With insolvency increasing at an alarming rate, what are the implications for Directors?
What is insolvency?
A company is deemed insolvent when it is unable to discharge its debts and liabilities using its cash or other assets. This could be because the company’s cash flow position means it is unable to pay bills when they fall due, or the value of the company’s liabilities is greater than the value of its assets on its balance sheet.
The Insolvency Act 1986 sets out various legal procedures for dealing with an insolvency scenario. If an insolvent company intends to continue trading there are three options available to it under the Act: 1) an informal agreement with its creditors to repay debts on different terms, 2) a company voluntary arrangement or CVA (a binding agreement proposed by the company’s directors to its creditors), or 3) entering the company into administration (which offers some protection from legal action by creditors). Alternatively, there remains the option of liquidating or winding-up the company at which stage all remaining assets are sold and distributed amongst its creditors.
Market Trends
Throughout 2022 there has been a sharp increase in insolvency events. The number of company insolvencies reported in the latest Office of National Statistics (ONS) data and the trajectory of the increase is very similar to trends seen during the financial crisis of 2008.
This recent increase is widely considered the result of a combination of issues, including the pandemic and associated lockdowns, and the consequent interruption experienced by businesses; inflation (in part a consequence of increased government spending during lockdown); the economic fallout from the Russian invasion of Ukraine; and a general global economic downturn.
The ONS data shows numbers of insolvencies decreased during lockdowns in 2020 when the government provided support to businesses. However, in the second quarter of 2022 (after government support was removed), total company insolvencies in England and Wales reached their highest quarterly level since Q3 2009.
Link to original source of table here.
Unfortunately, there are several liability exposures for directors arising from higher insolvency risk. Company directors should be vigilant and proactively take action to avoid or minimise liability risk where the business experiences financial difficulty.
Directors' Duties
Directors are under a duty to act in the best interests of the company they serve, but once they realise that the company is irredeemably insolvent, their duty switches to acting in the best interests of the company’s creditors. Failure to comply with this duty can expose directors to potential claims from administrators and liquidators, or from creditors directly (often with the support of specialist insolvency litigation funders).
Determining whether, and exactly when, a company becomes insolvent is particularly challenging for its directors, and the consequences of not adequately doing so are potentially severe.
A recent decision by The Supreme Court, on 5 October 2022, in BTI 2014 LLC v Sequana SA and others [2022] may assist with regards to directors’ understanding of what duty is owed to creditors of a company in financial difficulty and the point at which the interests of creditors must be given due consideration under s.172(3) of the Companies Act 2006. The case considered the extent and timing of the duties owed by directors of a company that is in financial difficulty to its creditors.
The Supreme Court found that creditor interest only arises at the point directors have knowledge, or ought to have knowledge, that the company is insolvent or close to being insolvent, or that an insolvent liquidation or administration is deemed probable.
Directors must still consider and balance the interests of all stakeholders with an interest in the company’s activities (including both its creditors and shareholders), in a manner that is reflective of the circumstances of the company at the time, and act accordingly. As the risk of insolvency increases, the more weight directors must give to creditors’ interests. At the point an insolvent liquidation or administration occurs or is deemed inevitable the interests of creditors must then be given priority.
Although this provides clarity in terms of the stages at which creditor duty changes, as previously discussed, determining whether and exactly when a company becomes insolvent is particularly challenging. Therefore, determining whether an insolvency scenario is ‘probable’ or ‘inevitable’ will likely remain as a potential point of dispute.
Disputes or claims may also arise where there is either a real or perceived inequity between the interests of the company’s creditors and shareholders as a result directors’ actions, or that it is perceived that directors have prematurely given priority to creditor interests to the disadvantage of shareholder interests.
Directors will need to remain diligent in their efforts to appropriately balance competing interests of all stakeholders where the company is in financial difficulty. A critical component of any defence against potential claims in an insolvency scenario will be the directors’ ability to demonstrate they have exercised sound professional judgment.
Claims and potential impacts for Directors
When a company enters administration or liquidation, the insolvency practitioner investigating it will consider how directors acted in the period leading up to the insolvency. Commonly this could lead to claims against directors under the Insolvency Act 1986.
Directors should also be aware of the potential threat of direct claims made by creditors or, under certain circumstances, claims that have been assigned to third parties with the appetite and resource to pursue legal action.
Typically, this will include claims for:
- Wrongful trading – where a director knew, or should have known, that the company was likely to become insolvent but failed to take the necessary steps to minimise the losses to creditors. Any director who knew the company was insolvent but made the decision to continue to trade can be made personally liable for the company debts. They can also be issued with fines.
- Misfeasance – where a director has misapplied money or property of the company and/or breached their duties as a director. Again, a director can be made personally liable for the misapplied funds.
- Fraudulent trading - where a company carries out business with the intent of deliberately deceiving and defrauding creditors. This is a criminal offence punishable by up to 10 years’ imprisonment or a fine (or both). It also renders guilty parties personally liable for contributions to the company assets.
Directors of insolvent companies could also be at risk of directors’ disqualification if their conduct in the run-up to insolvency is deemed to render them unfit to act as a director in the future. The insolvency service has shown that it is willing to use the powers at its disposal to secure disqualification orders against directors of an insolvent company, particularly where it is thought the company has been dissolved to avoid duties and other obligations owed to its creditors. A director can be disqualified for up to 15 years, however, the current average ban is 6 years.
Considering the strain and instability presently found within the global economic environment, the number of company insolvencies is likely to increase further. Where insolvencies occur, there will be various stakeholders seeking to recover losses or debts and, inevitably, the number of insolvency related claims made against directors is also likely to increase.
Regrettably the risks faced by directors in an insolvency scenario are extensive and should not be underestimated.
Current Liability Market
The regional management liability market continues to find its feet following a period of turbulence in 2020 and 2021, principally caused by the COVID-19 pandemic and UK recession concerns. Financial lines insurers continue to monitor their regional and mid-market insured’s exposures to inflationary pressures, the energy crisis and supply chain issues and exclusions relating to insolvency events continue to be commonplace.
Zurich’s management liability package policy, Executive Risk Solutions, provides cover for investigation and defence costs specific to insolvency hearings. It also provides coverage for damages, judgements, awards and settlements. As we’ve already learnt, the number of company insolvencies is likely to increase at an alarming rate throughout 2023 and 2024 and at a time at which high levels of scrutiny will be placed on the actions of the company’s directors and officers, it’s imperative to ensure coverage for insolvency related events is included within the directors and officer liability policy.
Martin Sanchez-Walker, Senior Claims Adjuster – Financial Lines, Commercial Insurance UK, martin.sanchez-walker@uk.zurich.com
Tom McCarthy, Senior Underwriter – Financial Lines, Commercial Insurance UK, tom.mccarthy@uk.zurich.com
