Few people set up a company fully understanding the legal responsibilities they undertake as a director. These responsibilities actually change when a company enters liquidation or administration. To explain we must first define the term insolvency and what it is to be a director (you don’t even have to be a named director to be liable!):
What is a Director?
It is very important to realise that it is not only registered directors who share the legal responsibilities for a company. Anyone who controls a company, is responsible for the direction of a company’s affairs or tells the directors what to do (referred to legally as a “shadow director”) is liable. It also includes someone who is a director in name only, such as many directors’ spouses or someone who has been appointed a director simply to have their name on the board. There are many circumstances where a director can be held liable for decisions made by the company, even if they didn’t agree with them!
What is Insolvency?
A company is considered insolvent when it no longer has the ability to pay its debts, for example if a business is no longer profitable and its assets do not exceed the value of its debts. It is not legal for the directors of a company to continue trading a business if they are aware creditors may go unpaid. When a company is insolvent, it can either enter liquidation or administration. An independent insolvency expert takes control of the business, selling all assets in liquidation or trying to continue trading the business with a view to selling it as a going concern in administration.
How do your responsibilities change when a company becomes insolvent?
Generally as a director, you are under a duty to act in the best interests of your company and its shareholders. However, the moment your company is deemed to become insolvent, you are under a legal duty to protect the interests of your creditors instead of your shareholders. The company must now function for the primary purpose of getting the best return for creditors. Only if there are excess funds available following a liquidation would the shareholders receive a payment from a liquidation event.
The company’s assets must be managed to give priority to the creditors. These principles have been set out repeatedly in the case law and in the insolvency legislation, the starting point for which is the Insolvency Act 1986. If the company is insolvent then the director’s duty is owed to all creditors, not just one or more specific creditors. The directors cannot dispose of any of the assets of the company or make any payments to shareholders, if provision for the interests of the creditors has not been made. If the company is indeed insolvent then in reality such provision will not be possible and therefore those types of payment should not be made.
A failure by the directors to obey that overriding duty can give rise to a number of claims against them by an insolvency practitioner acting as liquidator or administrator, if the company does go into some kind of formal insolvency procedure. The officeholder may bring a claim against the director(s) for misfeasance which essentially are claims for breach of duty. The duties can be those owed to the creditors, but also those owed more generally to the company (e.g. if a director has not acted in the best interests of the company).
Some helpful links: