When does a board decide to keep trading through financial difficulties? What factors should directors take into account when doing so whilst minimising the risks of personal liability?
In this article Matthew Brown considers the legal framework within which directors must operate when faced with financial shocks or underperformance. The article also offers some practical guidance to boards at this critical time.
Difficulty in financial planning
Most sectors of the economy are either experiencing or expecting turbulent times. The reasons could be varied but common denominators are rising costs and changing buying habits and markets.
These challenges often manifest in cashflow pressures which, if not understood and dealt with, can lead to business failure. Even when recognised there will be times of financial uncertainty and stress, with difficult decisions to be made, before directors can again focus on growth. All of this will lead to uncertainty in financial planning. Sensitised forecasts may show additional cash requirements.
Even reasonable assumptions may, if overheads cannot be cut and costs passed on, lead to uncomfortable forecasts. Many businesses are now accustomed to dealing with such shocks. This article reminds directors of the legal framework within which they should operate at such a time. Directors should be neither overly pessimistic nor optimistic in working through the many challenges they face. They should have a plan. It should be an effective one based on evidence rather than hope. They should execute it and keep checking that the assumptions upon which it is based still stand.
What is the legal framework I should operate within?
Directors will be familiar with the seven general duties codified in the Companies Acts, as well as the myriad of specific duties in areas such as health and safety. However, where a company is facing financial difficulties, directors need to focus in parallel on two statutory risks.
1. The duty to consider or act in the interests of creditors (arising under section 172(3) Companies Act 2006)
In other words, the normal duties that a director owes to the company and its shareholders are supplanted by a duty to act in the interests of creditors. The logic is straightforward: if creditors cannot be paid then by definition there is no value for shareholders. Decisions must be taken with the interests of creditors uppermost. This may require the acknowledgement of conflicts of interest which must be dealt with.
2. The wrongful trading provisions of section 214 Insolvency Act 1986
By describing poor behaviour and the consequences that follow from that, directors are told how they should behave at such a time.
A director may be personally liable for wrongful trading where a company enters an insolvency process and some time before then:
- the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into the insolvency process; and
- the director failed to take every step with a view to minimising the potential loss to the company’s creditors.
The director’s conduct is assessed both subjectively (what did the director think?) and objectively (what would a reasonably competent director carrying out a similar role in a similar company think?). It is also assessed against any particular knowledge, experience and skill (a finance director will be measured against his skill as a finance director).
What does this tell a director that they should be doing?
- A director should have an opinion, viewed both subjectively and objectively, on whether their company will avoid entering an insolvency process.
- If there is any concern that their company may not avoid an insolvency process, they must take every step with a view to minimising loss to the company’s creditors.
To read more about directors duties, click here to look at our helpful guide.
We set out below our tips as to how to comply with these duties and, importantly, how to demonstrate that they have been complied with.
Finally, insolvency legislation sets out a number of additional sanctions for particular actions. At a time of financial uncertainty directors should not sell assets for less than they are worth (especially not to themselves or their business or family associates). They should be very careful when paying one creditor ahead of another (and especially careful if paying themselves or their business and family associates). The vast majority of directors would never contemplate such actions, but there can be grey areas where an independent view should be taken.
Click here to read our article “dealing with a distressed or insolvent company – what are the risks?” to get some more information about this topic.
Record keeping and an objective view – why is it important?
For the majority of companies, these financial challenges will be faced and overcome. A minority of companies will enter administration or liquidation and the directors’ actions will be reviewed. Two important points arise.
First, it is essential that timely records are kept. Board meetings are the proper format to table and discuss a company’s financial position during a time of financial difficulty.
Financial information should be prepared and circulated and minutes should be kept. It may be necessary to hold board meetings monthly, weekly or even daily as circumstances change and important decisions need to be taken.
Second, these regular and well documented meetings will deal with the ‘subjective’ element described above but not the objective element. This is the time to engage restructuring professionals. Restructuring accountants will help with financial projections, will provide an objective challenge, and will offer good advice on dealing with the situation. Restructuring lawyers will provide objective assurance that directors are in compliance with their duties and will help answer the myriad questions that arise at such a time.
Directors may question how, when cash is tight, additional professional costs will help the company. The answer is that restructuring professionals will be part of the solution and will help protect the directors. Budgets should be agreed and managed so that the costs are affordable.
Practical steps to get through financial uncertainty
We set out below some insights from Gateley Restructuring professionals on getting through a period of financial uncertainty.
The rolling 12 week cashflow forecast – this is the finance director’s basic and most important tool. Most companies enter administration or liquidation because they run out of cash. The forecast should be constantly updated and should form the basis of board decisions.
A business plan and financial model showing a viable future – this is also known as ‘the light at the end of the tunnel’ test. It should show how the current challenges will be overcome and how any structural problems will be addressed so that they do not reappear. It should be objectively reviewed and reassessed regularly, paying close attention to the assumptions that underpin it.
The support of key stakeholders cannot be underestimated, and the best way to ensure it is regular balanced communication. Depending on the situation, it may be necessary to engage with lenders, landlords, HMRC, major suppliers, major customers, trades unions, regulators, pension trustees and any others whose actions could have a detrimental effect on the business (or whose support could have a positive effect).
The key to dealing with stakeholders is to look at the situation from their perspective, address where possible their legitimate concerns, and look for wins that will help you and be manageable for them.
Often a looming cash requirement will focus directors on the need to restructure their business. Operating within the legal and financial framework outlined above, directors will need to generate cash, sometimes quickly, and often without access to their usual sources of finance.
Some possibilities include:
- Cash generation. Now is the time to ensure that every ounce of efficiency is squeezed out of the company. How can credit control be improved? How can debtor days be reduced? Short-term cash may be more important than margin until the business is stabilised. Can stock buying be reduced (especially of less profitable items)? Can old stock be sold cheaply to generate cash?
To learn more about dealing with unpaid invoices, read our guide here.
- Alternate sources of finance. If the company banks with a ‘high street’ lender they will be a good place to start. It may be possible to increase existing facilities or add another facility such as invoice discounting or asset finance. However, their appetite for risk will be cautious and it may be necessary to look beyond them to the huge variety of specialist lenders that have emerged over the last 10 years. Consider appointing a broker as the lending markets have become increasingly fragmented. Lenders now specialise in particular asset classes (property, invoice discounting, cashflow, asset-based lending, leasing finance and many others). They may specialise in particular sectors, or in short- or medium-term finance. Each will come with its pros and cons.
Read our guide on accessing funding and debt advisory here.
- Mezzanine funders. Amongst the new entrants to the lending markets are a variety of mezzanine funders, with a risk and pricing appetite sitting between traditional lending and equity. Whilst rates of 15% per annum may seem high, appetites to risk will also be higher. The cost should also be weighed against the alternative which may be handing over control of a company in return for equity investment (where a 25%+ return per annum will be expected).
- Equity investment. Existing shareholders have the most to lose from a company failure and the most to gain from its success. Their first reaction may be to turn down any request for additional support but this resolve can be tested. There is no legal obligation to provide further funding but if shareholders believe in the future of a business they should be prepared to support it.
Whilst the mezzanine market has developed more recently, turnaround investors have been active for several decades. Typically they will require majority control of a company, but if they recognise a sound business with challenges that they believe can be addressed with their particular skillsets or finance, they may well want to invest. In particular non-core disposals to raise cash can happen very quickly.
To understand more about organisational restructuring, read our guide here.
- Creditor stretch. In the ordinary course a finance director may well choose to pay a creditor late to smooth out cashflow. When there are additional financial concerns, particular care should be taken if treating creditors differently. Delaying some payments for a short time may be perfectly reasonable, but incurring credit that a board knows it will be unable to pay can be grounds for personal liability and disqualification. This is an area where professional advice is essential.
Click here to read our article on when a director can be personally liable for a company’s debts.
How can my business successfully get through financial difficulty?
Many businesses will experience financial challenges this year. The majority will deal with them and move on. Successful businesses will:
- understand and take account of the increased focus on creditors rather than shareholders
- act on well prepared and regularly updated cashflow forecasts and financial projections, backed up by a business plan that is objectively achievable and supported by key stakeholders
- keep good records of decisions made and the reasons for them
- use trusted professional advisors to help navigate through the additional uncertainties
- act early to recognise funding shortfalls and deal with them using the many tools available to them, from self-help to external financing from the many lenders active in the market.