Directors and Corporate Insolvency Lecture Notes

Introduction

 Insolvency law scrutinises conduct of directors in management of insolvent

companies- significant objective of the law is to facilitate civil wrongdoing to benefit
creditors of an insolvent company- private law aim
 Fundamental role of liquidator is realise assets and redistribute assets to maximum
amount for creditors
 If the company's directors mismanaged the companies affairs- these directors would
be liable to make up any losses due to mismanagement- the claim will be for the
benefit of the creditors and maximisation
 Two core aims of director corporate insolvency rules
1. Civil Recovery- For liquidation pool and creditors
2. Public Interest- Insolvency law protects public from activities of rogue
directors
 Public interest aspect to insolvency- emphasised by Cork report- broader public
interest in detecting, sanctioning and deterring conduct- insolvency public policy
 Incorporation for limited liability/separate legal personality- risk that companies may
be incorporated to be abuse of these privileges- such as incorporation of an under
capitalised company or negligent management
1. This free access must come with barriers- increases risk of abuse of limited
liability so insolvency looks to address these with range of limits/actions
against the director
2. Therefore must be seen in the broader corporate law context and aim to limit
abuse of limited liability
 Limits/Actions against a director include (Facilitate private recovery and hindering in
with public policy/corporate debates):
1. Director's duties upon insolvency (s.212 1986 IA)
2. Fraudulent Trading (s213, s246ZA IA 1986)
3. Wrongful Trading (s.214, s246ZB IA 1986
4. Disqualification of Directors (public policy issues/deterrent)

Directors Duties Upon Insolvency

 Who is a director?- Anyone appointed as a director under company's constitution is

classed as a director (De jure)
1. De Facto Directors- Person occupies role of a director regardless whether
they've been appointed as a director under constitution- extends to anyone
carrying out role of director- . CA 2006 s.250; IA 1986 s.251, CDDA s.22(4);
2. Shadow Directors- : ‘A person in accordance with whose instructions the
directors are accustomed to act’- person instructing directors how to act, does
not act themselves act as director but instruct others (s.251 IA 1986 )),
 Directors Duties- Directors owe duties to the company (s170) and duties are focused
on shareholder focus- (s172 promote success of the company for members)
 Company, when approaching insolvency, the CL that DD to promote success of
company changes its meaning when approaching insolvency- the duty changes its
meaning to safeguard creditor interests.
1. If a director fails to protect creditor interests- breach of fiduciary duty and can
be required to compensate the company and impose personal liability
 2. This was first recognised in West Mercia Safetywear Ltd v Dodd [1988]-
Person director of company of WM- also a director of AJ Co.. Company A
owed Company B 30,000. Both companies in financial trouble and seek advice
of accountant in light of liquidation The director is advised that company is
insolvent and that the bank accounts should not be operated any further.
a. Company A still had bank account in credit- Credit B's bank account was
overdrawn. Indebtedness of B to bank was secured to a personal guanrtee
from D.
b. After advice given to D that both companies insolvent- D asks the bank
to transfer 4,000 from Company A to Company B to partly discharge
overdraft in Company B.
c. Liquidator commences proceedings saying transfer from A to B was a
fraudulent transfer/preference- seeks order that D repays 4000 to
Company A with interest
d. Trail judge said acted wrongly but no breach of duty- CA found was
breach of duty on basis that as A was insolvent, D owed a duty not to act
that unreasonably harmed the creditors- transfer away from A was not in
overall interest of creditors and liable for breach of duty,
e. Court said duty changes meaning to protect creditors- transfer did not
protect creditors
 The West Merica rule was reviewed in Sequana- (read)- Lord Reed summarises this
point and highlights the principles
 Fidcuairy duty is not owed to creidtors but owed to the company and is not a new
duty but rather a change in nature of the duty
 When does the change of the duty happen?- This is an issue in the case law that state
slightly different definitions as to timing in which switch of duty occurs
1. Re MDA Investment Management [2005] BCC 783: Case highlighted that this
happens 'in the zone of the insolvency'- so creditor's money is at risk- in
financial difficulties to extent that creditors money is at risk
2. BAT Industries plc v Sequana [2019] EWCA Civ 11- Reasoning borrowed
language from 214- ie director knowingly or reasonably ought t know that the
company is likely to become insolvent. The nearer company is to insolvency,
the more the creditor's interests will intrude- but if transaction- will have to
analyse it at the date
a. “when the directors know or should know that the company is or is
likely to become insolvent... . In this context, “likely” means
probable…” [220]
 The Function of the West Merica Rule:
1. Combatting Perverse Incentives- In pre-insolvency period- sharehodlers have
incentives to gamble excessively for profits - limited liability means that they
do not bear the costs if it doesn't work- unfair. This rule says that if D goes
along with this- they be personally liable for it
2. Lord Reed discussed this in Sequana- When company comes insolvent- the
creditors have principle economic interest in company- beneficiaries of the
wealth are creditors- not the case in solvent companies- which will be the
shareholders
3. Reinforces vulnerable transaction rules- allow the liquidator to unwind pre-
insolvency transactions- this rule compliments this at it can provide personal
liability as well as being able to unwind the transaction
Section 212 IA 1986: Actions for Misfeasance

 A person who ‘is or has been an officer of the company, ‘ (s.212(1)(a) IA 1986)
 ‘misapplied or retained, or become accountable for, any money or other property of
the company, or been guilty of any misfeasance or breach of any fiduciary or other
duty in relation to the company’ (s.212 (1) IA 1986)- s.213 gives court power to
examine conduct of D
 Liquidator can enforce DD against D- Liquidator can pursue multiple causes of action
under s.212
 General application of misfeasance against director often applied along side other
statutory provisions such as the vulnerable transaction rules
1. Roberts v Frohlich [2011] 2 BCLC 625- Concerned land development in whcih
it was alleged that D allowed company to undertake land transaction, which was
inadequately funded and bound to fail. Liquidator brough numeorus actions
against D on basis, sought for Wrongful Trading Claim, Alleged Breach of DD
and S.212 action for misfeasance- conducting business bound to fail
 Debate as to whether claims for misfeasance are available against shadow directors
1. Revenue v Customs Commissioners v Holland [2010] WLR 2793, where Lord
Hope suggested this was not possible as s.212 made no reference to shadow
directors- this reasoning can be criticised as s.212(c) says any person 'taken part
in of company'
 Only actions that vest in company can be pursued under Section 212- they are
derivative so suing for causes of actions that the company holds- sue in the name of
the company
 There is a possibility of relief for directors who the court feels have acted “honestly
and reasonably”: s.1157 CA 2006.

Fraudulent Trading s.213 1986 IA (Liquidation)

 Upon winding up of the company - business of company is carried on business of

company to defraud creditors- D can be personally liable to compensate the company
for any fraud
 Under the CA 1929- high standard of liability to 'defraud creditors'- less restrictive
now
 Liability under s.213 is not restricted to directors, and may even catch outsiders, see
e.g. Re Gerald Cooper Chemicals Ltd [1978] Ch. 262- Outsider takes benefits of
business that is fraudulently being conducted
 Fraud is a high standard to meet- useful rmemedy but not taht much practcial
application as standard is high- but how do we demonstrate dishonesty?
1. Yes. Twinsetera Ltd v Yardley [2002] 2 AC 164 (liability for accessory to breach
of trust. HoL held it was not enough under s.213 for conduct to be dishonest by
ordinary standards of reasonable people, the defendant must himself be aware
that he is acting dishonestly by those standards
2. No. Barlow Clowes Ltd v Eurotrust Ltd [2006] 1 WLR 1476 (Abou-Ramah v
Abacha [2007] I Lloyd’s Rep. 115- Can't hold to 'own moral standards'- slightly
more objective approach
Wrongful Trading s.214 IA (liquidation)

 Introduced following recommendation in Cork Report- The abuse of limited liability

and need for law to protect creditors during the pre-insolvency and undercapitalised
companies trading recklessly
 Company gone into ‘insolvent liquidation’- ‘Person who is or has been a director’;
‘knew or ought to have concluded that there was no reasonable prospect that the
company would avoid going into insolvent liquidation’; - can be made personally
liable for debts of company if caused company for carrying on trading during this
period
 Liquidator may apply to the court to establish liability for wrongful trading- court can
declare person to compensate company for losses suffered as result of wrongful
trading- thus personally liable for any debts taken on
 No need to establish fraud or dishonesty- WT intended to be more flexible and widely
applicable remedy providing for liability for reckless trading without needing to
establish fraud
 Must establish that company gone into insolvent liquidation or administration- has to
be insolvent- going into liquidation at time where assets insufficient to meet
company's liabilities- includes contingent or perspective liabilities (S.214(6) IA 1986)
 Trading per se not necessary for liability under s.214- culpable failure to minimize
loss to creditors’ is sufficient (Goode, 2011)- allowing things to carry on with
cupable failure to minimise loss sufficient
 Non-Directors might be caught- If bank involved in company- may run risk of being a
shadow director and potentially liable
 Liability arises at later point than West Mercia- 'know or reasonably ought to know
that company cannot avoid insolvency'- not necessary to identify precise moment of
liability- but will look at transactions and assess it then
1. Courts take a fact sensitive approach- more generous approach as to what they
ought to have known against standard of the reasonably prudent business person-
no strict legal approach
 Directors may, of course, rely on the statutory defence in s.214(3)- rests on director to
show they took ‘every step’ to minimise loss for creditors
 Intended to be lower standard (negligent standard)- same policy context as West
Mercia case- address perverse incentive pre-insolvency and limited liability
 Is s.214 remedy effective?
1. Directors made personally liable but only helps creditors if D can actually
pay/compensate the interests of the creditors- liquidator will not pursue it if they
cannot satisfy judgement against them- spending money on futile litigation
2. D can declare personal bankruptcy- thus personal liability provides relatively
limited benefit for the creditors
3. Still serve signalling function- ie deterring undesirable conduct and improving
standards of corporate governance- but civil recovery remains limited
4. Funding issues for 214 case- as have to fund it through the assets of the
company- unwilling to take financial risk
 Tend to overlap with other director liability provisions- ie transactions at undervalue
or preferences
Disqualification of Directors

 Different sort of remedy as more explicitly about public interest protection- prior
2015 no possibility of civil recovery
1. “The whole purpose of the 1986 Act is to protect the public from the future
activities of those who have…shown themselves unfit to act as directors of a
company” Secretary of State for Trade and Industry v Bannister [1996] 1 All ER
993 at page 988- Company Directors Disqualification Act (CDDA)
2. Intended in policy to address those that abuse limited liability
 A person subject to a disqualification order may not “be a director of a company, act
as receiver of a company’s property or in any way, whether directly or indirectly, be
concerned or take part in the promotion, formation or management of a company
unless (in each case) he has the leave of the court”
1. Thus discqualification means banned from mnagament of the company- aims to
take out undesirable people from companies
 Prior to early 2000, disqualification culd only happen by court order- relied on SOS to
take person to court to seek disqualification order- this was impractical/expensive- D
did not usually provide defence, CDDA changed as a result to disqualification
undertakings
 Disqualification undertaking- same effect as DO made my court- ie banned from
being involved in management in companies- meant as a way of disposing cases
quickly where D does not provide a defence - undertaking D agrees to accept period
of Disqualification so no need to go to Court- vast majority done by undertaking
1. Inducement will happen normally - if contest then more years disqualification- if
undertaking then less
 Overview of CDDA- Disqualification for specific wrongdoing: s.2 CDDA (conviction
of an indictable offence); s.3 (persistent failure to comply with companies
legislation),; s.4 (fraud in winding up); s.5 (summary conviction);
 Compensation Powers- additionally was disqualification as the onluy sanction-
however this was a gap in the act as talking about insolvent companies
1. Compensation needed as disqualification does not benefit creditors at all- so
compensation powers added into s.15(a)
2. In addition to disqualification powers, civil recovery can be sought against
disqualified directors under s.15A of the CDDA to fill civil recovery gap
3. Conditions for compensation (s.15A(3))
a. the person is subject to a disqualification order or disqualification
undertaking under this Act, and
b. conduct for which the person is subject to the order or undertaking has
caused loss to one or more creditors of an insolvent company of which the
person has at any time been a director.
4. Compensation can be paid to a creditor, group of creditors, or as a general
contribution to the funds of the company (s.15B(1))- doesn't go straight to the
pool of creditors
 Disqualification for Unfitness in Insolvent Companies: s.6 CDDA- Vast majority
under Section 6, only insolvent companies- s.8 in solvent companies- mostly section 6
cases
1. “The court shall make a disqualification order against a person in any case
where, on an application under this section, it is satisfied—
a. that he is or has been a director of a company which has at any time
become insolvent
 b. that his conduct as a director of that company makes him unfit to be
concerned in the management of a company
2. Public interest test for initiating disqualification proceedings- liquidator are
under statutory obligation to report potential unfit conduct in that company- cost
is borne by the creditors of the company. After liquidator produces report- sends
to civil servants- they then have to apply the 'expedient in public interest' that
disqualification is ordered
3. What is unfit conduct?- Various cases offer defintion was to what unfitness
constitutes as
a. Re Lo-Line Electric Motors Ltd [1988] Ch 477, at 486: “Ordinary
commercial misjudgement is not in itself sufficient to justify
disqualification. In the normal case, the conduct complained of must
display a lack of commercial probity, although I have no doubt that
anextreme case of gross negligence would…be appropriate"-
b. Legal standard rather legal rule- thus not limited to insolvency law
wrongs- legal standard that is deliberately vague to cover a range of
activities
c. Re Dawson Print Group Ltd (1987) 3 BCC 322. - “There must, I think,
be something about the case, some conduct which if not dishonest is at
any rate in breach of standards of commercial morality, or some really
gross incompetence which persuades the court that it would be a danger
to the public"- CA emphasised that should not be legal tests but rather
standards
d. Therefore unfit conduct is a question of fact- advantage of the broad
policy objective- broad legal remedy for broad commercial practice- but
question of fact so no legal test which creates vagueness and uncertainty
and possibility of misuse. By leaving it open- disqualification legislation
used in all sort of contexts and things that have nothing to do with
creditor interest- therefore taken it away from its insolvency roots/policy
goals
i. 10 percent of cases about immigration offences where directors
employed immigration illegally- unfitness cases
ii. Disqualifying people for 4-8 years on single ground of
misconduct- only 1 illegal work employed and no other unfit
conduct cited (see slides)
iii. These questions raise as to what is the purpose of disqualficistion-
rule drafted to portect creditors from harm and limited liability-
got nothing to do with any of it (immigration cases)- no corporate
rationale or creditor harm policy
iv. Case study of how 'unfit conduct'- legal standard broad but needed
to prveent under inclusion- broad remedies can be used for
different purposes intended for and were not designed for
e. See Handout list of examples of unfit conduct for disqualification
f. Unfair discrimination against the crown- not paying the taxes- directors
pay some creditors which they should have paid for tax- cited as evidence
of unfit conduct
 Leave of Disqualification- Leave of a disqualification order/undertaking may be
granted by the courts (see s.17 CDDA 1986). It has been suggested that in granting
leave the courts will consider two factors, the ‘need’ of the individual for leave, and
whether leave is compatible with the protective aims of disqualification