted to be challenging market conditions.
Who is a director? Given the liability risk, it is vital that individuals understand whether they are a 'director'. This may be obvious. For example, an individual may have been appointed as and hold the title of director. However, the duties will also apply to anyone who exercises the function of a director. This is the case even if they have not been formally appointed as a director, for example: (i) 'de facto directors' - a person who has assumed responsibility to act as a director even if not formally appointed; (ii) 'shadow directors' - a person who, while never formally appointed by the board, gives instructions that the board follows; and (iii) 'nominee directors' - essentially, an appointed director who acts in accordance with the instructions of another person.
The key takeaway is that even if you are not formally appointed as a director, but are in effect performing the role of a director, the director's legal duties may still apply to you.
Criminal liability under the Pension Schemes Act 2021. The recently enacted Pension Schemes Act 2021 is focused on protecting pension scheme members. This Act includes new criminal offences for those who put defined benefit schemes at risk. Fines can also be imposed on directors who provide false and misleading information to The Pensions Regulator. The regulator has shown that it is increasingly willing to investigate and take enforcement action against company directors who engage in conduct that harms the interests of scheme members.
New 'pre-pack' regulations. A 'pre-pack sale' is an agreement where a sale of all or part of a company's business and assets is negotiated prior to the appointment of an administrator who, immediately following his or her appointment, effects the transaction. While a useful tool to enable the continuation of a business, these sales have also been criticised due to a concern that they lack transparency and operate to the detriment of trade creditors. In some cases, these transactions involve the sale of the business to a new company which is owned by the same directors or shareholders (referred to as a 'connected' sale). Changes made to the law in 2021, under the Administration (Restrictions on Disposal etc to Connected Persons) Regulations 2021, now require that any such connected sales are reviewed by an external evaluator who will opine on the fairness of the transaction.
Environmental, social and governance (ESG) factors. ESG concerns now form part of a board's considerations, in some cases standing as a key performance measurement for directors. Coordinated action by activist shareholders and other special interest groups means that companies and company directors face a real litigation and reputational risk if found (or alleged) to be failing to meet their ESG commitments or found to be 'greenwashing'.
The increased community focus on ESG may also spark the interest of insolvency officeholders. For example, if a company has been fined for disregarding environmental regulations (and contrary to its own ESG commitments) an insolvency officeholder may investigate if the directors have breached the creditor duty. Further, allegations that the company has engaged in 'greenwashing' may prompt the insolvency officeholder to investigate these claims and consider if any fraudulent activity has occurred.
New money. Distressed companies need money. However, directors must carefully consider the need to incur new liabilities. Directors should ensure there is a clear business need and a reasonable prospect of being able to repay the debt.
There are two types of distressed funding which have been seen in the US market but are less common across Europe: 'asset drop-downs' and 'uptiering'. These are complex transactions which take advantage of 'cov-lite' loan documentation and may be attractive for the company to provide much needed financing and to deleverage outside a formal proceeding. However, directors should carefully consider the merits of the relevant transaction and whether it is consistent with the director's legal duties. A transaction that may be in the interests of one group company may not be in the interests of another and directors should be mindful that each entity may have different stakeholders with different interests. These transactions have been the subject of ongoing litigation in the US.
Crown preference. When a company becomes insolvent its assets are sold and the proceeds are applied to creditors in accordance with a concept known as a 'waterfall'. Unsecured creditors rank toward the bottom of this waterfall, and with some exceptions, are paid after both fixed and floating charge holders and the amounts due to insolvency practitioners are paid in full. Until recently, amounts owed to HMRC were categorised within this unsecured creditor bucket.
Now, amounts owed to HM Revenue & Customs (HRMC) in respect of VAT and certain other debts enjoy preferential status. This means these debts rank in priority to floating charge holders and unsecured creditors. This increases the assertiveness of HMRC in negotiations with an insolvent company and may give HRMC a louder voice in restructuring negotiations.
Guidance for directors
So, what can directors do when tasked with steering the ship of a financially distressed company? The good news is that there are some basic steps boards and individual directors can and should take to ensure these risks are managed, while making effective decisions that serve the interests of stakeholders and the business.
Professional advice. It is vital that the board seeks legal and financial advice on a regular basis. Individual directors can also seek their own independent advice if they have concerns with a course of action the board is taking.
Information. Directors should ensure they have access to the key financial information of the business. Up-to-date cash flows and accurate summaries of the group's assets and liabilities will allow management to make informed decisions.
Conflicts. If individual directors sit on a number of boards, they should consider if this gives rise to any conflict of interest (perceived or actual). Directors must remember they owe their duties to each company's shareholders and creditors, rather than the corporate group or its stakeholders as a whole.
Resignation. Resignation should be carefully considered. When a director resigns they are no longer able to assist the company. Directors managing a company in financial distress must focus their efforts on minimising loss to a company's creditors to protect themselves against wrongful trading claims. It is impossible to do this if the director has resigned (and wrongful trading applies to current and former directors).
Board meetings. Board meetings should be held regularly. If financial conditions worsen, then meetings should be held more frequently (even daily when facing insolvency). These meetings should always be properly minuted. This will help the directors prove that they have complied with their duties.
Engagement. If it looks like a debt will not be paid on time, directors should engage with those creditors as soon as possible. Early engagement will increase the chances of agreeing a solution and avoiding insolvency. Indeed, engagement will reduce risks of breach of the creditor duty where creditors are actively canvassed on their preferred course of action for the distressed company.
The decision to stop trading. Directors must review whether the business should cease trading. This is a finely balanced decision. If a viable path to recovery is not possible, trading may have to stop immediately to avoid incurring further liabilities that cannot be met. Equally, a decision to stop trading made too early may increase losses to creditors.
Review transactions. Transactions entered into by the company in the lead up to insolvency can be problematic for directors. An insolvency practitioner will review these transactions once appointed and consider if they were made to prefer a particular creditor or if they were made for fair value.
If a director authorises a transaction that is later challenged by an insolvency practitioner and reversed by the court, the director may be held to be in breach of their duties to the company.
D&O insurance. Even where directors do not anticipate litigation, they should ensure that the company has adequate protection in place to meet vexatious claims and defence costs.
Conclusion
As we approach the downturn, even experienced directors face new challenges and an evolving landscape of legal risk. But if managed appropriately, and with the right advice, directors can take effective and well-informed decisions that will drive recoveries for stakeholders and insulate them from the prospect of future claims and liability.
Previously published in Financier Worldwide, December 2022.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
