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Directors’ Duties in the Twilight Zone

16 Feb 2016

The recent High Court case of Re Ralls Builders Ltd [2016] EWHC 243(Ch) has highlighted the vexed issue of when directors may be held personally liable for wrongful trading in the twilight zone before a company enters a formal insolvency procedure.

If the solvency of a company is in question, the directors must consider and, when appropriate, act in the interests of the company’s creditors. If the company goes into insolvent liquidation, to avoid incurring personal liability for wrongful trading under section 214 of the Insolvency Act 1986, the directors must be able to demonstrate that they:

Took every step with a view to minimising the potential loss to the company’s creditors as (assuming him to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation) he ought to have taken.”

In practical terms this means that the directors should, on a continuing basis throughout such period:-

  • Fully document the company’s financial position on a regular basis – in a substantial business, this is likely to mean management accounts prepared monthly, preparing a budget for the current and forthcoming financial years, assessing actual performance compared to forecasted budget projections and analysing the reason(s) for variance and keeping budget and cashflow forecast projections regularly updated.
  • Before incurring fresh credit, satisfy themselves that the company will have the capacity to repay such credit within the terms agreed with the creditor. Again, the basis for this satisfaction should be documented (e.g. – by reference to the cashflow forecast at the time of scheduled repayment).
  • Where they are in doubt as to the company’s continued ability to pay its debts as they fall due, they should engage appropriate professional advice to undertake a review of the company’s financial position and the viability of the potential courses of action being considered by the directors – in the first instance, this may be the company’s own accountants.
  • Fully assess and document all options reasonably open to them, balancing the respective merits and risks of each course of action. This includes the degree of probability that it will be successfully implemented and the reason for following or not following a particular course of action.

The courses of action will be determined by the particular circumstances faced and the business judgment of the directors. It may include:

  1. further investment (including the availability and terms on which funds may be made available);
  2. restructuring of the whole or any part of the company’s operations; or
  3. cessation of the whole or any part of the company’s operations (including assessing the impact that such action may have upon the realisation of the company’s assets (e.g. – unfinished work and book debts) and the crystallisation of contingent liabilities (e.g. – bonds, guarantees and redundancy costs).

Re Ralls Builders Ltd highlights the ongoing responsibilities of the directors to constantly review the prospects for the company. Whilst the company came under severe financial pressure by the summer of 2010, the Judge held (in the light of negotiations with a potential external investor and advice from an insolvency practitioner) that it could not be said by 31 July 2010 that the course the Directors intended to pursue was unrealistic or doomed to failure. However, by 31 August 2010 (when the investment had failed to materialise) the Directors ought to have concluded that there was no longer any reasonable prospect of the Company avoiding insolvent liquidation.

Whilst the liquidators in Re Ralls Builders Ltd failed to satisfy the Judge that continued trading until it going into administration on 13 October 2010 ultimately worsened the position of the creditors as a whole, he concluded by stating:-

The real sin of the Directors, so far as the unsecured creditors left in the liquidation are concerned, is the manner in which the continued trading facilitated the repayment of the Bank and some existing creditors whilst leaving new creditors unpaid. I have already indicated my view that this is not something that the Directors ought to have permitted to occur…

For further information, please contact Neil Harrold, Partner at Hay & Kilner

Call: 0191 232 8345

Email: Neil Harrold@hay-kilner.co.uk