Seonaid Sandham

Yet, at a time when Scotland’s corporate insolvencies are 17% higher than they were pre-pandemic (Carpet Right, The Body Shop, Wilko, to name a few), it may be prudent to be cognisant of your responsibilities and these duties.

Whether it’s directors choosing to close down their business (such insolvencies having more than doubled since 2019), or creditors taking action, directors should be taking professional advice on all aspects of their role as a director. That includes seeking timely advice on the steps to take if the financial stability of the business is slipping beyond reach.

Creditor duty

Ideally, many directors will be aware of their statutory duties under the Companies Act 2006. Fundamentally, this requires that each director of a company is satisfied, acting in good faith, that the actions or otherwise taken by the company would be most likely to promote the success of the company for the benefit of its members.

However, that general duty is modified by the requirement for directors to consider or act in the interests of the creditors of the company “in certain circumstances” where any enactment or rule of law requires them to do so. This is referred to as the “creditor duty”. It engages when a company is in, verging on or is at real risk of insolvency. The concept of ‘creditor duty’ first arose in a court decision in 1988 and subsequently became the legal benchmark to guide decisions for the next 30 years. 

Creditor duty and the courts

Recently the courts have been examining the scope of the ‘creditor duty’ in a series of cases. These have considered: 

1. Whether directors, having taken professional advice at all times prior to the company being placed into liquidation, were exonerated from any subsequent finding that what they thought was legitimate tax avoidance, was in fact an illegal tax evasion scheme and as a result the company went into liquidation.
2. Whether directors were in breach of the ‘creditor duty’ when they paid out a large dividend to a subsidiary company, when the paying company had large contingent liabilities which may have risked insolvency at some future date should those liabilities be crystallised.
3. Whether the ‘creditor duty’ could be triggered when a company is actually insolvent at the relevant time, but the company directors believed the company was solvent because they had disputed the company’s tax liability.

It’s important to note that the fact a company is insolvent does not of itself make a director liable for its debts, liable to be disqualified or, generally, make transactions invalid. Insolvency is only a trigger but from a legal perspective, once insolvency is triggered it can be tricky to strike the balance between considering the interests of the company’s creditors and its shareholders.

Crucially, there must be some knowledge (actual or deemed) of insolvency/impending insolvency on the part of the directors before the ‘creditor duty’ arises. Even when the company is already insolvent. This is often an area in which directors stumble, for the court will decide (based on the facts and circumstances of each case) the point at which a director ought to have known the company would be unable to avoid insolvency. From that point onwards, the transactions of the company / decisions of its directors are subject to scrutiny and at risk of being challenged and/or undone.

Breach of creditor duty

If a director is found to have breached the ‘creditor duty’, the consequences can be serious, both financially and reputationally. The headline ‘Ex-BHS directors must pay £18m over chain’s collapse’ highlights one of the more extreme outcomes of a case. Even when a director considers s/he has been acting in good faith, the director can still be found personally liable to repay potentially significant sums to the company. 

The following two cases, from court judgements in August this year, also highlight the consequences of a director(s) being found to be in breach of their fiduciary duties.

In the first, a company director was unaware of his duty to creditors at a time when the only way the company could realistically repay a loan facility was to sell the company. The director was alleged to (and arguably did) make hasty, undocumented and high-risk investment decisions with no corresponding benefit to the company. The director claimed to have made certain decisions in an attempt to keep the company trading, He believed that he always acted in the best interests of the company. Notwithstanding the director’s claims, and his ignorance of the ‘creditor duty’ he was found liable to repay more than £700,000 to the company.

In other circumstances, it may be obvious (based on the court papers) that a director has acted improperly in a deliberate attempt to financially benefit personally. In this instance, what I’ll refer to as Company 1 paid a large sum of money to Company 2 and Company 3, at a time when Company 1 was insolvent. Notably, the director of Company 1 held significant shareholdings, directly or indirectly, in Companies 2 and 3. 

The payments were made just prior to the company being told by an insolvency practitioner that it was insolvent and shortly before Company 1 went into administration. The director of Company 1 (and both Company 2 and 3) was successfully pursued in respect of the payments which were found by the court to be transactions at undervalue and for no proper purpose. 

In this article I’ve only considered one of a director’s fiduciary duties. Many are intertwined. However, it should be clear from the above that the law does not discriminate between those directors acting improperly and those simply trying to save the company.

In summary, from a risk and legal perspective, there are clearly two fundamental aspects my colleagues and I at Shoosmiths always consider. Firstly, how a director can minimise their risk of being personally pursued for breaching one of more fiduciary duties. Secondly, being cognisant of the remedies available to insolvency practitioners appointed in a formal insolvency process, recognising that the practitioner is often under pressure from creditors to recover money into the company for the benefit of its creditors.

Seonaid Sandham is a senior associate at Shoosmiths in Edinburgh