In this article Hannah Drozdz looks at the circumstances where the corporate veil of limited liability may not protect a director.
Why might I form a limited company or an LLP?
One of the main reasons to form a limited company or an LLP is to limit liability for company debts. However, there are circumstances where directors may be personally liable, meaning the responsibility for covering business debts or liabilities falls to you. This article builds on our previous article regarding directors’ duties and explores in more detail where personal liability might arise in the context of a distressed company.
To learn more about a director's duties, click here and read our helpful guide.
Direct contractual responsibility
This article will mainly focus on areas where directors risk personal liability because they have fallen short of the standard expected of them. A director may also incur personal liability by agreeing to put their personal assets at risk for the company’s benefit.
Lenders often demand that one or more of a company’s directors give personal guarantees (and even security in support of the guarantees) to support a commercial loan applications. If the company defaults, the lender will look to the director to cover the debt. Suppliers may also try to include a personal guarantee in a credit account application form.
Where a company in financial difficulty wants to put in place a standstill agreement with its creditors, to allow the company time to restructure or refinance, creditors may expect directors to give warranties about the company’s financial status. These are often backed by personal guarantees. This gives added comfort to creditors that the driving force behind rescuing the company also has a vested interest in the success of the process.
One of the most well-known, and misquoted areas of personal risk for directors is wrongful trading. This only applies in administration and liquidation (sections 214 and 246ZB Insolvency Act 1986).
If it appears that a director of the company knew or ought to have concluded at some point before the insolvency process there was no reasonable prospect the company would avoid going into the insolvency process, the insolvency officeholder can ask the court to order the director to contribute to the company’s assets.
Liability only arises if, on a net basis, the insolvency officeholder can prove the company’s creditors (considered together) are worse off because of the company’s continued trading.
The test is subjective and objective. The Court will consider both the general knowledge, skill and experience:
- which that director actually has; and
- which would be expected of a reasonably diligent person carrying out the same functions as the director carries out in relation to the company
when it assesses the facts that a director of a company ought to know or ascertain, the conclusions the director ought to reach and the steps the director ought to take.
Click here and read more about trading through financial difficulties.
Fraudulent trading is much more serious than wrongful trading, as it is also a criminal offence. The difference between the two is that the director has behaved dishonestly. For example:
- inducing someone to lend money to the company knowing there is no prospect of repayment;
- accepting lines of credit from suppliers or placing orders, knowing the company will not be able to pay for the supplies or repay the credit; or
- taking payment on credit from customers, knowing the company will not fulfil the orders
Insolvency Practitioners bring fraudulent and wrongful trading claims. A creditor or supplier would, in these circumstances, also be able to bring a direct claim for damages against a director.
The punishments for fraudulent trading (although similar to wrongful trading) are more severe. A director may be:
- held personally liable for a larger proportion of the company's debts
- given a longer disqualification
- fined more for their actions
- sent to prison
Breach of Director’s Duties
The consequences of breaching director’s duties is being personally liable to the company for the losses caused by the breach.
Where a company is insolvent or on the verge of insolvency, the directors owe a duty to the company to act in the best interests of the creditors of the company.
Directors should not, for example, cause an insolvent company to repay shareholders' debts or make distributions to shareholders out of the profit from company contracts if this effectively amounts to an attempt to distribute the company's assets without proper provision for all the creditors. Directors might be paid through dividends as this can be more tax efficient. Payment of “salary” by dividends would not be excused where the statutory requirements for a company to pay dividends were not met.
Commercial pressure on a company's finances may lead to creditor demands, or commercial pressure, on the directors to cause the company to undertake actions which may be designed to ease the company's day-to-day problems. The transactions may be reviewable transactions, such as a preference or a transaction at an undervalue if the company later goes into liquidation or administration. Directors who cause the company to enter a reviewable transaction under insolvency legislation, risk personal liability for any resulting losses to the company’s creditors.
To understand the risks of dealing with a distressed company, read our guide here.
If a company does not pay the correct amount of NICs, HMRC can issue Personal Liability Notices to recover the unpaid NIC plus interest and penalties from a company’s directors or any other officers personally. HMRC will consider issuing a notice where a company made significant and/or regular payments to other creditors, connected persons or companies, or in the form of directors' salaries and yet failed to pay NIC.
HMRC can make directors and other persons involved in tax avoidance, evasion or phoenixism jointly and severally liable for a company's tax liabilities in certain circumstances. Directors of a company carrying on a trade similar to that carried on by at least two previous companies the director was connected to in the previous five years, and which entered insolvency with unpaid tax liabilities are at risk.
See our related article where we discuss the risks for personal liability where a director is involved with a company which re-uses the name, or a similar name, to a company in liquidation.
What can disqualify a director of a company?
The court can disqualify a director of a company that becomes insolvent, or that is dissolved without entering an insolvency process first, if that person's conduct as a director makes that person unfit to be concerned in the management of a company. The court will consider:
- Any misfeasance or breach of any fiduciary duty by the director in relation to a company here or abroad
- Any material breach of any legislative or other obligation which applies to the director as a result of being a director of a company
Where a director is subject to a disqualification order or a disqualification undertaking, the Court may make a compensation order which requires the director to repay the loss caused to the company or any of its creditors.
Where a director acts in breach of a disqualification order or a disqualification undertaking, creditors may bring a direct claim for compensation.
There are grounds for avoiding liability; Gateley has substantial experience of representing and advising directors in these circumstances.
The Pensions Regulator has the power to impose financial penalties on directors where the company has a defined benefit scheme. This will be a key consideration where a restructuring is contemplated.
- The Regulator can recover contributions from a director on behalf of the pension scheme by issuing a Contribution Notice where the director is party to an act or failure to act in specific circumstances. This could occur for example where the act or failure to act reduced the value of the employer's resources and that reduction was material relative to the scheme's estimated employer debt. A Contribution Notice will require any amount up to the full buy-out deficit to be paid.
- Restoration orders can be issued if there has been a transaction involving the scheme that is deemed to have been undervalued. These allow the assets (or their equivalent value) to be restored to the scheme.
This is a complex area of law and Gateley can provide specialist advice on this subject.
Indemnities/Directors' and Officers' insurance
Companies will often obtain Directors' and Officers' (D&O) insurance cover to insure directors against liability arising out of the discharge of duties as directors, including claims for negligence, breach of duty or other default.
A D&O policy is written on a "claims made" basis, meaning it covers claims made during the policy period (typically 12 months). Claims can be made for wrongful acts committed during the policy period or before the inception of the policy, subject to any exclusions.
The financial limit of cover provided is an aggregate amount to be shared between all directors and officers of the company. This would usually include directors and officers of any directly or indirectly owned subsidiary. Cover is usually written on a worldwide basis and so applies irrespective of the jurisdiction in which the liability arises.
These policies will often exclude any action that is considered fraudulent, dishonest or criminal, but will usually cover defence costs for these types of claims.
The company’s Articles may contain an indemnity for the directors for losses or liabilities incurred in the actual or purported execution and/or discharge of their duties. Directors may also have the benefit of direct contractual indemnities from a company, which are recommended as there is doubt about a director's ability to enforce a provision of the company’s articles in their favour. There are limits though:
- The Companies Act 2006 limits the ability of a Company to indemnify a director in connection with any negligence, default, breach of duty or breach of trust.
- Commercially: an indemnity is limited by the financial status of the company. In an insolvency scenario, an indemnity in the company’s articles might be worthless.
How to avoid liability
Directors who are concerned about the financial position of a company are wise to seek specialist advice on their legal duties and the financial position of the company at an early stage. Our Restructuring Advisory team has significant experience across the country in supporting and protecting directors of both mid-market, large, private and public companies.