When a company is trading successfully, directors have a responsibility to act in the best interest of the business and its shareholders. This involves making decisions that promote long-term success, maximise profitability and ensure ongoing viability.
However, once a company’s financial situation declines to the point of insolvency, the focus and responsibilities of its directors shifts. At this point, priority moves from maximising shareholder value to acting in the best interests of creditors.
Recognising when this shift occurs, and understanding what that means in practice, is essential to ensure that directors fulfil their legal obligations and avoid personal liability.
Directors’ duties under standard trading conditions
As standard, directors have a number of statutory obligations, enforced by the Companies Act 2006. This includes a responsibility to promote the success of the company for the benefit of its shareholders; ultimately, making decisions that are likely to lead to growth, profitability and sustainability.
It is entirely appropriate and expected for directors to focus on adding value to shareholders so long as the company remains solvent and pays financial obligations as they fall due.
Directors of a solvent business have flexibility to take commercial risks consistent with their appetite for growth and to pursue strategies solely designed to increase shareholder value.
While solvent, directors can consider long-term consequences of actions, employee interests and what kind of impact they wish to have on the community, such as pursuing CSR goals.
Once the company meets the legal definition of insolvency, this is not possible as responsibility shifts entirely to maximising returns for creditors.
Directors’ duties under financial concern
Once a director recognises that their company is experiencing financial concerns, such as persistent cash-flow issues or the inability to meet financial obligations when they fall due, increased caution is required.
These issues are a warning sign of impending insolvency, and while there is no statutory shift in directors’ responsibility, it is important that measures are taken in an attempt to improve the company’s financial situation.
Directors should avoid taking on new liabilities without first considering the wider impact that these may have on the profitability and sustainability of the company. They should also avoid disposing of any assets at less than their full value or making any payments which may treat some creditors better than others.
Directors’ duties under insolvency
Once it becomes clear that a company is unable to pay its debts as they fall due, or that its liabilities outweigh its assets, it is legally considered insolvent.
At this point, the duty of the directors undergoes a statutory shift. Their responsibility is no longer for the company’s shareholders but maximising the value of the remaining company assets for the benefit of its creditors.
In practice, this means that directors are required to:
- If trading at a loss, cease trading immediately to prevent further losses to creditors. Continuing to trade at a loss while insolvent may constitute “wrongful trading”, which may lead to personal financial liability falling on the directors.
- Avoid making preferential payments, such as repaying certain creditors (including directors or connected parties) before others. Doing so can later be challenged and reversed by an insolvency practitioner.
- Protect company assets and ensure they are not sold, transferred or otherwise disposed of for less than fair value. Transactions deemed to be undervalued can be challenged during insolvency proceedings. Directors should avoid customer receipts being paid into an overdrawn bank account, as these funds serve only to pay back the bank and are unable to be used to repay creditors.
- Maintain accurate financial records, including up-to-date accounts, cash-flow forecasts, and details of any key decisions. Clear record-keeping demonstrates that directors have acted in a responsible way and are helpful in defending against potential claims.
- Seek professional advice to ensure that you gain a full understanding of your situation and the options available to you, and that you are completely aware of your statutory obligations.
At this stage, it is essential that directors resist any temptation to take risks in an attempt to rescue the business unless it can be proven that there is a reasonable chance of success. Continuing to trade without a realistic recovery plan may worsen the position of creditors and expose directors to misconduct allegations.
The importance of acting early
It is essential to seek professional advice as early as possible. Spotting the warning signs early may help to avoid a formal insolvency procedure altogether or, in cases where that is not possible, help to manage the wind-down and ensure directors act in line with their statutory duties.
It can be difficult to judge the line between financial difficulties and insolvency, especially for those attached to a business, and formal insolvency occurs earlier than most people realise. Engaging a third party allows for an impartial, realistic assessment of your business and its current situation.
Early intervention may allow for a greater number of options, including restructuring, refinancing, or a Company Voluntary Agreement (CVA). These alternative options may achieve a better outcome for creditors.
How Cooper Associates Accountancy can help
Our team of insolvency specialists are on hand to provide clear, confidential advice to help directors to understand both the position of their company and their obligations.
We work with you to explore all available options, and to guide you through the entire process in an easy to understand, professional way.
If you’re concerned about your business’s financial situation, get in touch today to discover how Cooper Associates Accountancy can help you.
