Directors' duties: what should a board of directors do?

The importance of directors’ duties in the current environment

Compliance with directors’ duties is very important; fulfilment of these clearly impacts upon stakeholders and creditors alike. Trading through the last two years of the pandemic has been unparalleled and the economic consequences were largely held in abeyance in many sectors throughout the period of Government measures.

The partial suspension of “wrongful trading” penalties which ended on 30 June 2021 was largely symbolic and did not “switch off” related risks such as director qualification and compensation orders. Directors’ core duties all remain, and have been supplemented by a tightening of the connected party provisions on pre-packs and a closing of the loophole which complicated the disqualification of directors of dissolved companies.

As corporate UK trades through the build-up of pandemic debt, the importance of the distinction between balance sheet and cash flow insolvency will become more apparent.

Outline of directors’ duties

Executive and non-executive directors are broadly subject to the same duties, although they will vary in certain respects.

To whom are the duties owed?

• Duties are owed to the company and not any other group companies or individual shareholders. It is the company itself which can take enforcement action against a director, if there has been a breach of duty.
• A liquidator or administrator can bring action in an insolvency context – remembering that many Insolvency Act claims are also capable now of being sold in the market for value.
• Shareholders can sometimes bring a “breach of duty claim” known as a “derivative action”.
• Criminal prosecutions are a risk under various different legislative provisions.
• Directors act as agents of the company, appointed by the shareholders.

Other directors’ duties

There are additional legislative provisions in the Insolvency Act, the Pensions Act, Health & Safety and Environmental Social and Governance legislation – these duties are supplemented by various residual duties built up by case law over the centuries.

Further directors’ duties can be found in the Articles of Association, an employment contract and possibly an investment or shareholders agreement.

Risks (and protections) for directors 

Although acting as agent of the Company personal liability issues may include:

• direct contractual responsibility (e.g. a personal guarantee or a warranty) or where the director induces the company to breach contract;
• various qualifications to the usual indemnity in the Articles of Association against liability incurred by the director to third parties;
• disqualification to act as a director and the related risk of compensation orders;
• potential statutory offences to include misfeasance, preference, wrongful trading, fraudulent trading, breach of duty, etc.

Companies will often obtain directors and officers insurance cover to insure directors against liability arising out of the discharge of duties as directors, including claims for negligence, breach of duty or other default. These policies will often exclude any action that is considered fraudulent, dishonest or criminal.

What is insolvency?

The courts apply two tests to determine if a company is insolvent which are:

• the balance sheet test; and
• the cash flow test.

Neither test is rigidly applied.

The balance sheet test

• The balance sheet test involves a comparison of the present assets of a company against the liabilities of a company (including its actual, prospective and contingent liabilities).
• Whether the balance sheet test is satisfied depends on the available evidence and the circumstances of the particular case.
• The company’s assets are valued on a break-up basis and not on a going concern basis.
• Prospective and contingent liabilities are likely to be valued on the likelihood of a prospective or contingent liability becoming an actual liability.

If the company cannot reasonably be expected to meet those liabilities, it will be deemed insolvent on a balance sheet basis, even if the company is, at that time, able to pay its debts as they fall due.

The cash flow test

• The cash flow test involves consideration of a company’s income and outgoings and asks if the company can meet its liabilities as they fall due?
• The test looks to the reasonably near future, as well as to the present. What is the reasonably near future will depend on all the circumstances and especially on the nature of a company’s business.
• When a company’s directors look beyond the reasonably near future, any attempt to apply a cash flow test will become completely speculative and the balance sheet test will become the only sensible test.
• An endemic shortage of working capital means that a company is, on any commercial view, insolvent, even though it might be able to continue to pay its debts for the next few days, weeks or even months.

What is the impact of insolvency?

Insolvency does not automatically mean that the company should stop incurring new liabilities and cease trading as this may result in the worst outcome for the company’s creditors. Insolvency does mean that there are additional risks for the directors which can be reduced by the directors taking legal and restructuring advice and validating a proposed course of action as satisfying their directors’ duties.

How far can creditors be stretched?

Lenders may prefer that the company implements ‘self-help’, such as an injection of funds from shareholders, a reduction in the directors’ salaries; or stretching creditors.

Remember that a company does not have to cease trading because the directors have concluded, or should have concluded, that the company has no reasonable prospect of avoiding an insolvency process. 

The key issue is whether after the directors knew or ought to have concluded this, the directors took every step with a view to minimising the potential loss to the company’s creditors that they ought to have taken.

Creditor stretch should be monitored carefully and advice taken. Discriminatory treatment by a director against a particular creditor, for example, an involuntary creditor such as HMRC or a supplier that cannot withhold goods or services, can be grounds for a director disqualification application.

Net deficit impairment and outcome in an insolvency

If the directors fail to take every step then the court may declare on the application of the administrator or liquidator, that the directors are liable to compensate creditors with a contribution to the company’s assets.

The court will normally examine the reduction in the value of the company’s net assets from the point in time at which the directors knew or ought to have concluded that there was no reasonable prospect of the company avoiding a process.

Where a company’s directors should have concluded that an insolvency process was inevitable, but the continuation of trading caused the company’s creditors no loss, no award will be made.