Small company insolvency – Directors beware
Updated: Oct 28, 2021
We’ve all heard of limited companies. Limited companies are separate legal structures that separate a business from the management and the owners.
A limited company structure provides limited liability to shareholders. Limited liability generally provides that a shareholder’s financial liability is limited to a fixed sum, which is commonly the value of the shares that they have subscribed for as their initial investment in the company. So long as the shares have been issued and fully paid then no further liability should arise on a shareholder.
Directors manage a company and shareholders own the company. Directors have statutory and fiduciary duties to the company i.e. duties of care and good faith to act in the best interests of the company rather than themselves. In small businesses, the directors and shareholders can be the same people, or even the same person.
Directors and shadow directors of limited companies need to be careful when a company is struggling to pay its debts when they fall due, and particularly if the business has incurred losses. It can be tempting for directors, and especially if they are also shareholders in the company, to act in their own best interest rather than that of the company and its creditors.
In this post we review some of the main matters for directors to be aware of and consider when a company is insolvent or heading towards insolvency.
When a limited company goes into liquidation, the creditors or the state will appoint an Insolvency Practitioner; sometimes known as a liquidator. They have a statutory duty to investigate what caused the company’s failure and whether the directors committed an offence or failed to act in the best interests of the company. They must also report their findings to the Insolvency Service who will then consider any legal action to take against the directors.
The legal action could be any of the following:
civil court action
criminal charges and possible imprisonment
disqualification from being a director of a company
An Insolvency Practitioner has legal powers to bring the directors to court and pursue personal liability against them.
Repayments of Coronavirus loans and grants
An Insolvency Practitioner must investigate any potential fraud that has incurred following Coronavirus related support schemes. This includes all of the following:
Bounce Back Loans
CJRS for furlough pay
Local authority grants
Eat Out to Help Out grants
With respect to Bounce Back Loans, which can be relatively large compared to other Coronavirus based government financial support, an Insolvency Practitioner must try to assess whether the company genuinely met the criteria to apply for the Bounce Back Loan and how the funds were actually used.
The original terms behind Bounce Back Loans stated that they must be used to provide ‘economic benefit to the company and not be used for personal use’. It is not uncommon to find that directors have used the funds personally, often withdrawing the funds from the company for their own benefit, resulting in an overdrawn director’s loan account and where the directors then do not have the funds to repay the money back to the company. HMRC can charge a 100% tax penalty arising from fraud relating to the furlough scheme.
In three recently court cases, the Insolvency Service pursed several directors following misused Bounce Back Loans where the companies became insolvency. The directors used the loans for personal use rather than to support their business.
Three directors were banned following investigations that found that £100,000 of Bounce Back loans had been ‘inappropriately applied for or misused’. The directors were banned for 9 years. These cases show that the Insolvency Service will investigate and use its powers against directors who have abused their position regarding the Coronavirus support schemes.
Businesses could apply for loans of up to £50,000 to help the business following the impact of the Coronavirus.
Once the directors of a company conclude, or should have concluded, that there is no reasonable prospect of the company avoiding insolvency they have a legal duty under the Insolvency Act 1986 to take every step which a reasonably diligent person would do to minimise the potential loss to the company’s creditors. If it appears to a court that a director has failed to comply with their legal duty, the court can order the director to make a financial contribution to the company’s assets to help pay the company’s creditors.
Just because the company is insolvent does not mean that directors become automatically responsible for the company’s debts. The insolvency of a company may have arisen because of something outside of the control of the directors e.g. a large customer not paying an amount due to a company and therefore causing the insolvency of the company.
Directors need to be able to show that they took every reasonable step to minimising the company’s future losses. The directors only become responsible, for future losses generated, when they continue to allow the company to trade, the company’s financial position worsens and the directors have little prospect of generating profits to help improve the financial position of the company.
Directors can be optimistic that they can trade out of the current insolvency and therefore act in the best interests of the company. However, their best laid plans may not come to fruition and further losses may be generated. It is therefore important for directors in this position to maintain good contemporaneous records of the financial position and the rationale for their decisions to continue to trade or undertake significant transactions while insolvent.
This arises where one or more creditors are paid in preference to other creditors, and at a time when the company was insolvent. This is probably one of the most common types of claims brought against directors when a company becomes insolvent. It is normally quite easy to prove that one or more creditors have been paid a higher proportion of the company’s assets than any of the other creditors of the company.
An Insolvency Practitioner should review and, if appropriate, challenge any transactions between unconnected parties that occurred up to six months before the insolvency and up to two years before the insolvency for connected parties e.g. related companies, directors and their family or a creditor where the director has given a personal guarantee.
In such cases, an Insolvency Practitioner can request, through the courts, that creditors who are paid in preference to others must repay the company any amount paid in preference. The other creditors of the company can then receive their fair share of any funds. Directors of a company can also be ordered by the court to pay money to the company.
A company can only pay dividends from accumulated retained profits. Dividends should therefore not be paid when a company is insolvent. Any such dividends paid are known as illegal dividends. Any shareholder who knew, or should have been aware, that the dividend could not lawfully have been paid to them can be instructed to repay the dividend back to the company. Once again, this is a reasonably common situation where an Insolvency Practitioner can pursue the repayment of illegally paid dividends.
Transactions at an undervalue
A claim under this heading may arise when the company's assets are sold or transferred by the company for free or at far less than their market value and at a time when the company was insolvent.
The directors may set up a phoenix company, or move the existing trade of the company to another company, and transfer valuable company assets to that other company at a significant undervalue. As a result the creditors of the original company do not get paid the full amount due to them but the new phoenix company receives valuable assets at a significantly reduced price.
Directors can become financially responsible for the repayment of the undervalue transferred. Directors should therefore obtain professional or other quality valuations of assets being sold or transferred to another party at the time of the transfer or sale.
It is the responsibility of the Insolvency Practitioner to review and possibly challenge any transactions where assets may have been sold or transferred at an undervalue up to two years before the insolvency.
This type of claim brought against the directors is very rare. Fraudulent trading occurs when the directors carry on the company business with the intent to defraud creditors e.g. not paying their tax liability, but still continuing to withdraw money from the company for themselves. Directors who are convicted of this offence can be held liable to make contributions to the company’s assets.