Our litigation specialist, Gary Cousins, spends much of his time pursuing financial claims against directors on behalf of insolvency practitioners and in defending those claims. All too often directors are financially ruined after the demise of their company and some of them even end up in prison.

What is common to most of them is that they did not understand the risks (both legal and financial) they were taking at the time their business troubles started and a fair few of them never realised that their business was in trouble until it was too late.

So what are the risks you run as a director when your company becomes insolvent?

Before answering the question, it is important to realise that it is not only registered directors who run these risks but also anyone who controls a company, is responsible for the direction of a company’s affairs or tells the directors what to do (referred to legally as a “shadow director”). It also includes someone who is a director in name only, such as many directors’ spouses or someone who has been appointed a director simply to have their name on the board.

It is not always easy to tell. The law says that a company is insolvent when either it cannot afford to pay its debts as they fall due or when its liabilities exceed its assets.

It is perhaps easier to tell when you cannot afford to pay your debts and are moving funds around simply to keep the business afloat. You must also be aware however of what your assets and liabilities are, especially when these figures are close. Do you regularly monitor your company’s financial position by keeping up-to-date records and management accounts? You should do.

You should also be aware that liabilities can include debts that may not be payable or even arise until later, for example where a contract went wrong and a legal claim is not made against you until a later date. If it is a good claim, you could find yourself in a position where you were technically insolvent from when the contract first went wrong. It is often important to take legal advice on any claims or potential claims at the earliest opportunity.

Generally as a director, you are under a duty to act in the best interests of your company and its shareholders. However, the moment your company is deemed to become insolvent, you are under a legal duty to protect the interests of your creditors instead of your shareholders. The company must now function for the primary purpose of getting the best return for creditors.

If your company eventually goes into a formal insolvency procedure, your conduct and your company’s transactions would generally be investigated and the investigation could go back 3 years.

You can be held personally liable and be ordered to pay money to the company for the benefit of its creditors under several circumstances. The main ones are listed here.

Wrongful Trading. This is when you continue to trade or enter into contracts after you, as a director or shadow director, knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation, unless you can prove that you took every step to minimise the potential loss to creditors.

If a court believes you have been wrongfully trading, it can order you personally to make a contribution to the company without financial limit. It can also disqualify you from acting as a director for up to 15 years.

Hindsight is a wonderful thing and it is often difficult to say in retrospect whether and when you ought to have known that your company could not have avoided insolvent liquidation. It is therefore vital for you to keep up-to-date financial records of the company’s position and to obtain professional advice as soon as you fear you might be approaching insolvency.

Fraudulent Trading. This is when you carry on business with the intention to defraud creditors or for any other fraudulent purpose.

This might include taking deposits for orders you know you cannot fulfil, entering into contracts when you know there are insufficient funds to conclude them, transferring money around from one bank to another to keep them happy or giving wrong or inaccurate information to obtain credit or contracts.

If a court believes you have been fraudulently trading, it can order you personally to make a contribution to the company without financial limit. It can also imprison you for up to 7 years.

Misfeasance. This is a breach of certain duties of care, known as fiduciary duties, that you legally owe to your company as a director.

You must not for example take out money wrongly from the company or use company money for matters not associated with company business.

If a court believes you are guilty of misfeasance, it can order you to make a contribution to the company without financial limit by way of compensation.

Personal guarantees. You may have entered into personal guarantees as a director to obtain credit for the company. If the company cannot afford to pay these off in full the creditors can claim against you personally for the shortfall.

You can also be personally liable, as can any 3rd party, if the company has transferred assets to you in certain circumstances.

Preferences. This is when you make payments or transfer assets to one creditor in preference to another. When your company is insolvent, you are under a duty to the body of creditors as a whole and must treat all your creditors equally.

You cannot for example pay off one creditor because he is about to sue you when the others are not, pay off your bank or any other creditor to avoid liability under a personal guarantee, or repay friends and relatives. You also cannot repay your loan account.

If a court believes the company has made a preference, it can use its powers to set aside the transaction, including ordering you, or any other recipient of the assets, to refund them to the company.

Transactions at an undervalue. This is when the company has transferred assets for significantly less than their market value.

As in a preference, if a court believes the company has entered into a transaction at an undervalue, it can use its powers to set aside the transaction including ordering you, or any other recipient of the assets, to refund them to the company.

There are various exceptions, time limits and defences available in each of these circumstances and it is therefore vital to take legal advice as soon as possible if you think any of them might apply to you. Such advice could help you minimise the risk of personal liability or reduce the amount you might eventually have to pay.

• Keep good, accurate and up-to-date financial records so you can monitor exactly how the company is fairing.
• Consider what has caused the problem. Is it short term or long term? Is it a large bad debt? Do you have a legal claim against someone you have not pursued? Is someone making a claim against you? Is it bad financial management although you basically have a good company?
• Consider a financial stratagy for your company. You should identify how you can reduce costs and overheads, what aspects of your business are profitable and what are not. You should consider obtaining additional finance as part of a package of other measures but only if you can be reasonably sure that you can repay it.
• Do not continue to trade when your company is insolvent, unless you are certain that there is a strong possibility that your company will be able to avoid insolvent liquidation. There are other insolvency procedures available short of liquidation and so it is important to obtain professional advice as soon as possible on whether or not you can avoid liquidation and what your alternatives are.
• Do not incur further credit when there is little prospect that you can repay it.
• Do not write cheques if you believe they will bounce.
• Do not take deposits for orders you know the company cannot fulfill.
• Do not pay certain creditors in preference to others.
• Take professional advice as soon as possible. The sooner you do this, the more options are likely to be available and the lower will be the risk of personal liability.
• If the other directors do not agree with you, make your views plain at a board meeting or in writing. If at a board meeting, make sure your views are adequately minuted. Resigning from the board is unlikely to safeguard your position. Take immediate professional advice.

This article only sets out some of the issues involved. It is not intended to be a comprehensive or detailed statement of the law. Every situation is different and it would be dangerous to act on the basis of this article alone. It is important for you to obtain individual advice based on your own set of circumstances.

Gary Cousins at Woolley & Co can review your situation and make recommendations on the next steps. Contact Gary on 0121 778 3212 or email him at gary.cousins@business-lawfirm.co.uk.