The aim of the changes is to encourage companies to continue trading, even if there are insolvency fears, where in other circumstances these might lead directors, concerned about incurring personal liability, to cause companies to cease trading.
In order to understand the change in the law, it is necessary to understand how the law works at present.
Directors of companies are bound to act in accordance with various statutory and common law duties. Those duties, which include a duty to promote the success of the company and a duty to exercise reasonable care, skill and diligence, are owed to the company and its shareholders if the company is solvent. However, when a company is insolvent (whether cash flow or balance sheet insolvent) or at risk of insolvency, the interest of the creditors of the company take precedence over those of the company and its shareholders. In the event that the company enters a formal insolvency process of administration or liquidation, the administrator or liquidator appointed will examine the performance of the company and seek to identify the cause or causes of the company’s insolvency, the point at which the company became insolvent, and the point at which insolvent liquidation or administration was unavoidable.
The wrongful trading provisions (in sections 214 and 246ZB of the Insolvency Act 1986) provide as follows:
If it transpires that at some time before the company went into insolvent liquidation or insolvent administration a company director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going in to insolvent liquidation or insolvent administration (and the company did so enter such an insolvency process) then the administrator or liquidator may apply to court for a declaration that the director is liable to make such contribution to the company’s assets as the court thinks proper. It is that period between the date of (i) knowledge or imputed knowledge that there was no reasonable prospect of avoiding liquidation or administration; and (ii) the commencement of the liquidation or administration, that is the focus of a wrongful trading action.
The risk of personal liability on the part of a director, combined with a director’s compliance with the duties described above, will often influence his decision to put the company in to liquidation or administration.
It is obvious that the interruption to businesses caused by the coronavirus pandemic and the societal response to it is causing many directors to be concerned about causing their companies to continue trading. Recognising this, the government had to respond to avoid companies that might be facing cash flow challenges currently but may be viable in the future, going into liquidation or administration.
Presently, the legislation provides that a court will not make a declaration that a director is liable to contribute to the company’s assets if it is satisfied that after the point of knowledge (or imputed knowledge) that the company could not avoid insolvent liquidation or administration, the director took every step he ought to with a view to minimising the potential loss to the company’s creditors.
That limitation on liability would not necessarily help a director who has to decide now whether or not to continue trading through this uncertain period where the future viability of the company is uncertain. It is possible that the change proposed to be implemented through the awaited legislation will be to exclude the period of three months from 1 March 2020 from the period under examination, but it may not be as simple as that.
In the event of a future insolvency, directors can expect their decision-making to be scrutinised as now, and where there was already knowledge (or imputed knowledge) of insolvency or the inevitability of insolvency, notwithstanding the pandemic, the new legislation may not provide the ‘get out of jail free’ card that many hope it will represent.
The Business Secretary’s reminder that “all of the other checks and balances that help directors fulfil their duties properly will remain in force” should not be forgotten and directors should avoid being lulled in to a false sense of security. The text of the proposed legislation, once it is published, should be considered carefully and directors with concerns about the solvency and/or future viability of their companies should seek advice in the usual way.
