Directors’ duties and coronavirus (COVID-19)—The risk of wrongful trading when you cannot trade

Directors’ duties and coronavirus (COVID-19)—The risk of wrongful trading when you cannot trade

This analysis looks at directors’ duties, particularly concerning wrongful trading, in the context of companies facing financial difficulties as a result of coronavirus (COVID-19).

The novel coronavirus is already creating significant health, social and economic challenges as governments around the world try to protect their populations and their economies.
The UK Government has ordered the closure of pubs, restaurants, gyms and schools. Shops are closing and the private sector is largely in hibernation. Other European countries have already gone further with strict enforced social distancing and border closures. Globalisation is on hold and countries are on lockdown.
How directors in the UK respond will depend on the nature of their business, their current financial position, and what assistance financiers and the state can provide. It will also depend on how long the coronavirus pandemic lasts for and how long social distancing is maintained, both in this country and abroad. Many businesses will find themselves in financial distress and directors of those companies will need to pay careful consideration to their duties.

When is a company insolvent?

Although there is no definition of ‘insolvent’ in the Insolvency Act 1986 (IA 1986), a company may be wound up by the court if the company is unable to pay its debts.

Under IA 1986, s 123(1)(e) a company is deemed to be unable to pay its debts the company is unable to pay its debts as they fall due (so-called 'cashflow insolvency'). Under IA 1986, s 123(2), a company is also deemed to be unable to pay its debts if the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (so-called 'balance sheet insolvency').

Both tests require a consideration of the company’s present, prospective and contingent liabilities. However, while ‘cashflow insolvency’ is concerned with whether the company is likely to be able to meet its liabilities in the short to medium term, ‘balance sheet insolvency’ requires a longer-term view on whether the company has sufficient assets to have a reasonable expectation of meeting its liabilities. 

Wrongful trading—the statutory framework

When a company is financially distressed and insolvency becomes likely, a director’s duty to promote the company’s success (ie to act in the interests of the members as a whole) is replaced by a duty to act in the interests of the company’s creditors as a whole (ie to preserve the value in the company in order to maximise the return to creditors).
While there is no offence of trading while insolvent, directors who do not take every step to mitigate losses to creditors once they conclude or ought to conclude that there is no reasonable prospect of avoiding insolvent administration or insolvent liquidation, face liability for wrongful trading under IA 1986, s 214. The directors are then liable to make such contribution to the company’s assets as the court thinks fit, which in practise will be the increase in losses to creditors incurred from the onset of insolvency until a formal proceeding was commenced.

It is important to note that directors may be liable for wrongful trading even though their business is not actually trading, but losses are increasing. 

When is enough, enough?

Coronavirus will create different challenges for different businesses. 

Directors of supermarket chains are seeing record sales, so assuming their supply chains hold out they are in a good position. Directors of businesses that rely on face-to-face interaction will encounter greater challenges, as will those who rely on cross-border supply and trade chains. If non-essential shops and leisure facilities close, directors will need to consider how long they can continue meeting their liabilities when they can no longer trade. Directors may also need to consider how long they can continue operating with a reduced workforce, either due to illness, health and safety concerns, or employees being forced to stay at home. 

Subject to contractual provisions, directors of businesses such as gyms and sports centres, for example, may find that many annual subscriptions have already been paid which may allow the business to be mothballed if forced to close. Landlords may agree rent holidays and financiers may be willing to support businesses while they continue to pay wages. The UK government announced a package of measures on 17 March 2020 aimed at supporting businesses during this period. This support package continues to expand as the Government tries to keep the economy on life support. Depending on the business model, specific help may also be available, for example in the case of the aviation industry.

Provided short-term cash flow can be managed, despite being unable to trade, many directors may conclude that insolvent administration or liquidation can reasonably be avoided, at least for the time being. 

Immediate steps

The decisions directors take will inevitably evolve in line with the national situation. Directors should carefully record decisions made and the reasons for those decisions in case they come under scrutiny in the future. 

Discussions with stakeholders will be essential, particularly with those in the supply chain. If necessary, directors may need to consider whether alternative suppliers are available.

Directors should check the terms of finance documentation to see whether they are at risk of breaching covenants. Realistic financial forecasting and early conversations with lenders can make a huge difference to the survival of businesses, particularly now, when the Government is working with banks to help businesses affected by coronavirus. The same will be true of landlords. Business rates holidays may help, but rental payments will also matter as the March quarter day approaches.
Checking contracts for the effect of force majeure clauses will be important, as will checking the terms of insurance policies to see if cover is available. Illegality provisions in contracts may also be relevant where Government action requires businesses to close.
Finally, professional advice from lawyers and insolvency professionals should be sought to help protect the directors’ position and to help facilitate a contingency plan if the situation worsens.

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About the author:
Helen joined LexisPSL in 2019, prior to which she was a Professional Support Lawyer at CMS specialising in insolvency and restructuring. She has broad experience in advisory, non-contentious and contentious work, including directorsâ?? issues, formal appointments, security issues and cross border recognition and assistance. She advised on financial institution insolvency and the insolvency of professional partnerships.

Helen trained at Lovells (now Hogan Lovells), qualifying in 2008. She was previously an associate at Lawrence Graham (now Gowling WLG) as well as the commissioning editor of Corporate Rescue and Insolvency journal.