The effect of COVID-19 on directors’ duties and creditor action

Article updated to 26 May 2020 and is not a substitute for legal advice and should not be relied upon as constituting legal advice.

On 20 May, the government published its Corporate Insolvency and Governance Bill. The government intends to fast track this bill through parliament. Once it has been made into law, the bill will make a number of important changes into the UK’s insolvency regime, including the introduction of a new free-standing company moratorium, a new restructuring plan (based on the existing scheme of arrangement), and restrictions on the use of termination clauses by suppliers when their customer is in an insolvency process. The bill will also impose a number of temporary restrictions on the use of statutory demands and winding-up petitions. A creditor’s right to issue a winding up petition will almost certainly be curtailed in the short term. We have published a separate article on the bill.

As a direct result of the restrictions imposed by the government on us all in response to the COVID-19 pandemic, many companies have suddenly and unexpectedly found themselves in a position where they are unable to pay their suppliers and are therefore insolvent on a cash flow basis.

The current situation has brought the issues of directors’ obligations to their company’s suppliers, and the action which can be taken by unpaid suppliers, into sharp focus.

30 March update – the government announcement on 28 March

The government announced that it would introduce legislation to temporarily (and retrospectively) suspend the wrongful trading provisions (summarised below) from 1 March 2020, for an initial period of 3 months, so that directors can keep their businesses going through this period without threat of personal liability.

The insolvency and restructuring trade body R3 has expressed reservations about the government’s plans, highlighting the fact that the wrongful trading provisions are to protect creditors and expressing the view that a blanket suspension could risk abuse.

For the reasons set out at the end of this article, it is important that directors continue to have regard to their obligations as directors and to the interests of creditors, notwithstanding the government’s proposed relaxation of the wrongful trading provisions.

In 2018 the government had announced plans to introduce new restructuring procedures, which would bring about a short moratorium for companies in financial distress (preventing creditor action, including the issue of winding up petitions) and the protection of essential supplies during this moratorium period. Based on the government’s announcement on 28 March, it now appears that (as well as relaxing the law on wrongful trading) the government intends to fast track these proposed reforms.

Directors’ duties – an overview

Directors are obliged to exercise reasonable skill and care in the management of their company’s affairs.

When a company is solvent, its directors are under a duty to act in the best interests of the company and its shareholders. However, when a company becomes insolvent, its directors have a duty to act primarily in the interests of the company’s creditors.

A company may be insolvent on a cash flow basis (when it is unable to pay its debts as they fall due), or on a balance sheet basis (when the value of a company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities).

The obligations on directors to consider the interests of creditors apply not only to statutory directors, but also to shadow directors and to ‘de facto’ directors.

In the context of a group of companies, each company’s solvency needs to be assessed on an individual basis, as directors’ duties are owed to each individual company and its creditors, and not to the group as a whole.

Wrongful trading provisions – a brief summary

The wrongful trading provisions are of particular relevance to directors of companies in financial distress. Section 214 of the Insolvency Act 1986 provides that if the directors of a company continue to trade in circumstances where they knew or ought to have known that there is no reasonable prospect that the company would avoid going into administration or insolvent liquidation, they may be liable for wrongful trading.

In these circumstances, a court can impose personal liability on directors to contribute to the assets of a company if such trading increases the net deficiency to creditors. In order to avoid liability for wrongful trading, the directors would need to show that they took every step which they ought to have taken with a view to minimising the losses to creditors.

This does not necessarily require the directors to cease trading immediately when their company becomes insolvent. A company may be able to trade through its difficulties, or a period of ongoing trading may result in a better outcome for creditors than an immediate cessation of trade.

However, in many cases it is the directors’ potential exposure to personal liability from the wrongful trading provisions which is the main driver behind them putting their companies into liquidation or administration.

Practical steps for directors

For companies in financial distress, the following steps should be borne in mind by its directors, in order to minimise the potential losses to the company’s creditors and reduce the risk of personal liability on the part of the directors:

• an urgent business review should be conducted to prioritise cash flow, for example by reviewing staff levels and reducing expenditure
• the company’s creditors should be treated equally and no creditor should be preferred over another
• however, in a critical situation and where cash-flow dictates, payments to creditors which are necessary to ensure the continuation of the company’s business may have to be prioritised. Professional advice should be sought from an insolvency practitioner before putting in place measures of this nature
• proper records should be kept. The company’s books and records should be kept up to date, and there should be regular financial and operational reporting to the board, and timely escalation of issues
• the directors should meet regularly and stay informed (e.g. with updated management and cash flow information) and the meetings should be fully and properly minuted
• the directors should consider seeking appropriate professional advice (from lawyers, accountants, and/or insolvency practitioners). If a company ultimately fails and a wrongful trading claim is subsequently brought by a liquidator, the courts are likely to be more lenient on directors if they sought professional advice on the viability of continued trading and if they followed the advice they received.  Again, it is recommended that a proper record is kept of who the directors have consulted and when
• all transactions should be carefully considered in the context of the company’s solvency position and the reasons for entering into or not entering into a transaction should be fully recorded
• in the context of a group of companies, consider the intra group arrangements in place, in particular any existing cash pooling arrangements and whether they should be continued given how it operates and the impact on each company in the group. Be aware of the possibility of conflicts of interest where a director sits on the board of more than one company
• engage with the company’s funders and key suppliers, and keep them informed of the company’s financial position and circumstances as appropriate
• seek to form partnerships with your key suppliers that will enable the company and its suppliers to trade through the current situation.  By way of an example, in the context of a fixed term contract for the provision of cleaning services to sites which are temporarily closed, the supplier may agree to its customer paying the supplier’s fixed overheads but not its employee costs for the duration of the site closures
• ensure that you can explain the rationale for the company’s continued trading with reference to the position of the company’s creditors.

Creditor action

A widely used and perhaps the most effective enforcement option open to an unpaid supplier is to issue a winding up petition. As matters currently stand, a supplier which is owed at least £750 which is overdue for payment and where the debtor company has no legal right to refuse payment can issue a winding up petition against that company.

Winding up petitions are often issued in the Insolvency and Companies Court. The Insolvency and Companies Court in London has recently adjourned outstanding winding up petitions on the basis that (unlike other hearings) the general winding up list cannot be conducted remotely by the court. Existing petitions have therefore been adjourned to a series of dates from 17 June 2020 onwards.

As a result of this, it appears that winding up petitions will be listed for hearing on dates significantly later than the usual six to eight week period from the date of issue.

Nevertheless the issue of a winding up petition (and threat of issue) will still have a significant adverse impact on the debtor company and may by itself bring about the collapse of that company, notwithstanding the fact that it may take longer than usual for the petition to be listed for a hearing. The ability to issue a winding up petition therefore remains one of the most important tools in the unpaid suppliers’ armoury.

Updated recommendations for directors and creditors in light of the government announcement on 28 March

The proposed relaxation of the law relating to wrongful trading should be treated with caution by company directors. Although the government has stated that the changes to the law will have retrospective effect, it may be some time before the changes to the law are enacted. 

Furthermore, there are no proposals that we are aware of to change insolvency law in other respects. For example, the law relating to fraudulent trading (which can impose criminal as well as civil liability on directors), misfeasance (i.e. wrongdoing or misapplication of funds by company directors), and to what are known as ‘antecedent transactions’ (i.e. transactions at an undervalue and preferences whilst a company is insolvent) will remain the same. Equally, there are no proposed changes to the circumstances in which company directors can be disqualified. 

For these reasons, directors with concerns over the solvency of their businesses should continue to follow the steps outlined above and seek professional advice in appropriate cases.

Looking at matters from creditors’ perspective, based on the government’s announcement it appears that there will be no temporary curtailment of the ability of a creditor to issue a winding up petition for an unpaid debt in the immediate future. So as matters stand, this remains the ultimate sanction available to an unpaid supplier.