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Directors’ duties and liabilities in distressed situations
12th Apr 2022
Directors’ duties and liabilities in distressed situations - Linkilaw Solicitors
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Being a director is a rewarding job, but it is also a difficult one. Directors are in charge of the company’s day-to-day operations and are subject to several duties that are not always clear to whom they are owed, especially when their businesses are in financial difficulty.

Among the often-asked questions are whether directors may sign into new contracts if they are uncertain about the company’s ability to satisfy its commitments and the ‘tipping point’ at which the board must prioritise creditor interest above protecting shareholder value.

These are critical concerns, and directors should be aware of their primary areas of possible risk to safeguard the business and their position.

What are the areas of potential liability for directors?

One of the fundamental concepts of company law is that a company is a legal entity distinct from its shareholders and directors. Thus, generally, company directors cannot be held personally accountable for the company’s liabilities or debts.

However, directors should note that they continue to owe specific duties to the company, its members and third parties and may face legal consequences if they fail to fulfil those duties.

(i) Wrongful Trading

One of the most frequently discussed areas of liability is wrongful trading, covered by section 214 of the Insolvency Act (1986).

A wrongful trading claim can be brought against a director if, at some time before the commencement of the insolvent liquidation, they:

(a) knew or should have known that the there was no reasonable prospect of the company avoiding insolvent liquidation; and

(b) from that point forward, the director did not take “every step” to minimise the potential loss to the company’s creditors.

Some conduct that may constitute wrongful trading includes taking excessive compensation, accumulating debt or repaying directors’ loans before creditors.

Therefore, keeping track of the exact financial position of the company is critical for directors to navigate their duties. Directors should hold frequent board meetings to review their decisions and keep accurate records of the thought process.

(ii) Other liability

Other areas of liability may also include fraudulent trading and misfeasance. Fraudulent trading, governed by section 213 of the Insolvency Act (1986), occurs when a director conducts the company’s business to defraud creditors.

Unlike wrongful trading, a fraudulent trading claim can also be brought against other company members (not just directors) if they had knowingly participated in carrying out the business with the intent to defraud.

Additionally, a director may be held personally liable for misfeasance, which may occur when a director provides personal guarantees to other creditors that they will be paid first or sells assets for less than their market value. In such cases, a creditor or shareholder who has experienced a considerable financial loss may file an action against the director.

Directors duties

Financial distress: Duty to shareholders or creditors?

Sections 171-177 of the Companies Act (2006) impose some general obligations on a director of a UK limited company.

When the business is solvent and operating regularly, directors have a duty to act in the manner they believe, in good faith, would most likely promote the success of the company. The meaning has significantly been debated but is commonly interpreted to indicate that directors should act in the best interests of shareholders and ensure the business generates profit.

The duty imposed above has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

Therefore, if the business is experiencing financial problems, directors should be cautious of a change in attention away from shareholders toward the company’s creditors.

The case of BTI 2014 LLC v Sequana SA & others [2019] EWCA Civ 112 is informative here since one of the issues before the Court of Appeal was when the directors’ duty to creditors was engaged. The Court held that such duty would arise when the director knows or should know that the company is currently or is likely to become insolvent.

Unfortunately, the question of whether, from this point forward, creditor interests should take priority was not addressed, as it did not arise in the facts. Nonetheless, the Court did state that it is difficult to see how creditors’ interests could be anything but paramount when the director knows or ought to have known that the company is presently insolvent.

Consequently, if the company is insolvent, the directors’ duty would move to creditors, whose interests take precedence. In the absence of actual insolvency, the degree to which creditor interests take precedence or are mere to be considered is a matter on which further clarification is awaited.

How can we help?

When the company starts facing financial difficulties, directors need to seek advice as soon as possible and retain a record of the choices made to prevent liabilities.

At Linkilaw Solicitors, we assist directors on all aspects relevant to their duties and responsibilities and corporate governance. If you want to find out more, you can speak to one of our legal specialists by booking a free consultation.

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