This article was first published in Private Client Adviser
Suing directors when a company goes bust
It is becoming increasingly common for creditors to sue directors of companies that have failed, such as Craig Whyte, the ex-director of the former The Rangers Football Club plc. As we approach thirty years since The Insolvency Act 1986 gave a more defined route for wronged creditors to “pierce the corporate veil” and pursue directors personally, and the Government introduced the Company Directors Disqualification Act to prosecute directors and disqualify them from holding office, it is opportune to have a look at how the law has evolved and whether or not there are effective remedies for creditors against rogue directors. What are the potential actions, who can bring a claim and what are the likely outcomes? Firstly, let us define a director which is not as simple as it seems. There are three different terms defining directors:
- de jure director: someone who is properly appointed, knows they are appointed and acts accordingly;
- de facto director: someone who is not a de jure director but assumes the responsibilities as if he were one; and
- shadow director: a term widely bandied about but perhaps misunderstood, is someone who is not a de jure director, but is someone upon whose instruction the board are accustomed to act.
All of the following actions can be taken against any class of director described above, providing, of course, one can first prove their status. The Companies Directors Disqualification Act: Whilst it is within the power of anyone to report a director’s conduct as improper, the vast majority of disqualification orders are made following the winding up of a company. When a company enters liquidation or administration the appointee, usually a Licensed Insolvency Practitioner (IP), or where a winding up order has been made through the court, the Official Receiver (OR), is required to submit a report on the director’s conduct to the Department for Business Innovation and Skills (BIS). The report will either recommend that no action be taken, or that a person is unfit to be a director. Whether or not a prosecution will then follow is determined by any number of issues, but generally action will be taken when it is deemed to be in “the public interest”. In the years from 6 April 2008 to 5 April 2014 there were some 7,175 disqualifications. Disqualification orders range in terms, with the average length of disqualification being around six years based upon the last five years’ statistics. But it does not necessarily follow that because a director has been disqualified that he is ordered to repay amounts to the creditors or to the estate. However, there are actions that can be taken against directors that do result in returns to the estate. The Insolvency Act 1986 There are a number of provisions within the Insolvency Act 1986 which address this. These provisions fall into two separate areas, one is transactional and one institutional. Transactional provisions The Transactional provisions relate to what is referred to as Antecedent Transactions and relate to transactions carried out by the company for another’s benefit and are described in Sections 238 and 239 of the Insolvency Act 1986. They involve what are termed as Transactions at Undervalue and Preferences. In short, a transaction at Undervalue is a transaction from which the company has derived little or substantially less value than would normally be expected. For instance, where a director has work done on his own property for no value or sells a piece of machinery for less than market value. There are hurdles to overcome when pursuing the claim and it needs to be demonstrated that there was a desire on the part of the director to place the beneficiary of the transaction in a better position. However, where the beneficiary is a connected party, such as a wife, former employee, business partner or blood relative, then this test is assumed. A Preference is where a transaction is designed to put a creditor in a better position than he would otherwise have been in i.e. the creditor has been paid or received assets in preference to other creditors. The hurdles are broadly the same as Transactions at undervalue and again where the creditor is connected then the desire is assumed. In such cases, the director, the creditor or the beneficiary of a “transaction at undervalue” can be ordered to restore the company to the position it would have been in had the transaction not taken place. Institutional provisions The provisions that relate to “institutional” breaches are referenced in the Insolvency Act 1986 as Misfeasance, Wrongful and Fraudulent Trading. Wrongful trading is often misinterpreted as fraudulent trading but in actual fact, fraudulent trading is where the business or purpose of the business is fraudulent or has the intention of defrauding creditors. Wrongful trading can simply be defined as trading a company to the detriment of its creditors. The test that is most broadly applied is that the director(s) trade the company beyond the point that any reasonable individual would have concluded that the company should have been placed into some form of formal insolvency procedure. The director(s) could be held liable for any damage that continued trading has caused to creditors. Consequently it is usual for such cases to be brought with a range of dates in mind. It should be borne in mind that there is more than one test for insolvency: a balance sheet test i.e., the companies liabilities outweigh its assets, and a cash flow test which is the point at which the company can no longer pay its creditors as and when they fall due. If it can be demonstrated that the company was beyond redemption, for instance it was in receipt of demands for money, threats of proceedings etc. and the director(s) continue to trade and incur further credit then they could be held liable for the damage caused. Misfeasance We then come to misfeasance, which in layman’s terms catches all of the above and any other breach which is not described above. A misfeasance could be anything from a breach of fiduciary duty to a misapplication of company funds, all of the above described acts are in themselves a misfeasance and it is not uncommon for cases to be brought on multiple grounds. For example, a director’s brother lends the company money, the company is short of cash so the director repays the loan in kind by giving stock to their brother. This could be a preference, a transaction at undervalue and a misfeasance and could form part of a wrongful trading claim. In short there are remedies against delinquent directors, some of which are available to creditors directly. However, it should be remembered that in most cases it is the company that is reimbursed and that the spoils will therefore be split between all of the creditors. Legal action has its own risks and any creditor who wishes either to take action or sponsor an IP in taking action should be aware of those risks. Notwithstanding the above, there are many instances where substantial sums have been recovered and in my experience most cases are settled before they reach the courts. Directors should take advice as soon as there is the merest hint of financial difficulties to protect themselves and the company’s creditors. Hindsight is an exact science and I have numerous experiences where the misguided actions of a director, however well-intentioned, have cost them dearly. Ignorance is not a defence. It may also be possible for directors to insure against certain of these claims, but I would advise reading all of the small print in the policy before paying the premium as the disclaimers will be lengthy. John Dickinson is a Licensed Insolvency Practitioner and partner at CBW, John can be contacted on firstname.lastname@example.org or 020 7309 3832.