Threatened insolvency: Personal Exposure of Directors

It is perhaps not surprising that, in practice, a director’s exposure to personal liability is at its greatest when the company of which he or she is or was a director is in financial difficulty.  It is at moments such as this that the activities of the company and its directors come under severe scrutiny: questions arise as to whether the assets of the company have been diminished in such a way as to deprive creditors of full satisfaction of their proven claims – if so, has this been the result of some breach of the directors’ duties?

The general rule is that directors owe their duties to the company. However, when a company is insolvent or in danger of becoming insolvent there is a shift and the interest of the shareholders gives way to interests of the company’s creditors as a general body.

Put simply, where a company faces financial instability, the interests of the creditors intrude and the duty of the company and its directors is then to preserve the assets of the company. If liquidation is commenced, a company’s liquidator may be able to attack the directors for not putting the creditors’ interests first.

Generally speaking, a company is insolvent if it is unable to pay its debts, taking into account contingent and prospective liabilities.  Section 162 of the Companies Act 1981 (Companies Act) provides further guidance on this theme. In form the test appears to be a “cash flow” test of solvency, which means a test of whether the company has sufficient liquid assets to pay its known obligations for the foreseeable future.

However, the Companies Act directs that contingent and prospective liabilities will be taken into account.  Accordingly, any company that cannot pass the conventional “balance sheet” test – a test of whether assets exceed liabilities – might also be insolvent for the purposes of Bermuda law.  Of course much depends on the timing of paying contingent and prospective liabilities.

Whether or not the company is cash flow or balance sheet insolvent is a matter of fact for the directors to determine based on their knowledge of the cash position of the company (including likely available cash) and known liabilities and asset values respectively.

If the directors conclude (or ought to conclude) that the company is insolvent, the company should not incur any further financial obligations unless the directors believe that there is a reasonable prospect that the company will avoid an insolvent liquidation.

There is no single formula or set of principles applicable to companies generally which can be applied to decide if the company is cash flow and/or balance sheet insolvent. Directors must consider and decide if the company is beyond “the point of no return” in terms of prospects and its ability to continue in existence.

If a company is, or is likely to become insolvent, the directors should consider their obligations and liabilities under the Companies Act. The Companies Act provides for certain situations where directors and others may be liable for civil or criminal penalties. In relation to threatened insolvency, the applicable sections are as follows:

(i) Fraudulent Preferences (section 237(1))

A pre-liquidation transaction that a liquidator would look for is the giving of a preference. A preference involves a transfer of money or some interest in property by a debtor to a creditor to settle an outstanding debt and it benefits that creditor, to the prejudice of other creditors, by granting the favoured creditor a greater share of the diminished assets of the debtor company, than the creditor would otherwise receive in liquidation.

In any action brought by a liquidator, the liquidator must establish that the company was unable to pay its debts at the time of the alleged preferential transfer and that the transfer was carried out with the principal or dominant intention of giving a creditor preference over other creditors.

(ii) Offences by officers of companies in liquidation may create criminal liability (Section 243)

A director of a company which is in (or subsequently goes into) liquidation may commit offences and on conviction may be liable to imprisonment. There is an extensive list of such offences in this section. They are largely concerned with failing to disclose or deliver assets to the liquidator, with falsifying or destroying records (see also below) and with obtaining on credit or disposing of property obtained on credit under false pretences.

(iii) Defrauding creditors by the falsification of book or records may create criminal liability (Sections 244 & 245)

The falsification of books or records with intent to defraud creditors of a company or other persons is made a criminal offence and a director in contravention may be liable, on conviction, to imprisonment.

(iv) Fraudulent Trading (Section 246)

If, in the course of a winding up of a company, it appears that any business of a company has been carried on with the intent to defraud creditors, the court (on application of the liquidator, the Official Receiver or any creditor of the company) may declare, that any persons who were knowingly parties to the fraudulent trading are personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company.

(v) The court has the power to assess damages against delinquent officers (Section 247)

The liquidator or any creditor of a company being wound up may apply to the court for orders against directors and other persons involved with the company who are found to have misapplied the assets of the company to, inter alia, compel to the directors to repay or restore money or property with interest or to contribute such sum, to the assets of a company by way of compensation in respect of any misapplication of funds, or other misfeasances or breach of trust, as the court thinks fit.

(vi) Prosecution of delinquent officers and members of a company (Section 248)

If it appears to the court, in the course of a winding up by the court, that any director or shareholder of the company has been guilty of an offence in relation to the company for which he is criminally liable, the court may, either on the application of any person interested in the winding up or of its own motion, direct the liquidator to refer the matter to the Attorney-General.

(vii) Disqualification of Directors (Section 95)

Where the court convicts any person of an offence relating to the affairs of a company, which, in the opinion of the court, involves dishonesty, it may order that such persons shall not, directly or indirectly, take part in or be concerned in the management of any company without leave of the Supreme Court. Also, undischarged bankrupts may not take part in the management of companies. (Section 94)

(viii) Circumstance in which the company could continue to trade without exposing the directors of the company to personal liability

It is safe to say that once a company is in danger of becoming insolvent, the directors have to  consider  the  interests  of  the  creditors,  weighing  on  one  hand  the  gravity  of  the company’s financial predicament against the realistic prospects of the company solving its financial problems.

Directors are exposed for causing a company to trade, when to their knowledge, the company is insolvent without any credible hope of rescue.

In light of the above, directors will be penalised for taking actions which clearly disadvantage the company (e.g. making gifts of assets to third parties or undervalue disposal of assets or improving the position of certain favoured creditors over others) or for involving the company in transactions which are for the benefit of the directors personally or a person or company connected with a director.

You will appreciate that it is almost impossible to unequivocally list the circumstance in which a company may continue to trade without exposing the directors to personal liability. Rather each contemplated transaction would have to be considered in the extent of the Bermuda law as set out above.

PRACTICAL GUIDELINES

Upon discovery that the company is in financial distress, the board of directors should exercise caution and may consider taking the following practical steps which will go some way to counter arguments of ‘unreasonableness’ should these be advanced at a later date:

1. Assess Operational Viability. Each director should consider whether the business is still viable and whether there is any reasonable prospect that the company would avoid going into insolvent liquidation noting that if the company continues to trade and ultimately ends up in an insolvent liquidation, the courts are more likely to determine that directors have carried on business with the intention to defraud and the directors could be held personally liable for the debts of the company.
2. Invoke Additional Austerity Measures. The directors should capitalise on opportunities to strengthen the balance sheet and fortify the cash position (e.g. lean into segment(s) of the business that is generating revenue, innovate /attract new income sources, apply for government stimulus, identify sponsors to provide a recourse guarantee and/or inject equity, restrict workforce size, impose a moratorium on distributions, evaluate business interruption insurance policy coverage, reduce compensation, prioritise business critical operations, exact expense discipline).
3. Stay Informed. Board meetings should be held on a fairly regular basis in order to review the position of the company and to ensure that all directors are kept fully informed.  These meetings should increase in frequency if the financial position worsens.
4. Ensure Proper Reporting Protocols Exist. Decisions of the board should be carefully and comprehensively documented. Full minutes of each meeting should be drawn up, setting out a clear rationale for each decision taken.
5. Aggressively Monitor Corporate Liquidity Profile. Each director should be supplied with information so that he or she can interrogate the financial position of the company, generate financial forecasts (as to market movements, global macro trends, cost and revenues) and/or cash projections and take active steps to monitor operational viability on a regular basis.  Management accounts should be prepared on a prompt and regular basis to ensure directors can keep the financial prospects of the company under review.
6. Holistic, Proactive and Transparent Dialogue with Lenders. As directors grapple with how to resuscitate their balance sheet, they should engage and establish trusted relationships with creditors. A lender approached in good times will be more inclined to offer debt relief support (e.g. standstill/forbearance agreement, restructure debt, waiver of covenants, interest only and payment deferrals, liquidity relief).
7. Establish Information Sharing Channels. Each director should ensure that he or she obtains the information required to recognise potential problems and opportunities early enough to take effective action to avert a further deterioration of the company’s financial position.
8. Seek and Rely on Professional Advice. Each director should ensure that he or she is able to rebut criticism of their actions through careful and regular review of the company’s financial affairs and prospects and by taking early independent, professional advice (e.g. from a restructuring lawyer or an insolvency specialist) when circumstances demand such action – which will evidence reasonable steps being taken by a well-informed board.
9. Formulate Business Continuity Plans. They should work with management to prepare a comprehensive and sequenced contingency plan, agreeing trigger points and ultimately ensuring the timely winding up of the company should this become necessary.
10. Remain Vigilant. The directors must remain adaptive to change and uncertainty as they continue to navigate a world in flux ever mindful of the personal harm they can suffer if their conduct runs afoul of laws put in place to protect creditors of the company.

In short, directors must do all they can to ensure that their conduct in the run up to a formal insolvency process cannot be challenged or criticised.  A director may be excused from personal liability if they take reasonable (data driven) steps to minimise the potential loss or otherwise protect the creditors’ position where difficulties arise.

Coronavirus has upended the daily lives of persons and businesses globally.  One of the major difficulties with the pandemic is that it is impossible to say with any degree of certainty when “normalcy” will be restored and what the new normal will look like. What is certain is that a dynamic management team that carefully monitors the situation and keeps all stakeholders fully apprised will be best placed to protect the interests of creditors and shareholders thereby mitigating the risk of any personal exposure.