Legal Briefing

The twilight zone: legal issues for directors

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Finance | 01 February 2010

There is no legal definition of the term ‘twilight zone’ (perhaps derived from the cult TV series, the writer would like to think), which is now widely used to describe a period of trading when a company has, or is predicted to have, insufficient cash to pay its debts as they fall due. This might be an immediate cash-flow crisis or the problem might be anticipated many months ahead.

The twilight zone continues until the company is put back on an even keel, meaning a positive cash flow and balance sheet, usually achieved by restructuring, rescue and turnaround techniques, often involving refinancing. Alternatively, the business or shares of the company might be sold. A company might come out of the twilight zone, only to dip back into it from time to time. Unfortunately, many companies in the twilight zone are incapable of rescue and have to be put into administration or liquidation. The date of the commencement of the formal insolvency procedure then triggers the vulnerable period in English law, governing claw backs in relation to preferences, transactions at undervalue, floating charges and other matters, which come under the scrutiny of the liquidator and the creditors in a winding up.

In the UK, unlike some jurisdictions, it is not necessarily unlawful for a company to continue to trade in the twilight zone. In certain circumstances it is often the right thing to do both for the company and its creditors. For company directors it is essential to understand the lawful limits of trading in the twilight zone and to be clear about what their own personal duties as company directors are. Directors must seek a successful but realistic outcome for the company and its stakeholders, while at the same time protecting the interests of the creditors of the company in the event that formal insolvency proceedings turn out to be unavoidable. The latter outcome will usually lead to intense scrutiny of the directors’ conduct and, worse, could lead to disqualification from acting as a director for up to 15 years under the Company Directors Disqualification Act 1986 and/or personal liability for the company’s debts under the wrongful trading provisions of the Insolvency Act (IA) 1986.

DIRECTORS’ DUTIES UNDERTHE COMPANIES ACT (CA) 2006

Directors have to be aware of the duties codified in CA 2006, which expressly state that these provisions should be interpreted in the light of the case law that it replaces (see s170(4)). One of the most important duties of directors is now the duty to promote the success of the company for the benefit of its members. In doing so, they must have regard to the following: the likely long-term consequences of any decision; the interests of employees; the need to foster relationships with suppliers, customers and others; the impact of the company’s operations on the community and environment; and the desirability of the company maintaining a reputation for high standards of business conduct.

In the twilight zone, it is important to note that, following the common law principle (see West Mercia Safetywear v Dodd [1988]), the directors’ duty to promote the success of the company for the benefit of the shareholders is replaced by a duty to act in the best interest of the creditors of the company (s172(3) of CA 2006). Given the switch of primary duty to the creditors in the twilight zone, it is anticipated that the courts will not judge directors too harshly in relation to any reasonable and/or unavoidable lapse in respect of the stated criteria for ‘success of the company’. For example, a restructuring of the business to enable the company’s survival may necessarily involve making employees redundant, which might otherwise be viewed as contrary to the duties to employees. Directors would be ill-advised to ignore their statutory duties under CA 2006, unless certain action is essential to the survival of the company and then only having obtained expert legal advice. Directors and Officers (D&O) insurance policies, if taken out by the company in favour of the directors, may provide some protection in this regard. However, a company in the twilight zone is likely to have other pressing uses for its cash if a D&O policy is not already in existence.

KEY TEST OF CORPORATE INSOLVENCY

To understand the limits of trading in the twilight zone, it is necessary to understand the test for corporate insolvency. The cash-flow test is the crucial one. The ‘cash-flow’ definition of insolvency contained in s123(1)(e) of IA 1986 provides that a company:

‘… is deemed to be unable to pay its debts if it is proved to the satisfaction of the court that [it] is unable to pay its debts as they fall due.’

It is also easy for creditors to prove, as a company that fails to pay a debt due following service of a statutory demand is deemed to be unable to pay its debts, with no further proof needed (s122(1)(f) of IA 1986). This is one of the grounds on which the court may make a winding-uporder. The other main definition is the ‘balance sheet’ definition, which requires proof that the value of the company’s assets is less than its liabilities, taking into account contingent and prospective liabilities (s123(2) of IA 1986).

WRONGFUL TRADING

Most directors are aware of the wrongful trading provisions, which create personal liability on those who fall foul of them. The provisions are a significant deterrent to directors despite the fact that few cases ever come to court. Broadly, they empower a liquidator to bring proceedings against directors who permit the company to trade past the point when insolvent liquidation was inevitable, causing loss to the creditors in the process. If found liable, the directors can be ordered by the court to personally contribute to the creditors’ losses.

The key elements of wrongful trading, under s214 of IA 1986, are as follows. At some time before the commencement of the (insolvent) winding up, the director knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation. There is a defence available to directors if they can show that they took every step with a view to minimising the potential loss to the company’s creditors as they ought to have taken. Directors will be judged on the assumption that they are reasonably diligent, and are subjected to a test containing both objective and subjective elements. The facts that they ought to know or ascertain, the conclusions they ought to reach, and the steps they ought to take are those that a person having the general knowledge, skill and experience reasonably expected of a director carrying out the director’s functions, and (the subjective element) the general knowledge, skill and experience that the director actually has.

The law does not require directors to automatically place the company into a formal insolvency process at the point at which they become aware that the company’s cash flow has turned negative (see Marini Ltd (The Liquidator of) v Dickenson & ors [2003]). Often, there may be no alternative to doing this, but for directors to have to act precipitately would suggest that their monitoring of the company’s financial position was poor, unless there was an extraordinary external reason for the cash crisis.

When there is no possibility of raising funds to provide working capital and when creditors are pressing for payment, there is often no alternative to a formal insolvency procedure (usually administration or liquidation). In such circumstances, it would be a mistake, bordering on fraud, for the directors to put their heads in the sand and continue to trade on the basis of the hope that something might turn up. The sanctions and penalties of the provisions relating to misfeasance, fraudulent trading, as well as wrongful trading, await directors who behave like ostriches.

FRAUDULENT TRADING

The fraudulent trading provisions only apply if it appears during the course of the liquidation that the business was carried on with the intent to defraud creditors or for some other fraudulent purpose (s231 of IA 1986). Since the wrongful trading provisions are sufficient to catch the fraudulent incurring of credit and since there is an easier burden of proof, the fraudulent trading provisions are rarely used against directors, although they have been used occasionally to prosecute persons other than directors.

MISFEASANCE

Directors can also be prosecuted by the liquidator for misfeasance (s212 of IA 1986). This section applies where directors have misapplied or retained, or become accountable for, any money or assets of the company, or where they have breached a fiduciary duty. Misfeasance is easier to prove and less expensive to pursue than claims for wrongful trading and fraudulent trading. In the court’s discretion a director may be personally liable to compensate, restore or contribute to the company’s assets. Directors who have acted honestly and reasonably, or ought in fairness to be excused, should have a successful defence.

DE FACTO AND SHADOW DIRECTORS

It should be noted that the provisions of IA 1986 apply to de facto directors and shadow directors. There is sometimes confusion over these, but in essence the position is simple and any person involved in such a role must assume that they will be liable as a director. A de facto director is a person who acts as a director without being formally appointed as such.

A shadow director is defined under s251 of IA 1986 as:

‘… a person in accordance with whose directions or instructions the directors of the company are accustomed to act (but so that a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity).’

The board of a parent company will quite often act as a shadow director in relation to its subsidiary. This may not be problematic so long as the board realises the potential liability, eg for wrongful trading.

NON-EXECUTIVE DIRECTORS

The crucial thing for non-executive directors to understand is that they are subject to all the same duties as full-time directors. This is especially important if the company is about to enter the twilight zone, as non- executive directors have the same liability for wrongful trading as their full-time colleagues.

PRACTICAL POINTS

Once it is clear that the company is about to enter or is already trading in the twilight zone, the following are amongst the usual points of advice for the directors, although for obvious reasons, it is not intended to be a comprehensive list:

  • It is essential that, as and when appropriate, directors take expert professional advice from lawyers, accountants and licensed insolvency practitioners. The courts will usually take into account whether directors have acted with the benefit of expert professional advice when trading in the twilight zone and those that have done so are far less likely to be regarded as culpable (see Re Douglas Construction Services Ltd [1988]).
  • The directors are solely responsible for the running of the business and it will be no defence to allegations of misfeasance that duties were delegated to employees or others. Directors should implement systems to ensure that what needs to be done is done and must expect to be found liable if those systems do not work.
  • Full and up-to-date financial information is essential, including cash-flow forecasts for at least six months ahead, preferably 9-12 months or longer. Financial records should be kept strictly up to date and a weekly cash flow should be produced in addition to the usual monthly management accounts.
  • Regular board meetings should be held, preferably weekly when cash flow is most problematic, with all directors attending. The cash-flow forecasts and cash-flow management should be discussed in detail, and the advice of professional advisors noted. Accurate minutes should be kept of the reasons for permitting the company to continue trading, including why there is considered to be a reasonable prospect of avoiding insolvent liquidation. These minutes should be reviewed and updated at each future board meeting. This will help to provide protection if a future liquidator accuses the directors of wrongful trading.
  • Regular communications should be maintained with the company’s bankers in order to maintain their support. The same applies to key creditors, suppliers and subcontractors.
  • Crown debts should be paid promptly, failing that a negotiated repayment arrangement should be sought swiftly.
  • Payments should be monitored to avoid those which might constitute a preference. Arguably, payments to ensure the continuance of key supplies and services will not constitute a preference if the motive for payment is the survival of the business, but the reason for payment should be clearly recorded to protect against allegations that might be made later.
  • Directors will need to take care not to infringe the sections of IA 1986 relating to preferences (s238), transactions at undervalue (s239) and granting of floating charges (s245), when raising funds or causing the company to repay guaranteed debts or disposing of assets.
  • Directors of publicly listed companies will have a range of regulatory issues to consider, including the duty to notify the company’s financial difficulties. There are criminal sanctions for misleading statements.
  • Directors should consider carefully before resigning as this may open them to the allegation that they failed to take steps to minimise the losses to creditors. A director who advocates formal insolvency because of a disagreement with the majority of the board’s view as to the ability to avoid insolvent liquidation should take independent legal advice. At the very least, a director in that position should always seek to have their minority view minuted before taking the decision to resign.
  • Placing the company into administration will require some planning, including negotiating funds for trading in administration, if that is what is intended.
  • If it becomes inevitable that the company will have to go into liquidation, directors should swiftly take every step reasonably necessary with a view to minimising the loss to the company’s creditors. It is essential not to incur any further fresh liabilities, except those necessarily incurred placing the company into liquidation.