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Directors’ duties in an uncertain economy

Successive releases of figures relating to the UK economy in the time of Covid-19 support what many businesses have known for some time. There is a general drop which is likely to be unprecedented in its steepness and, as the government feels its way through the unenviable task of balancing public health against the interest of the economy, uncertainty as to when and how things will improve. Whilst for a number of businesses the downturn has been manageable, for many others the simple fact of what they do or how they have to do it has led to a downturn in turnover which has been so quick that they are having to deal with serious financial issues. The Q and A which follows includes some of the questions which are bound to arise and how directors might address them. It does not cover the availability of schemes such as Covid scheme loans, furloughing and deferment of some tax, but rather looks at how directors should approach their financial duties in these uncertain times.

Q.  I’m worried that the company might be insolvent-how is insolvency defined?

A.  There are two legal tests of insolvency. The first is where the company’s liabilities, including liabilities which are known but not yet due, are greater than its assets. The second is where the company is unable to pay its debts as they fall due. If either of these situations arises, the company will be technically insolvent.

Q. If a company is technically insolvent, does it need to cease trading?

A.  No - technical insolvency does not automatically mean that it should stop trading. However, if a company which is technically insolvent does continue to trade, its directors will need to have given and to continue to give careful thought to the question of why it should carry on and how creditors’ interests will be protected.

Q.  How often should directors monitor the financial position of the company if they are concerned about its solvency?

A.  As often as they reasonably can. There should be regular monitoring of sales, cash collection, customer difficulties or delays in collecting book debts and of outgoings alongside budgeting for the future to take future obligations into account. Some of these can be done daily, whilst others would ideally be done on a weekly or fortnightly basis. The balance sheet should also be monitored, and outline management accounts prepared at least monthly.

Q.  If its directors think that a company may be insolvent, on what basis can the company continue to trade?

A.  From a legal perspective, the keynotes are:

  1. to look after the interests of creditors. No new credit should be taken up, even on an ordinary trading account, if it is not reasonable to expect that it can be repaid and, as a general rule, no creditors should be favoured over others unless there is a clear financial advantage to the company, and therefore its creditors as a whole, in doing so;
  2. to have a thought out and cogent plan to turn the company’s finances round; and
  3. to monitor performance regularly against that plan and react quickly if it isn’t working.

Q.  Can you give a practical illustration of your last answer?

A.   Yes - if, for example, a company has suffered a rapid reduction of sales due to its customers’ businesses being reduced under the Covid-19 lockdown but, is unable to turn off its supplies and reduce its workforce through the furlough scheme quickly enough to avoid making substantial losses, it may find that it breaches one of the insolvency tests, but is able reasonably to see a position where, for example, buy a combination of cuts or agreed deferment of costs, furloughing and borrowing from its bank under the Covid Loan Scheme it can find sufficient cash to take it into a period where it is able to match income and outgoings an pay its way on an ongoing basis.

Another scenario is where a company has nearly completed the manufacture of an item for which it will be paid £25,000 on delivery but cannot complete it without a component for which it has to pay £1,000 and the component supplier is insisting on being paid straightaway. In such a case, it would be in order to pay the component supplier as it has asked because of the overall net benefit to the company of £24,000.

Q.  What happens if directors get it wrong?

A.   In most cases, the issue which directors would have to consider is wrongful trading. This is an insolvency law provision under which, in a nutshell, if a company has got into a position where it is insolvent and its directors knew or should have known that it was likely to go into liquidation or administration and they have not taken reasonable steps after it became insolvent to look after creditors, those directors may be obliged to make compensatory payments to the company in liquidation or administration.

Q.  This is tough given the speed with which changes have happened in the market place and the unpredictability of when and how the lockdown will be lifted. How do directors cope with that?

A.  For the moment, the wrongful trading provisions have been suspended because the government has recognised the dilemma which many directors will face. If this had not been done, the Covid Loan Scheme would have been very unattractive to many companies and we would be seeing the pressure of wrongful trading taking many companies into liquidation or administration when they had a reasonable chance of achieving a turnaround. However, the suspension of wrongful trading, whilst of comfort, does not mean that directors can carry on without proper regard for creditors’ interests and monitoring and responding appropriately to the company’s financial position.

Ian Waine leads Prettys’ Corporate Services Team and has advised on a large number of corporate recovery and corporate restructuring cases over the last 30 years. He can be contacted on 07979 498817 or iwaine@prettys.co.uk.

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