How can directors navigate insolvency risk during an economic sea change?

Events since the start of the decade have brought accelerated and transformative change across the UK business landscape and economy. The way businesses, employers and employees work and how business growth is driven has changed and is changing profoundly. 

Brexit has required businesses to work in different ways, whether around red tape, workforces and goods flows. The Covid-19 pandemic brought large-scale restrictions, temporary business closures and swathes of office-based employees working remotely. In 2022, rising energy costs, staff shortages and supply chain disruption have increased cost pressures on businesses while inflation rises to levels not reached since the early 1990s.

In some cases, businesses that had viable long-term business plans at the start of 2020 have had to rethink and restructure in order to survive in this "new normal". Directors, who have been at the helm of profitable businesses, may find themselves chartering new, unknown waters, with cash flow projections turning negative, a reduction in cash resources and increased creditor pressure. What action can directors, who may be experiencing these types of pressures for the first time, take to mitigate risks? 

Assessing insolvency risk

Directors should be aware that there are two core legal tests for assessing a company's insolvency:

• The "cashflow" test. Where a company is unable to pay its debts as they fall due, typically (but not always) evidenced through a company's failure to pay a statutory demand in relation to an undisputed debt.
• The "balance sheet" test. Where the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

Should directors be concerned in relation to either of these tests, seeking professional advice at an early stage offers the best opportunity to carry out contingency planning and to obtain strategic advice in relation to refinancing, restructuring or insolvency options. It is important to emphasise that satisfying either test does not inevitably mean that an entity should cease trading, but rather it should act with caution and follow the points set out below.

Duties when a company is in financial difficulty

As opposed to a director's usual core duty to act in the best interests of the company and its shareholders, directors are required to act in the best interests of creditors when a company is facing financial difficulty. This means that every decision made should be taken with a view to minimising loss to creditors, even if this is at the expense of the shareholders or the company's wider group. 

There are significant personal risks for directors continuing to trade when there is a risk of a formal insolvency, and a failure to act in the best interests of creditors of the company may lead (amongst other things) to:

• Actions against directors for wrongful trading. Where directors continue to trade a company in circumstances where they know, or ought to know, that the company has no reasonable prospect of avoiding an insolvency process, they may be personally liable for the losses which continued trading causes, unless they take every step to minimise such loss.
• Actions against the director for misfeasance or breach of duty. Where the directors have breached a duty, or misapplied, retained or otherwise become accountable for assets of the company, they may be personally liable to account for such assets, or to make a contribution to the company's assets following insolvency.
• Actions against the director for deceit. Creditors may be able to take action against directors who make commitments to them knowing that the company would not be able to pay for supplies when payment falls due.
• Challenge to transactions or other actions. A future administrator or liquidator may challenge transactions entered into by the company which are made as a gift, or for significantly less than the value of the relevant assets. They may also challenge actions taken by the company which have the effect or putting certain creditors of the company (including intragroup creditors) in a better position than they would otherwise have been if that action had not been taken; and
• Disqualification action against the director. Action may be taken to disqualify an individual from acting as a director in the future where they are involved in the failure of a company and act in a way which calls into question their fitness to be involved in the management of a company.

How can directors mitigate their risk?

Where a director has concerns about solvency, practical steps to mitigate risk include:

• Seeking early professional advice. This will likely provide the company with the largest range of contingency options, including potential refinancing, restructuring or sales processes. Such advice will also enable the director to evidence that they took appropriate advice with a view to minimising losses of creditors, as reliance on professional advice (if acting reasonably) may be a good basis for continued trading.
• Holding regular board meetings. In order to assess the financial position of the company and whether the company should continue to trade, discussions at such meetings should then be formally documented in board minutes.
• Obtaining regular, clear, and up-to-date financial information. In order to assess current financial performance and future cash flow, including financial pinch-points, this will assist the directors in establishing potential remedies to the financial difficulties being faced.
• Making decisions on an entity-by-entity basis. Where directors are common directors across multiple entities in the same group, decision-making should be made on an entity-by-entity basis as if they were independent directors. This may mean that certain decisions (such as intergroup transfers) usually taken on a group-wide basis become inappropriate and expose the directors to risk.

There may also be other actions which the directors should take, particularly where the company is subject to specific regulatory obligations or listing rules. 

Osborne Clarke's Restructuring and Insolvency practice is well-versed in advising boards of directors on their duties, restructuring mechanisms and contingency planning advice. Connect with one of our experts today.