Directors' liability: directors facing increased exposure from insolvency events

Following changes to the Insolvency Act 1986, directors (and others where fraudulent trading is involved) are now exposed to a wider pool of potential claimants seeking compensation. That pool of potential claimants now includes administrators of the company, the Secretary of State and third parties.

These new risks are particularly significant in cases where criminal, rather than civil, breaches are alleged. Nevertheless, the changes press home the potential risks for all directors that the position can hold, and the need to take advice when their business is struggling.

Wrongful trading and fraudulent trading

Upon a company entering liquidation or administration, the insolvency practitioner will invariably scrutinise the directors’ conduct. If at some point earlier in the life of the company it reached an insolvent position, but it continued to trade beyond a point where insolvency could not reasonably be avoided, the directors are likely to face accusations of wrongful trading. In essence, they can be held personally liable to contribute to a shortfall incurred after the point that they should have known that there was no prospect of avoiding a formal insolvency and they should have ceased trading.

Fraudulent trading, by contrast, is where directors or others involved in the business carry on business with the intent to defraud creditors. Where this is the case, those individuals can be held personally liable for the losses caused to creditors.

Wrongful trading is a civil offence which could lead to a director disqualification and/or financial penalties, while fraudulent trading is a criminal offence which carries the additional potential sanction of a prison sentence.

Liquidators have long benefitted from procedures available to enable them to seek compensation from directors of insolvent companies under the wrongful and fraudulent trading regimes (sections 213 and 214 Insolvency Act 1986). New legislation, however, increases the number of potential claimants.

What has changed?

In 2015, the combined effect of two new pieces of legislation – the Deregulation Act 2015 and the Small Business, Enterprise and Employment Act 2015 – was to introduce a number of changes to the Insolvency Act 1986. These changes could have a material impact on directors and significantly enhance their exposure to claims.

The main changes that relate to directors’ liability are that:

• administrators (as well as liquidators) can now pursue wrongful and fraudulent trading claims;
• liquidators and administrators can now assign the right of action to bring those claims to third parties. They could, for example, assign the claim to a creditor that might have both the motivation and the means to pursue the action more vigorously (sometimes insolvency practitioners are hampered in their pursuit of actions by lack of funds in the liquidation or administration or the lack of appetite of creditors to support the pursuit of the claims);
• transactions at an undervalue or preference and extortionate credit transactions can also be assigned;
• the Secretary of State now has 3 years (previously it had been 2 years) from the date of the company’s insolvency to pursue directors disqualification proceedings seeking the disqualification of a director. Generally, there is a greater prospect of such action being taken where allegations of criminal behaviour are made against the director;
• within 2 years of a disqualification order having been made (or the director agreeing to a disqualification undertaking), the Secretary of State can apply for a compensation order where a director’s conduct has caused loss to one or more creditors of an insolvent company of which the person has at any time been a director. The compensation is payable either:
  • to the Secretary of State, for the benefit of a creditor or creditors specified in the order or a class or classes of specified creditors; or
  • as a contribution to the assets of the company; and
• the Secretary of State can accept a compensation undertaking (instead of a compensation order), which would be a voluntary arrangement between the director and the Secretary of State for the director to pay compensation.

What does this mean for directors?

These changes create a potentially greater risk of financial penalties for directors, as well as non-directors in the case of fraudulent trading. If the liquidator or administrator does not have the funds to pursue claims, there are options for creditors to bring claims or compensation orders to be made through the new Secretary of State route. If there are possible criminal issues, the Secretary of State may consider that there is a stronger reason to pursue compensation orders.

It is yet to be seen how this will work in practice. Will the Secretary of State only pursue proceedings if the office holder does not do so, or does not assign the claims to third parties who will? These concerns could hang over a director for some time – firstly, 3 years during which disqualification proceedings could be issued, followed by 2 years from any order or undertaking during which a compensation order can be issued. If any of those proceedings are challenged, this would further extend the period of uncertainty for the director.

This is a serious message to directors. They must be aware of all of the potential liability to make a financial contribution following the insolvency of a company of which they were director, not just the possibility of a disqualification (which could be subject to a successful application for leave to act whilst disqualified).

Given the more onerous risks for directors, it is more than ever critical that they obtain legal advice if they encounter distressed situations. Case law shows that if directors act reasonably and take professional advice, they have an improved prospect of avoiding sanctions.