An Uncertain Market

01 June 2001

Brett Israel

The last year has brought a year of uncertainty to the market. After a sustained period of what appears to have been a generally stable, if not necessarily well performing, economy in most regions and sectors (though of course this may just reflect typical "affluent South East" thinking!), things have dipped. Aside from the macro issues at the world market and central bank level, an apparent catalyst for change on a UK national level (as indeed elsewhere) has been the reaction of investors to the much-hyped hangover. Perhaps the leading case in point was After initial frenzied activity post-IPO, share values fell back quickly - a crystallisation of thinking that a sustained period of stability was coming to an end.

Hard on the heals of that spirit dampener came formal insolvencies of a number of high profile new economy companies, notable among them, and in the UK and widely publicised difficulties for their ilk elsewhere in Europe and the US primarily. Elsewhere in the economy, the aftermath of the foot and mouth outbreak has been felt beyond the farming community most obviously affecting the tourist trade and hotel sector among others.

And then there has been what is generally considered to have become (or, depending on your viewpoint, long since been) a recession in certain parts of the manufacturing sector, culminating in several quite considerable company crashes like Harland & Woolf in some of the already hardest hit traditional industrial regions in the country.

Commentators over this period have understandably concentrated on the invidious position of investors whose investments in the "new economy" have often been entirely wiped out. Never has the regulatory warning that the value of investments may go down as well as up proven to be so prescient.

Less has been said about the position of the management of such new age companies. Entrusted with the proceeds of initial rounds of seed corn funding (often from so called business angels in the absence of true venture capital investment), they have effectively had to go it alone, many without substantial prior management experience and executive skills. The cash burn rate of many has put the management on the back foot often from a very early stage, further skewing their strategy in terms of the proactive running of their businesses.

The very fact that many such businesses are start-ups restricts them from having access to the many potential sources of funding out there. As mentioned, VCs, though often having quite substantial funds available for investment, have not unsurprisingly tended to follow something of a herding instinct which has caused them to restrict their further exposure to swathes of new companies rightly or wrongly lumped in as part of the phenomenon. Traditional bank debt finance has largely been inaccessible too -aside from limited current account overdraft facilities, term loan arrangements have been missing from the finance menu list. This in turn derives from entrepreneurial spirit needed for future economic growth. So, we find that planned legislation in the pipeline includes that designed to remove the stigma of bankruptcy for those considered "innocent" rather than "culpable" bankrupts. A similar philosophy may apply in the assessment, in hindsight, of the conduct of some directors in the run up to their companies' insolvencies.

Trading whilst Insolvent - a Timely Repeat Warning for Directors

When profits fall and trading performances go south, the guiding principle for directors comes from the law pertaining to wrongful trading*.

The need to avoid wrongful trading when a company encounters financial difficulties in many respects supersedes the usual company law fiduciary responsibilities incumbent on directors before insolvency intervenes. Key here is the shift in the responsibilities owed. Whereas hitherto, the directors will have acted in accordance with the wishes of their shareholders, the focus when the company's insolvency is imminent becomes one of limiting creditors' exposure to the company (with the interests of shareholders ranking behind the creditors). This does, of course, merely reflect the position in any liquidation where shareholders only receive any of their investment back to the extent that creditors have then been paid in full.

So what is wrongful trading and what does it mean for directors? Wrongful trading is unusual in English law - it represents one of only a very limited set of circumstances when a director can incur personal liability arising from his office. In essence, where a director (either alone or with one or more of his fellow directors) has failed to realise that the company is doomed and caused it to pull down the shutters, he can be made to contribute towards the losses incurred to the company's creditors from the date when he should have realised the hopelessness of continuing to trade.

Though undoubtedly a potentially serious issue for directors, it is important to highlight the main components of wrongful trading. These include:

  • The relevant provision in the Insolvency Act 1986 (section 214) comprises objective and subjective elements when determining whether the director knew (subjective), or should have known (objective), that there was no reasonable prospect that the company would be able to avoid going into insolvent liquidation. This means that each director needs to consider not just his own view of the company's chances at the time but also whether, if a court were to consider the matter with the benefit of hindsight, he has any justifiable basis for that opinion.

  • Wrongful trading can only be tested where the company has gone into insolvent liquidation. This then excludes solvent windings up as well as other forms of formal insolvency procedure (such as receivership and administration, provided that none is then followed by an insolvent liquidation).

  • A challenge against a director can only be made by the liquidator, and not creditors individually or collectively. The liquidator must bring the claim in court, its ruling being based on the strength of the claim in all the circumstances. This in turn requires the liquidator to have sufficient funds available to him to finance the claim.

  • Each director is potentially at risk. It may not matter that a director is only a non-executive or was, for instance, not intimately familiar with the trading and financial position of the company. The rationale of the legislation is to ensure that each director acts responsibly - it is up to each to ensure that he has sufficient information available to him to discharge his obligations.

  • A successful finding by the court that a director has caused a company to trade wrongfully can found a claim for the disqualification of that director. Only the DTI can bring disqualification proceedings, but, on conviction (or against an undertaking given by the director concerned), a director can be banned from being involved in the promotion, management or formation of any UK company for between 2 and 15 years.

There is a let out for directors at risk. To escape liability, a director will need to show that he "took every step with a view to minimising the potential loss to ... creditors as ... he ought to have taken". The exact ambit of these words, though obviously very broad, is unfortunately not clear. Generally, the safe course will be for him to do all that he reasonably can to cause the company to stop trading (and thereby incurring fresh debt). Typically, this is done by calling in receivers or putting the company into administration or liquidation (as may be appropriate). Conversely, in certain circumstances, it may be that such action would not be in the creditors' best interests. Some guidance on the interpretation of this would be helpful. The approach that Parliament seems to have taken when formulating the legislation is that directors are expected to be diligent, must decide for themselves what is the appropriate action to be taken and that it is neither possible nor perhaps desirable for set action to be laid down when in fact the position of each insolvent may be uniquely different. One thing is more certain - resignation per se will not represent the taking of every step necessary to protect that director.

Practically speaking, how should directors act when their company gets into financial difficulties? To start with, recognise when your dog has had its day. If, frankly, there is no real future, take prompt action to stop trading (on the assumption that, usually, this will be the best course of action to take). This establishes the date from which the directors cease to be potentially liable for future losses.

If there is a broad consensus on the board that there still is hope (such as from an improved trading performance or future fundraisings) and that hope is not misplaced, then the company can probably trade on. Nonetheless, all board level discussions, which should be very frequent and be participated in by as many directors as possible and represent the views of individual directors, should be fully minuted. This should then leave an audit trail should there ever be any subsequent inquiry. Take professional advice (and duly record the advice given). Taking soundings on the company's position from its auditors or better still an insolvency practitioner will show the directors' due diligence. If in further doubt, speak to an insolvency lawyer.

A final thought. Strictly not be construed as a licence to trade wrongfully, a recent Court of Appeal ruling* has actually made it somewhat less likely that the wrongful trading provisions will be enforced against delinquent directors (the decision turning on the ability of the liquidator to recover the costs of bringing the litigation in the first place). Nonetheless, it would be a foolhardy director who chances his luck based on that finding.

This article is not exhaustive and is not intended to be used as a substitute for taking legal advice on any particular circumstances.

* A "director " for these purposes is not just someone formally appointed as such to a UK company (whether in an executive capacity or not), but also de facto directors fulfilling the responsibilities of directors and those " shadow directors " who exert a controlling influence on a company's board of directors and who are assumed, for company and insolvency law purposes, to be acting as one of them.

* Lewis v Inland Revenue Commissioners & Others (2000), 2 November 2000

First published in MIS magazine in June 2001.