Interestingly, a director or shadow director of a company which has gone into insolvent liquidation can be personally liable for debts of any other company with a confusingly similar name which he runs within five years after liquidation of the first company. This is another example of the possible extent to which directors can be held personally liable by courts if their company becomes insolvent.
Sections 213-214 of the Insolvency Act 1986 focus on directors’ behaviour in fraudulent and wrongful trading. If, during the winding up of the company it appears that any business has been carried on with intent to defraud creditors of the company, or, if a company has become insolvent and at some time before the commencement of the winding up of the company and a company director knew or ought to have known that the company would become insolvent, the court, on the application of the liquidator, may declare the person liable to make contributions to the company’s assets. The court only exempts directors from being liable if the director takes every step with a view to minimising the potential loss to the company’s creditors as he is ought to.
The Company Director’s Disqualification Act 1986 governs the position of disqualification of a director. Sections 6-9 of the Act provide for disqualification for unfitness. A court will make a disqualification order if it is satisfied that a director’s conduct (whose company has become insolvent) makes him unfit to be concerned with the management of a company.
Specific to where the company has become insolvent, a director can be considered unfit for two reasons: if he/she was to a significant extent, responsible for the company entering into a transaction which may be set aside as a gratuitous alienation or unfair preference under ss.242-43 of the Insolvency Act 1986 or any other rule of law in Scotland, or if he/she failed to comply with one or more of the obligations under the Insolvency Act relating to the provision of a statement of affairs, co-operation with the liquidator etc. The maximum period of disqualification for this is 15 years and the minimum period is two years. Thus showing the extent to which a director could be found personally liable for a company’s insolvency is a disqualification order for up to 15 years under the Company Director’s Disqualification Act 1986.
In Secretary of State for Trade and Industry v Gray (1995), the Court of Appeal allowed an appeal where the first instance judges had considered that the future protection of the public did not merit a period of disqualification. The Court of Appeal stated that if the respondents’ conduct fell below the standard appropriate for persons considered fit to be directors then it was the judge’s duty to make a disqualification order.
An example of disqualification for unfitness is provided by Re Firedart Ltd (1994), where F, the director, had continued trading through the medium of a company when it was insolvent, had received excessive remuneration and had failed to keep proper accounting records. The appropriate period of disqualification was held to be six years.
A disqualification order is not made principally to punish a director but: “…to protect the public against the future conduct of companies by persons whose past records as directors of insolvent companies have shown them to be a danger to creditors and others”.
As a consequence, although it is possible for directors to be held personally liable to the extent of disqualification for up to 15 years, courts have rarely disqualified directors for periods even approaching the maximum possible under the Act and have frequently allowed disqualified directors to continue on the board of a company which relies on their personality. A recent example occurred in Secretary of State for Trade and Industry v Henderson (1995). In this case, a disqualification order of seven years was held appropriate where a director had over a period of years failed to file accounts to pay National Insurance contributions. Meanwhile, the company was encountering increasing financial distress, yet the particular director took as part of his remuneration package a Jaguar, a BMW, and entertained his family on a regular basis in a bar/restaurant owned by the company at the company’s expense. The court concluded that the director was living off the company’s creditors. Since the introduction of the new director’s duties to consider creditors in the Companies Act 2006, it is likely that the disqualification sentence for that case now would be longer.
In Secretary of State for Trade and Industry v Palfreman (1995), a director of an insolvent company which had failed to pay taxes was the subject of a three year disqualification order but was, nonetheless, allowed by the Outer House to remain on the board of two other companies, provided that his presence on these boards was monitored by an independent solicitor who was also to be appointed to the respective boards.
Ergo, the risk of director’s personal liability has been increased with the introduction of the Company Director’s Disqualification Act 1986, however, it is evident from the case law that courts are not harsh in handing out long disqualification orders and allow discretions for directors who are relied upon within other companies.
The Companies Act 2006 has certainly increased the risks for directors to face personal liability if their company becomes insolvent. The Act has codified director’s duties which were originally a series of common law fiduciary duties into a statutory statement of “general duties”. The seven “General Duties” set out in Part X of the Act are:
- A duty to act within powers;
- A duty to promote the success of the company;
- A duty to exercise independent judgment;
- A duty to exercise reasonable care, skill and diligence;
- A duty to avoid conflicts of interest;
- A duty not to accept benefits from third parties; and,
- A duty to declare interest in proposed transaction or arrangement with the company
A breach by a director of any of these duties will make the any relevant company transactions voidable, and may lead to the company director being held personally liable if the company becomes insolvent and has breached one or more of their duties as director.
A directors duty of good faith, to act for the benefit of the company as a whole, as set out in the 2006 Act was also a common law and equitable principle. Directors are required to act in what they honestly believe to be the interests of the company. In considering what is ‘in the interests of the company’, a director must have regard to the interests of the shareholders of the company and the interests of the company as a commercial entity.
The courts have also considered it proper to take into consideration the interests of the company’s creditors. The decision as to what will promote the success of the company, and what constitutes such success, is one for the director’s judgment. This ensures that business decisions on, for example, strategy and tactics are for the directors to decide, and not subject to decision by the courts.
In the case of E Hannibal & Co v Frost (1988) – a liquidator brought an action against the company after discovering they had paid a bribe with company money. It was held that the director had breached the duty to act in food faith for the benefit of the company. As good practice, and to avoid personal liability, directors should keep minutes as evidence of discussions as to what will benefit the company as a whole which will be taken into account and form a good defence for the director, as evidencing his intentions for the company, should things go awry.
In terms of the directors’ duty to promote the success of the company, the Companies Act 2006 states in Section 172(3): “The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.” This new derivative action makes it clear that the statutory duties set out are subject to certain obligations of directors to act in the interests of creditors; however, the Act does not set out when such circumstances arise. Although weighing up the risk to creditors of any course of action is a necessary part of any director’s duty, a possible issue which this new legislation throws up is whether creditors can take advantage of this and hold them liable for their actions, if directors don’t consider them when their company is becoming insolvent. The matter of having regard for creditors’ interests may be easily dealt with in a wholly solvent company, but for many large companies, the task of balancing risk to creditors against profit to shareholders can be an onerous task, and therefore a constant function of the board. To secure themselves against creditors holding them personally liable for breach of duty if their company becomes insolvent, it will be essential directors for directors now to take proper professional advice from if they see the company beginning to flounder.
With the passing of the Insolvency Act 1986, the Company Directors Disqualification Act 1986 and, more recently, the Companies Act 2006 directors’ liabilities have increased considerably, especially if a company becomes insolvent. Particularly with the introduction of directors “General Duties” now defined in statute and their duties to consider creditors, it is now more likely that directors will be held personally liable. In order to protect themselves, directors should ensure that they are aware of these possible risks and that they are protected as far as possible. They must ensure to take the appropriate steps of analysing and weighing up the risks to creditors and keeping a close eye on their profits and assets to make sure that they will be covered if insolvency does occur.
Bibliography
Primary Sources
Statute
Insolvency Act 1986
Company Directors Disqualification Act 1986
Companies Act 2006
Case Law
Secretary of State for Trade and Industry v Gray (1995) B.C.L.C. 276
Firedart Ltd (1994) or Official Receiver v Fairall 2 B.C.L.C. 340
Re Lo-Line Electric Motors Ltd (1988)
Secretary of State for Trade and Industry v Henderson (1995) G.W.D. 21-1159
Secretary of State for Trade and Industry v Palfreman (1995) S.L.T. 156
E Hannibal & Co v Frost (1988) 4 B.C.C. 3
Article: Director’s Liability Issues, www.ashurst.com/doc.aspx?id_Content=2241
Secondary Sources
Professor Fraser Davidson & Laura J. MacGregor: Commercial Law in Scotland,
W. Green & Son Ltd, 1st Edition, 2003.
Denis Keenan & Josephine Bisacre: Smith & Keenan’s Company Law for Students, FT Prentice Hall, 10TH Edition, 1996,
Brian Pillans and Bourne: Scottish Company Law, Cavendish Publishing LTD, 2nd Edition, 1999.
Insolvency Act 1986 s.75(1)
Insolvency Act 1986 s.75(2)(a)
Insolvency Act 1986 s.75(2)(b)
Insolvency Act 1986, s.133(1)(c)
Insolvency Act 1986, s.133(1)(c)
Insolvency Act 1986, s.217
Insolvency Act 1986, ss.213-214
Company Director’s Disqualification Act 1986, s.6
Secretary of State for Trade and Industry v Gray (1995) B.C.L.C. 276
Re Firedart Ltd (1994) or Official Receiver v Fairall 2 B.C.L.C. 340
per Browne Wilkinson V-C in Re Lo-Line Electric Motors Ltd (1988)
Secretary of State for Trade and Industry v Henderson (1995) G.W.D. 21-1159
Secretary of State for Trade and Industry v Palfreman (1995) S.L.T. 156
Companies Act 2006, Part 10, Chapter 1 ss.171-177.
E Hannibal & Co v Frost (1988) 4 B.C.C. 3
Companies Act 2006, s.172(3)
Recommended in: Director’s Liability Issues, www.ashurst.com/doc.aspx?id_Content=2241