The Duties Of Directors In A Financially Distressed Or Insolvent Company In Kenya

In our previous article on the Duties of Company Directors in Kenya, we discussed in detail the statutory duties of directors of a limited liability company. As therein indicated, under section 143 of the Companies Act, a director must act in the way which he considers, in good faith, would be most likely to promote the success of the company 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 creditors of the company. Failure to do so exposes the director to risk of disqualification, criminal conviction or being personally liable to pay the company or the creditors. It is therefore critical that directors are aware of the risks they face when the company is in financial difficulties or insolvent, and how to avoid personal liabilities. In this respect, we shall by way of a series of articles, explain the duties of director personally once their company start experiencing financial difficulties or becomes insolvent and the legal pitfalls which a director should be aware of. We shall also give practical measures or steps which a director can employ or take to avoid breaching these duties. To start us off, in this article we define insolvency and look at the duties accruing to the directors upon the company becoming insolvent.

What Is Insolvency?

The Black’s Law Dictionary, 9th Edition, defines “Insolvency” as the condition of being unable to pay debts as they fall due or in the usual course of business. In Kenya, the Law that regulates the affairs of Insolvent persons is the Insolvency Act, No. 18 of 2015 . Under section 384 of the Act, 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; or
• 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 (take a controlling hand in the company but are unregistered) or defacto directors (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 resignation. The Insolvency Act spells out the duties of directors when the company is insolvent and covers a number of areas of potential misconduct on the part of a director of a company, either prior to or while the company is insolvent.

What are the consequence where 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, by the members, the Creditors or the Insolvency Court, will investigate the events and circumstances leading up to the company's insolvency. Where it is established that the directors of the company acted wrongfully or fraudulently to the detriment of the company’s creditors in breach of these duties, the directors can be held personally liable, or the wrongful transactions reversed. Additionally, where culpability is established, the insolvency practitioner, the lender or a third-party creditor may institute civil proceedings against the directors as contemplated under Section 504 of the Insolvency Act for the directors to repay, restore or account for the money or property or any part of it or to contribute such amount to the company's assets as compensation for breach of these duties. In our subsequent article we shall look at the difference between fraudulent trading and wrongful trading both being conduct that constitutes breach of directors’ duty to act in the best interests of the creditors inviting personal liability on their part.