Michael J M Reid, licensed insolvency practitioner and partner of Meston Reid & Co, chartered accountants in Aberdeen explores the impact on directors when firms go under

When a sole trader or partnership becomes subject to formal insolvency proceedings, it is fairly well known that either the sole trader or the partners as individuals have personal liability for every debt that the business has incurred. Accordingly, if there are insufficient assets to pay such liabilities, an individual will have to fund the deficit e.g. by selling a house, in order to meet business liabilities.

With an LLP and limited liability company, many directors operate on the basis that if a liquidator is appointed, liability remains with the company and hence, if there are insufficient assets to pay creditors, the liquidator merely pays a dividend from the monies realised e.g. selling property, collecting book debts etc. The director hopes to walk away financially unscathed !

Whilst this can be the case, a director should beware because there are a number of situations where the Insolvency Act 1986 “ the Act” and the liquidation process generally makes him liable to contribute to the liquidated estate.

For example, it is quite common for a director to have an overdrawn loan account as at date of liquidation. Once the accounting records have been brought up to date and the balance finalised/agreed with the director and/or his advisor, the liquidator will ask the director to repay whatever is due. Similarly, it is fairly common to find that a director, in his capacity as a shareholder, has received illegal dividends i.e. monies declared as dividends in excess of a company’s distributable reserves, and finds that the liquidator approaches him quite quickly in order to seek financial recovery.

Many directors find that they have issued a personal guarantee to the bank and again, shortly after liquidation and the realisation that full recovery will not be made from company assets, it comes as no surprise that the bank will contact the director seeking repayment proposals. Often, a director has to guarantee a property lease, a supplier’s contract or an asset on finance such as a car. In such cases, and assuming that the creditor does not obtain full restitution from the liquidated estate, the director will face a challenging negotiation with the creditor in terms of how any shortfall is settled.

It is not uncommon to find that a company has been incorporated as a result of a successful sole trader business activity, but the director has not ensured that supplier invoices are addressed to the limited liability company. In such case, the supplier who has not been paid by the company will seek to pursue the director on the basis that the invoices have always been addressed to him as an individual rather than the limited liability company. This situation can also apply to VAT registration and thus, it is of paramount importance that when a business incorporates, proper steps are taken to ensure that all appropriate documentation is in place.

Also, a director can find himself with a moral obligation to accept personal liability e.g. if family and friends have lent money to a company and risk facing a substantial loss.

If one delves into the Act for guidance about recovering money to the liquidated estate, two sections tend to be used fairly frequently by a liquidator : sections 242 and 243. The first section refers to a gratuitous alienation and perhaps the easiest example of this is where a director realises that his company is failing and decides to pay far less for an asset than it is worth e.g. the car that he drives. If the director pays, say, £1,000 for a car worth £10,000, the liquidator can seek recovery of the car. As well as losing the car, all that the director receives is the right to rank as a creditor for the amount that he has paid e.g. £1,000. The director is out of pocket.

Section 243 has a similar outcome because it refers to an unfair preference. An example of this is when a director realises that his company is struggling and decides to repay the loan account due to him on the basis that he has worked hard for the company for many years and deserves to have the cash. Such transaction prefers the director over other creditors who do not have access to the company cheque book and again, the liquidator can challenge the director, in court if necessary, seeking recovery of the monies paid shortly before liquidation. Experience suggests that when sections 242 and 243 are brought into use, the director will wish he had sought advice before acting because, at worst, he could find himself at risk of personal bankruptcy if the amounts withdrawn are too large to repay.

The Act also contains a suite of sections ( from 206 to 217 ) which give the liquidator a substantial array of powers in order to recover monies from a director. For example, if a director re-uses a company name without proper permission, section 217 can make him personally liable for all debts that the new company has created whilst using the previous company’s name. A director who is found guilty of contravening section 216, which is the one applying to the re-use of a company name without permission, can be faced with a fine to pay.

Sections 206 and 207 deal with transactions that have the effect of defrauding creditors and can land the guilty director with a court fine, as well as a term of imprisonment at Her Majesty’s pleasure. Some of the sections in this part of the Act address a director being fined for misconduct and of course, if section 213 is instigated and fraudulent trading proved in court, the court may make the director liable to contribute to the company’s assets as the court thinks appropriate.

One of the more popular sections in pursuing a director for personal liability is section 214 which refers to wrongful trading. If there is a successful legal action against a director, the director becomes liable for the unpaid liabilities of a company which were incurred when the director knew, or ought to have known, that the company could not have avoided insolvent liquidation. The test tends to be undertaken with the benefit of hindsight and means that a director requires to be very cautious about his company incurring credit when there is a risk of suppliers being unpaid.

Clearly, if a liquidator instigates legal proceedings, for whatever reason, a director is likely to be liable for defence costs and may also be liable to contribute to the liquidator’s costs if there is an adverse finding. A similar situation arises if the director disqualification unit elects to instigate proceedings against a director in terms of having him disqualified, and the director wishes to defend his position.

In summary, any director who thinks that he can simply walk away from his company if it is liquidated should think again. The clear message is that if a director believes that his company is either in trouble or heading for turbulent financial conditions, specialist advice should be sought at the earliest possible opportunity. Always remember that ignorance of the law is no excuse for being caught by it.

The views in this article are those of Michael J M Reid, licensed insolvency practitioner and partner of Meston Reid & Co, chartered accountants, Aberdeen. They do not purport to represent the views of the firm in general.