Economic downturns typically give rise to increased insolvency proceedings and stakeholder-driven litigation (as described in our recent briefing). The current economic circumstances are, therefore, likely to lead to greater scrutiny on director conduct.
This briefing looks in more detail at potential risk areas before offering practical guidance on what directors can do to protect themselves and the companies for which they act, particularly in circumstances where a requirement arises to have due regard to creditors' interests.
What are my duties and where are they owed?
Under Guernsey and Jersey law, in general terms, directors owe fiduciary duties to act in good faith in the best interests of the company, to exercise independent judgment, to avoid conflicts of interest and not to act for improper or collateral purposes. They also owe either a statutory duty (in Jersey) or a common law duty (in Guernsey) to demonstrate the reasonable level of skill and care that may be expected of somebody in the director's position. These duties apply to executive and non-executive directors alike and are the measures by which directors' conduct will ordinarily be assessed.
Directors owe these duties to the company for which they act. In times of financial health, this means that directors will meet their duties by reference to the interest of the company's members taken as a whole. Where, however, a company cannot satisfy the solvency test (described below) or has reached what may be broadly termed as the 'zone of insolvency', then a director's duties change.
At that point, directors are required to have paramount regard to the interests of the company's creditors (as a whole). This means that directors will need to carefully consider whether steps, including those that may otherwise have been readily taken, are likely to improve or worsen the position of the company's creditors. Directors will also need to consider very carefully whether any decision to carry on trading is the correct one; particularly given the potential for personal liability if they get this wrong.
In Guernsey, solvency is established on the basis of a two-stage test. First, can the company meet its liabilities as they fall due? This is commonly referred to as the 'cash flow test'. Secondly, does the value of the company's assets exceed the value of its liabilities? That second limb is commonly referred to as the 'balance sheet test'. If the company does not satisfy both limbs, then it is technically insolvent.
In Jersey, the solvency test is the cash flow test. However, for a director of a company that is facing financial difficulties from a cash flow perspective but where the balance sheet test would be met, the interests of the ultimate stakeholders should not simply be ignored, even if they are not paramount.
When assessing solvency, directors are required to have regard to all circumstances that they know (or ought to know) will or may affect the value of the company's assets and liabilities. Insolvency issues should not, therefore, be considered with regard to some perfectly crystallised point in time. Directors need to consider what may reasonably be on the horizon and whether the company has or is about to enter the 'zone of insolvency'. That will arise where insolvency is likely or probable within a reasonable period - 12 months may be considered as a rule of thumb but by no means strict. If the company has reached that point, then the scope for personal liability is worthy of heightened consideration.
What are the personal risks?
Misfeasance or breach of fiduciary duty in relation to the company - Directors (including past directors) can be ordered to personally repay, restore or account for money or property or be required to contribute to company assets where they have appropriated or otherwise misapplied company assets, become personally liable for any company debts or liabilities or are otherwise been guilty of any misfeasance or breach of fiduciary duty.
Wrongful trading - A summary of the legal provisions in BVI, Guernsey, Ireland and Jersey was set out in our earlier briefing (you can read the full briefing here). In short, wrongful trading provisions offer protection for creditors by creating director liability if, despite the inherent likelihood of insolvency, the company is allowed to continue to trade and incur additional debt.
For directors to incur personal liability, the court would need to be satisfied that i) at some time before the commencement of winding up proceedings the director in question knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation and ii) from the moment a director knew, or ought to have known, that insolvent liquidation could not be avoided, he or she failed take every step they should reasonably have taken with a view to minimising the potential loss to the company's creditors. Where liability is established, directors may be ordered to make personal contributions to the assets of the company. The amount to be paid will be compensatory rather than punitive.
Fraudulent trading - These provisions enable the court, on the application of a liquidator, administrator (in Guernsey), creditor or member of a company, to declare that any persons who knowingly carried on company business with an intent to defraud creditors are guilty of a criminal offence and are civilly liable to make any contribution to the company assets that the court directs. Additionally in both Guernsey and Jersey, a transfer entered into to defeat creditors may be set aside using the customary law concept of a Pauline action, should it be shown that the debtor was insolvent or became insolvent as a result of the transfer in question.
Recovery of Distributions and Dividends - Directors may be required to repay to the company the value of distributions (including dividends) that are made to members at a time when the company did not, immediately after payment, satisfy the solvency test. Directors will, therefore, need to have regard to proper procedure for the approval of distributions to members and whether or not reasonable grounds exist for a director to be satisfied that the company met the solvency test immediately after any distribution. As a matter of Jersey law, it is an offence for a director to give a solvency statement (which will need to include a statement that the company will be able to meet its liabilities as they fall due for a period of 12 months following the distribution, or earlier dissolution) without reasonable grounds. Members in receipt of unlawful dividends can also be liable to repay the dividend (or if in specie, the value of it).
Disqualification - The courts in Guernsey and Jersey can make a disqualification order if it considers that a person is unfit to be concerned in the management of a company. In making such an order, the court must have regard to things such as a director's probity, competence, soundness of judgment and whether the interests of members or creditors of any company are likely to be threatened in any way by him or her being a director. The court may also have regard to previous conduct and activities in business, conduct in connection with any company that has gone into insolvent liquidation, any misfeasance or breach of fiduciary duty and any requirements to make personal contributions for wrongful or fraudulent trading.
In Jersey, an application would be made by the Chief Minister, the Attorney General or the JFSC. A liquidator who suspects the conduct of a director may warrant an application for disqualification, is under a duty to report that concern to the Attorney General and provide all relevant information. In Guernsey, the range of parties who may apply is wider and includes the GFSC, any company in which the individual in question has been a director or officer and any liquidator, administrator or creditor of such a company.
What can I do to protect myself and the company?
There are a variety of sensible and pragmatic steps that directors should consider implementing in order to protect not only the company, but also their own personal position during these uncertain financial times.
- Directors should have regard to the company's obligation to creditors, both old and new. Should the company reach the "zone of insolvency" then the interests of creditors must be given priority when taking any further decisions relating to the company.
- Directors should not turn a blind eye to difficulties in the hope that things will improve; equally they should be mindful of the risks associated with quick fixes but be alive to creating longer term issues (for example the danger of using customer pre-payments or deposits to meet day-to-day expenditure).
- Board meetings should be frequent, with decisions properly minuted and be focused on the company's financial position (its cash flow in particular and how that might be impacted by outside influences).
- Early consideration should be given to the protections and benefits that may be provided by way of insolvency processes but Directors should to continue to be aware of their duties to the company and recognise that resignation may not be a solution to personal risk.
- Directors of group companies need to be mindful of the potential risks and impact on a subsidiary or a parent that actions in respect of assets and/or liabilities within the group can have.
- Early and ongoing discussions with creditors and shareholders will invariably be beneficial to manage expectations and ensure stakeholders remain informed.
Directors are not expected to have foreseen and covered every eventuality. By understanding their duties and areas of potential risk they will, however, be better prepared to achieve the best outcomes for themselves and the companies for which they act.
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.