Standing on the precipice of insolvency can be heart-wrenching for directors - Michael Thomson

It’s an unfortunate truth that with challenging economic times comes an increase in the number of businesses facing financial difficulty. There is a general acceptance that the UK is heading for, if not yet officially in, a recession and we have seen several high-profile companies go into administration in recent months – including Joules and Made.com.

For many directors, particularly founders and those who have equity, insolvency is a hugely distressing time. As well as the obvious personal financial exposure, the emotional turmoil of seeing your business – one you have put huge effort and sacrifice into nurturing, sometimes from inception and often over many years – standing on the precipice can be heart-wrenching.

The challenge for directors facing this situation is not to bury their head in the sand, as there are several issues that need to be addressed in order to give the business the best possible chance of survival, to ensure that the interests of stakeholders are appropriately protected, and, when all other options have been exhausted, to effect an orderly wind-down.

In the worst-case scenario, there is potential personal liability for wrongful or fraudulent trading if a company director does not perform their duties in the proper manner – carrying the risk of financial penalty, disqualification or, in the case of fraudulent trading, a criminal offence.

Michael Thomson is a partner and head of restructuring and insolvency at Burness Paull

Once a company reaches a certain stage towards insolvency, the scope and nature of the duties of its directors shift significantly. In particular, the directors’ primary duty shifts so that the directors must begin to consider the interests of the company’s creditors (balancing them against the interests of the shareholders where they conflict). The greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors. Where insolvency becomes inevitable, the creditors’ interests become paramount.

Knowing the exact moment at which the financial position of the company means that insolvent liquidation or insolvent administration is effectively inevitable is difficult in practice. However, documenting all possible funding sources for the company, and drawing up a timetable by when financial milestones must be met, will help identify this point.

At this juncture, there are a number of practical steps directors should take to ensure the best possible outcome in what are otherwise challenging circumstances.

Firstly, always have up-to-date financial information. Directors should not wait for an event like a creditor’s claim, a winding up petition, or a failure to meet sales or cash-flow forecasts to alert them to the fact the company is in financial difficulty. It certainly shouldn’t come as an overnight surprise. In particular, directors should be careful to monitor compliance with lenders’ financial covenants.

Secondly, seek professional advice. As soon as a director is aware of financial difficulty, they must raise the problem with the rest of the board with a view to taking immediate advice. This will allow the business to best explore all the options available.

Thirdly, it is crucial that regular full board meetings are called if the company is in financial difficulties and that the commercial decisions of the directors are reported in full in the company’s minutes to ensure accountability. The minutes will be evidence of whether the steps taken by the directors minimise potential loss for the company’s creditors, for the purpose of avoiding liability for wrongful trading.

In some cases, a director may be tempted to resign to avoid the problem. However, resignation is not generally looked on favourably by the insolvency profession or the courts, as it may be regarded as an abrogation of the director’s responsibilities. However, if a director comes to the conclusion that there is no reasonable prospect of the company avoiding an insolvent liquidation but fails to persuade the majority of the board of that despite their best efforts, it may be sufficient if they resign as a director.

The insolvency of their business is a situation most directors hope never to find themselves in. And, fortunately, many never will. However, in the event it does happen, it’s important to have a full understanding of the responsibilities that come with the role – supported by advisers to guide you through the process.

Michael Thomson is a partner and head of restructuring and insolvency at Burness Paull