Directors Duties when a company is facing Insolvency

Directors Duties when a company is facing Insolvency

1)     Introduction

The definition of insolvency has two elements, negative net assets and the ability to pay debts as they fall due. Given the fact that many viable companies may have, and for various reasons, negative net assets, the true test is more often the liquidity or cashflow test – with common indicators being a judgment action / a creditor statutory demand or sheriff notice. In these circumstances directors have a duty to assess the business outlook and carefully consider next steps.

In the normal course of business, the directors in their capacity as stewards of the company, owe a certain amount of duties, and paramount among those are the fiduciary duties owed to the members/shareholders. However, when a company is deemed insolvent, the directors’ duties switch to act in good faith in relation to the creditors.

2)     Fiduciary duties

The Companies Act 2014 set on a statutory footing the fiduciary duties of company directors which were previously recognised only in common law.  Section 228 sets out the following duties of directors (6 of which are derived from common law and 2 of which were previously included in company law): https://www.irishstatutebook.ie/eli/2014/act/38/section/228/enacted/en/html

1.     To act in good faith in what the director considers to be the interests of the company;

2.     To act honestly and responsibly in relation to the conduct of the affairs of the company  (this duty was previously set out in law under section 150/628 of the Companies Act 1990);

3.     To act in accordance with the company's constitution and exercise his or her powers only for the purposes allowed by law;

4.     Not to use the company's property, information or opportunities for his or her own or anyone else's benefit (unless in specific allowed circumstances);

5.     Not to agree to a restriction of his/her exercise of independent judgement (unless in specific allowed circumstances);

6.     To avoid any conflict of interest between the director’s duties to the company and his/her own interests (unless in specified allowed circumstances);

7.     To exercise the care, skill and diligence which would be exercised in the same circumstances by a reasonable person;

8.     To have regard to the interests of the members of the company, in addition to the duty under section 224 to have regard to the interests of the company’s employees in general (this duty was previously set out in law under section 52 of the Companies Act 1990).

3)     Case Law

There has long been a deference to the interests of creditors in case law, in instances where the company is insolvent. In Re Frederick Inns (1993), subsequently endorsed by Swanpool (2006), the matter of director duties and the safeguarding of company assets on behalf of creditors were deemed paramount. Once a company is facing insolvency, it is imperative for the assets of the company to be dealt with in a manner designed to ensure the proper distribution of those assets in accordance with insolvency law.

In a seminal case in respect of directors of a liquidated company La Moselle Clothing (1998), approved by the Supreme Court in Re Squash Ireland (2001), the following tests were outlined with a view to assessing director conduct and whether they have acted responsibly:

(a)  The extent to which the director has or has not complied with any obligation imposed on him by the Companies Acts.

(b) The extent to which his conduct could be regarded as so incompetent as to amount to irresponsibility.

(c) The extent of the director’s responsibility for the insolvency of the company.

(d) The extent of the director’s responsibility for the net deficiency in the assets of the company disclosed at the date of the winding up or thereafter.

(e) The extent to which the director, in his conduct of the affairs of the company, has displayed a lack of commercial probity or want of proper standards.

4)     Liquidator Section 682 Report

A liquidator is prescribed to carry out an investigation into a liquidation and the antecedent causes for the company collapse, and the directors’ conduct. The report based on the investigation, will cover all persons who acted as director or de facto directors in the 12 months up to the liquidation date.

The liquidator is obliged to file the Section 682 Report with the Corporate Enforcement Authority (CEA), and to set out the grounds for relief from the obligation to take Section 819 restriction proceedings to restrict the directors from acting as directors (or in more serious director derelictions of duty, disqualification proceedings).

One of the most important questions in the prescribed format of the Section 682 report is section 23 (f):

Has the Person demonstrated to you that s/he has acted honestly and responsibly in relation to the conduct of the Company’s affairs?
 
 The basis of the reply to this question will be borne out by the liquidator’s report and will include mention of a range of factors including the following conclusions from the liquidator’s investigation:

-        The causes of the liquidation

-        The date of insolvency of the company

-        Whether the company continued to trade, and the resultant deficit in assets

-        Whether the directors maintained proper books and records and management accounts

-        Whether the company was up to date with returns and compliance

-        Whether the directors sought professional advice

5)     Other relevant matters for liquidator Investigation:

Unfair Preference: further to Section 604 of the Companies Act, a liquidator will investigate preferential payments to creditors in the six months preceding the liquidation date (two years look back for transfers to connected parties)

Misappropriation of Assets / Phoenix Company: a liquidator will investigate any diminution of assets from a review of company records, including Phoenix company instances whereby tangible or intangible assets are sequestered away to a new company.

Books and Records: a liquidator will investigate whether the company has maintained proper books and records further to Section 282, and whether this contributed to the insolvency of the company, in which case the directors may be held personally liable.

6)     Director duties – new statutory duties

The CEA have recently published an Information Note 2023/1 (here) which set out the newly codified director duties for companies facing insolvency. The guidance is in response to The European Union (Preventive Restructuring) Regulations 2022 which transposes a recent EU directive concerning insolvent companies into Irish law.

Notably, the new directive highlights the interests of creditors in such circumstances, which are now placed on a statutory footing:

 “A director of a company who believes, or has reasonable cause to believe, that the company is, or is likely to be, unable to pay its debts, within the meaning of section 509(3), shall have regard to:

a) the interests of the creditors,

b) the need to take steps to avoid insolvency, and

c) the need to avoid deliberate or grossly negligent conduct that threatens the viability of the business of the company”

7)      Directors – a proactive approach

As detailed in the CEA publication, directors of insolvent companies have certain duties and obligations, and the interests of creditors are at the forefront. In this regard, there are various steps for directors to follow to ensure that in their stewardship of the company, they have acted honestly and responsibly. These measures, as referenced, include:

-        The maintenance of adequate books and records to appraise to true trading position of the company

-        Management accounts are prepared, being ‘‘Early Warning Tools’’ to decide on a course of action, and whether to continue or to cease to trade

-        The maintenance of budgets and cash flow projections

As well as the measures referenced in the guidance, it is imperative that directors convene regular Board meetings and to retain documentary evidence of the decisions and courses of action. To this end, directors will go a long way towards defending their decision making in light of subsequent insolvency investigations.

The CEA Information Note 2023/1 also highlights a number of restructuring mechanisms for companies in financial difficulties. ‘‘The earlier that a company can detect its financial difficulties and take appropriate action in response, the higher the probability of avoiding an impending insolvency or, in the case of a business the viability of which is permanently impaired, the more orderly and efficient the liquidation process is likely to be.’’

The restructuring mechanisms as referenced in the Information Note are:

Examinership: more details here -  www.mccarthywalsh.ie/services/insolvency

SCARP: more details here - www.mccarthywalsh.ie/scarp

Informal restructuring arrangements: Private restructuring arrangements are sometimes negotiated between a debtor and some, or all, of its creditors. These flexible and informal restructurings are not a matter of public record.

Schemes of arrangement:  Under Chapter 1 of Part 9 of the 2014 Act it may be possible for a company to enter a scheme of arrangement with its creditors. This allows a company to reach an arrangement with its members or creditors or any class of them.

The CEA Information Note places a certain emphasis on professional advice, and that directors of companies in financial distress should seek advice at the earliest opportunity. In this regard, the directors will be able to assess whether there is a potential rescue mechanism for the company, or whether the company should be wound up in an orderly manner. In addition, by following the director code and responsibilities, directors will go some way too to protect themselves from potential restriction proceedings.

This article is of a general nature in relation to directors’ duties in insolvent companies. For professional advice call our team at McCarthy Walsh are available on our confidential line 01 444 5260 for queries and advice.