Directors’ Duties where a Company is in Financial Difficulties or Insolvent
In our previous article, we discussed in detail the statutory duties of directors. As therein indicated, under section 143 of the Companies Act, a director must act in the way he considers, in good faith, would be most likely to promote the company’s success for the benefit of its members (shareholders) as a whole. Nevertheless, where a company is in financial difficulties or otherwise insolvent, the director’s duty shifts to the interest of the creditors of the company. Failure to do so exposes the director to the risk of disqualification, criminal conviction or being personally liable to pay the company or the creditors. Therefore, directors must be aware of the risks they face when the company is in financial difficulties or insolvent and how to avoid personal liabilities.
In this article, we shall explain the director’s duties once their company starts experiencing financial difficulties or becoming insolvent and the legal pitfalls a director should be aware of. We also give practical measures or steps that a director can employ or take to avoid breaching these duties.
What Is Insolvency?
Under section 384 of the Insolvency Act, Act No. 15 of 2015, a company is unable to pay its debts if:
- A creditor (by assignment or otherwise) to whom the company is indebted for KShs. 100,000 or more has served on the company by leaving it at the company’s registered office, a written demand requiring the company to pay the debt and the company has for 21 days afterwards failed to pay the debt or to secure or compound for it to the reasonable satisfaction of the creditor;
- execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part;
- it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.
- it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities (including its contingent and prospective liabilities).
Are directors equally liable when a company is insolvent?
As explained before, when the company is insolvent, all directors, including non-executive directors, shadow directors (who take a controlling hand in the company but are unregistered) or defacto directors (who hold themselves out as directors) owe duties to creditors collectively. In addition, former directors may be liable for some transactions that were carried out before their resignation.
The Insolvency Act spells out directors’ duties when the company is insolvent and covers several areas of potential misconduct on the part of a company director, either prior to or while the company is insolvent.
What is the consequence when directors breach these duties?
Generally, where a company goes into a formal insolvency process, such as liquidation or administration, then the insolvency practitioner (IP) appointed over the company, the lender or the courts, will investigate events and circumstances leading up to the company’s insolvency. Where it is established that the directors of the company had acted wrongfully or fraudulently and to the detriment of the company’s creditors, the directors can be held personally liable or the wrongful transactions reversed.
Where culpability of established, the insolvency practitioner, the lender or third party creditors may properly institute civil proceedings against the directors.
What is fraudulent trading?
This is provided for under section 505 of the Insolvency Act, and it invariably involves an element of fraud or dishonesty. Generally, fraudulent trading occurs where a liquidator (in the course of the insolvency process) establishes that the business of the company has been carried on with intent to defraud creditors of the company or third parties, or for any fraudulent purpose and that, in those cases, the directors or officers of the company had participated (directly or indirectly) in the business with the knowledge that the business was being carried on in that manner.
Where fraudulent trading has been established, the liquidator can apply to the insolvency court for responsible directors to make such contributions to the company’s assets as the court considers fair and reasonable. This can be easily established where it is proved that the directors had acted deliberately to avoid payment of company liabilities or debts by continuing to trade or had accepted supplier credit or taken payments from customers knowing that the company would not fulfil the orders before liquidation.
The cases of fraudulent trading are common in creditors’ voluntary liquidation as well as in compulsory liquidation processes where the liquidator is required to investigate the directors’ conduct leading to insolvency and make a report to the court or the Official Receiver.
Fraudulent trading is both a criminal and a civil offence. Therefore, it will invariably trigger criminal sanctions. In many cases, the culpable director will also be disqualified. This means that such a person would be banned for a certain duration (up to 15 years) from being or acting as a director of a company or a partner of a limited liability partnership or in any way, whether directly or indirectly, being concerned in the promotion, formation or management of a company or limited liability partnership.
What is wrongful trading?
This is provided for under section 506 of the Insolvency Act. Unlike fraudulent trading, wrongful trading does not involve dishonesty. Under this section, a company is in insolvent liquidation if, at the time the liquidation commences, its assets are insufficient for the payment of its debts and other liabilities as well as the expenses of the liquidation. A director will be liable for wrongful trading if he knew or ought to have known that there was no reasonable prospect that the company would avoid being placed in insolvent liquidation and neglected to take reasonable measures or steps to prevent potential loss to the company’s creditors.
Where culpability and failure to act reasonably are established, the court will usually, at its own discretion, order the culpable director or directors to make such contribution to the company’s assets as it may consider appropriate. Moreover, such directors may also be liable to repay the increase in creditor claims that arose between the time they should have stopped wrongful trading and when the insolvency proceedings were initiated. In addition, the disqualifications discussed above will similarly be imposed on the wrongdoers.
What are transactions at undervalue?
Under the Insolvency Act, there are two methods that can be employed by directors to give a creditor an advantage to the detriment of the body of creditor. These are transactions at undervalue (covered under section 682) and preference under section 683 of the Insolvency Act.
Under section 682 of the Act, a company enters into a transaction with a person at undervalue if it
- makes a gift to the person or otherwise enters into a transaction for no consideration; or
- enters into a transaction with the person for a consideration the value of which, in money or money’s worth, is significantly less than its actual market value.
As can be deciphered from the foregoing, in an undervalue transaction, the recipient of the asset is accorded a benefit to the detriment of other creditors. In insolvency law, if the person who received the benefit of the transaction was connected, there is a rebuttable presumption that the transaction was undervalued.
Under section 684 of the Insolvency Act, the transaction will fall under undervalue claim or proceedings if the company was at that time unable to pay its debts or where the impugned transaction caused this to happen.
What is a preference to a creditor?
Preference occurs when the company does something which has the effect of putting a creditor into a better position than he would have been had the preference not taken place, and the company was influenced by a desire to prefer that creditor over other creditors. Generally, the desire to give preference is presumed where the creditor in whose favour the preference was given is connected with the company at the time, for example, a director of the company or a relative of the director or shareholders of the company.
Under section 683 of the Insolvency Act, where a company has at a ‘relevant time’ given a preference to a person, the court has powers to cancel or void such transaction and restore the position that would have existed had the preference not been taken place.
What is regarded as ‘relevant time’ in such matters is defined under section 864 of the Insolvency Act? In the case of a connected person, this is within 2 years of formal insolvency, between the making of an administration application to the issuance of an administration order, or between lodgment of an application for the appointment of an administrator and the making of an appointment. In the case of an unconnected person, the timeframe is within six months of insolvency or the aforesaid events.
The time at which a company enters into a transaction at an undervalue is a relevant time if the transaction is entered into at a time:
- During the two years immediately preceding the onset of insolvency; or
- between lodgment with the court of a copy of the notice of intention to appoint an administrator under section 534 or 541 and the making of an appointment under that section.
For cases where a company does not enter into a transaction at undervalue, the time at which a company gives a preference is a relevant time if the preference is given:
- In the case of a preference given to a person connected with the company (except an employee) -at a time during the 2 years immediately preceding the onset of insolvency;
- in the case of a preference that is not a transaction entered into at an undervalue and is not so given—at a time during the 6 months immediately preceding the onset of insolvency;
- at a time between the making of an administration application in respect of the company and the making of an administration order on the application; or
- at a time between lodgement with the court of a copy of the notice of intention to appoint an administrator under section 534 or 541 and the making of an appointment under that section.
A preference claim may be where directors decides to repay themselves or their family monies owed to them by the company before the company goes through an insolvency process. Such money can be recovered from the directors or the recipient. Preference can also occur when one supplier is treated more favourable compared to other creditors. The directors should take legal advice before undertaking any transaction that could be considered a preference as this will invariably expose them to personal liability.
What are the Remedies for Undervalue or Preference?
As alluded to before, where there are undervalue or preference transactions, the court will typically declare the impugned transaction as void and restore the company to the position it would have been in had the undervalue or preference not occurred. Other remedies that the court will impose in addition to such a revocation and or restoration order include orders that:
- require property transferred as part of the transaction or in connection with the giving of the preference to be vested in the company;
- require the property to be so vested if it represents the application either of the proceeds of the sale of the property so transferred or of money so transferred;
- release or discharge (in whole or in part) any security given by the company;
- require any person to pay, in respect of benefits received from the company, such amounts to the relevant office-holder as the court may specify;
- provide for any surety or guarantor whose obligations to a person were released or discharged (in whole or in part) under the transaction, or by the giving of the preference, to be subject to such new or revived obligations to the person as the court considers appropriate.
What are the transactions defrauding creditors?
This is a transaction at an undervalue entered into for the deliberate purpose of putting assets beyond the reach of a person making a claim against the company (now or in the future).
Under the Insolvency Act, this occurs where a director or other officer of the company has made or caused to be made a gift or transfer of, or charge on, or has caused or connived at the levying of execution against, the company’s property. It can also happen where there is concealment or removal of any part of the company’s property since, or within the two months preceding, the date of any unsatisfied judgment or order for the payment of money obtained against the company.
Under the insolvency law, such transactions will attract criminal and civil sanctions. Therefore, where after the examination, the court finds that the director examined has engaged in the impugned conduct, it may make an order compelling the director to repay, restore or account for the money or property or any part of it, with interest at such rate as the court considers appropriate. In addition, the court may order such person to contribute such amount to the company’s assets as compensation for the misfeasance, breach of fiduciary or other duty as the court considers fair and reasonable.
How can a director be protected from liability?
The Companies Act prevents companies from making any provision which exempts a director from any liability arising from negligence, default, breach of duty or trust concerning the company concerned or an associated company. Nevertheless, such indemnity can be provided for certain liabilities incurred in relation to third parties. This will usually cover the cost of the litigation and any other cost. There can be no indemnity for fines incurred for breach of regulations or the cost of defending a director in criminal proceedings and related fines where that defence that is proffered is unsuccessful. Moreover, the Act does not outlaw the company from taking out insurance that covers its directors and any liabilities it may incur. Again these may not cover the act of criminality or dishonesty.
In addition to the foregoing, where a director has breached his legal duty, subject to the provisions of the Companies Act, the shareholders may elect to ratify the breach, especially where this is regarded to be in the best interests of the company.
Further to the aforementioned solution, a court can also grant relief where proceedings for negligence, default, breach of duty or trust are brought against a director if the court considers the director has acted honestly and reasonably and they ought fairly to be excused. Directors would be a liberty to can apply directly to the court for this relief if it is anticipated that such a claim is being brought against them.
Practical steps that a director can take to protect creditors or avoid personal liability?
There are various measures that can make director cake to avoid or reduce the risks of personal liability or exposure whenever a company is in financial distress. These include:-
- You should never continue incurring liabilities or procuring goods or services from third parties when there is no reasonable prospect that the company will be able to honour its payment obligations.
- It would be best if you never ignored legal demand letters for payment or insolvency notices that have been served on the company. Instead, you should consult your lawyers and have the matter resolved in accordance with the law.
- You should have a personal lawyer from whom you can seek independent legal advice on your directorship duties.
- It would help if you kept appropriate indemnity from the company and also ensure that the company has procured appropriate directors and officers’ professional indemnity cover in relation to any liability that may arise from your directorship duties.
- You should never incur additional credit when the company is in financial distress or otherwise issue cheques or take customer deposits if it is unlikely the company will be able to honour its side of the bargain.
- Where a company is in financial difficulty, you should never strike any deals with a particular creditor without taking advice from your lawyer on whether this would be contrary to Insolvency Act.
- As soon as you become aware that the company is in financial distress, you should call a board meeting to discuss the matter and, where appropriate, seek legal advice from a lawyer who has good insolvency experience.
- You should never ignore accounting and disclosure requirements by your auditors in your financial statements.
- You should never repay shareholders’ loans or loans from a person related to your directors when the company is in financial difficulties. This will always be regarded as a preference.
- You should always conduct professional valuation whenever you are selling the company’s assets and ensure that the buyer pays the best obtainable price for the same. Such sale transactions should also be subjected to board approval and appropriate contracts signed between the parties.
- You should have regular board meetings during which the financial position and related matters like budgeting, procurements and disposal of assets, management accounts and financial statements are discussed and minutes of all resolutions adequately maintained.
- Always keep appropriate communication channels with your lenders and creditors and honour your payment obligations. Whenever you believe that the company will not be able to pay its obligations, you can reschedule the payment terms or restructure the debt.
How can CM Advocates help?
CM Advocates has excellent and experienced Corporate and Debt Recovery, Restructuring and Insolvency lawyers from whom you can get appropriate legal advice on your duties as a director. If you are experiencing financial difficulties in your company and are concerned about what to do, if creditors are pressing for payment, if you have been served with courts summons concerning recovery or winding up proceedings or otherwise served with a statutory notice, you should contact one of our team today to discuss your options. Remember, a stitch in time saves nine.
Written By: Cyrus MAINA – Managing Partner