What are directors’ duties when a company is insolvent? Learn about Insolvency and the Director Duties and Responsibilities to Creditors

When a corporation is or is likely to become insolvent, the obligations of the company directors shift significantly.  In these situations, the company director’s duty to creditors takes precedence over all other duties. We are, as the government frequently reminds us, in the midst of difficult times. Most people would simply state that we are in the middle of a worldwide economic crisis caused by the credit crunch, with the UK economy in recession, leading many firms to become insolvent. As a result, many once prosperous businesses are on the verge of insolvency.

What is insolvency and What Does it Mean to be Insolvent?

According to Section 123 of the Insolvency Act of 1986 (the Act), a corporation is declared insolvent when it is unable to pay its obligations as and when they fall due. The conditions include:

• Being unable to pay amounts specified in a statutory demand.
• Being unable to pay payments specified in a judgement debt.
• The balance sheet test examines whether a company’s liabilities outweigh its assets. If they do, it is deemed insolvent.
• The cashflow test asserts that if a corporation is unable to pay its debts when they become due, even if it has significant capital invested in assets, it is insolvent.
• The balance sheet test is frequently employed when a firm ceases to trade and is unlikely to generate more revenue.

If a firm is still in operation and additional revenue is predicted, the cash flow test might be employed.

Directors responsibilities in liquidation

When a firm is or is about to become insolvent, the company directors‘ responsibilities shift significantly.  In these situations, a director’s obligation to the creditors takes precedence over all other duties. The company’s assets must be handled in a way that prioritises creditors. These principles have been frequently stated in case law and insolvency legislation, with the Insolvency Act of 1986 serving as the foundation. If a corporation is bankrupt, the company director’s duty to creditors extends to all creditors, not simply one or more specific creditors. If no provision for the interests of creditors has been made, the company directors are unable to dispose of the company’s assets or make payments to shareholders. If the firm is truly insolvent, such provisions will be impossible to implement, and such payments should be avoided to comply with the Insolvency Act 1986.

Duty to Creditors

If the firm enters into a formal insolvency proceeding, the directors’ failure to comply with that overriding responsibility may result in a number of claims against them by an insolvency practitioner serving as liquidator or administrator. The officeholder may file a lawsuit against the directors for misfeasance, which is effectively a violation of duty. Duties might include those owing to creditors as well as those owed to the corporation as a whole, as indicated above.

Fraudulent Trading and Wrongful Trading

Insolvency legislation also allows officeholders to file claims against directors who have engaged in improper trading. Many company directors violate this clause of the Insolvency Act 1986 because they assume (incorrectly) that the firm may trade its way out of its problems. The Act states that once a board determines that there is no reasonable possibility of the firm avoiding insolvent liquidation, the directors are obligated to take every effort that a reasonably intelligent person would take to reduce the probable loss to the company’s creditors. The test consists of both objective and subjective components to determine the firm’s financial status under the Insolvency Act 1986. As a result, a director must operate in the same way that a reasonably diligent individual would, but with the director’s real talent, knowledge, and experience in mind. 

Breach of Directors Duties Upon Insolvency

Directors should also be aware of the dangers of violating other sections of insolvency legislation, such as carrying out transactions at undervalue, wrongful trading, or permitting preferential payments to creditors. Officeholders can pursue monetary claims against company directors to augment the insolvent company’s assets. Care must thus always be taken, especially with respect to payments that may represent preferences, i.e. Paying one creditor over another, or placing one creditor in a better position than he would be if the specific arrangement was not in place, increases the risks associated with wrongful trading under the Insolvency Act 1986.

What should you do to avoid liability?

If directors are unsure whether the firm is solvent or insolvent, they should obtain guidance from an insolvency practitioner or lawyer to minimise the risk of wrongful trading. This step is helpful for two reasons: to minimise liabilities and to ensure compliance with the Insolvency Act 1986. 

First and foremost, the insolvency expert may provide practical guidance and help, as well as an impartial assessment of the company’s status, thus assisting in minimising the company’s liabilities.
Second, the fact that a director or board of directors sought expert guidance may serve as a defence to any of the charges listed above, such as improper trading.

When confronted with an insolvent corporation, directors cannot just quit; they must take constructive efforts to fix the issue, even if those steps are as simple as transferring the firm to the hands of an insolvency practitioner.

If the Directors’ objective assessment is that the firm is bankrupt, they must seek expert counsel from an insolvency practitioner or an insolvency lawyer. No director should hesitate to reach that decision and take the necessary procedures.