Directors’ duties in insolvency—paramountcy of creditors’ interests (Re Micra Contracts Ltd (in liquidation))

In Re Micra Contracts Ltd (in liquidation) the court examined directors’ duties with respect to company insolvency and clarified the fiduciary nature of such duties. Christopher Brockman, barrister at Guildhall Chambers, examines the case and concludes that the courts are increasingly willing to focus on the paramountcy of creditors’ interests as whole when a company is insolvent.

Original news

Re Micra Contracts Ltd (in liquidation) [2015] Lexis Citation 165, [2015] All ER (D) 24 (Aug)

The applicants, in their capacity as liquidators of Micra Contracts Ltd (the company), brought a misfeasance application, under section 212 of the Insolvency Act 1986, against the respondent directors. The Companies Court held that, among other things, whether the subjective or objective test was applied, on the evidence, the respondents had acted in breach of their duties under section 172 of the Companies Act 2006 (CA 2006). The court proposed to order that the respondents restore the sum of £72,225.66 to the company.

What was the background to the application briefly?

The misfeasance application was brought by the liquidators of Micra Contracts Limited (Micra) against its three directors for breach of duty. In 2008, Micra ran into financial difficulty as a result of failures in relation to a building contract on which it was working. On 9 April 2008, the directors contacted an insolvency practitioner and on 16 April 2008 a meeting of creditors was convened.

On 9 April 2008, the directors carried out the following transactions:

  • a £400,000 loan to an associated company, Micra Interiors Limited (Interiors) was notionally called in
  • an invoice for £142,500 from Interiors was set off against the loan
  • a book entry for £329,725.66 (the recharges) representing a tallying up of certain recharges was entered into the nominal ledger and was also set off against the loan
  • this left a sum of £72,225.66 (the payment) due from Micra to Interiors with the same directors and shareholders—Micra paid this sum to Interiors

As at 9 April 2008, Micra had £526,000 in its bank account. By 16 April 2009, only £9,000 odd remained. During the same period the directors caused Micra to pay selected creditors, one of which subsequently employed one of the directors.

What were the legal issues that the Registrar had to decide in this application and why did they arise?

The main decisions for the Registrar were first whether the recharges were genuine and/or they had been created in breach of the directors’ duties. Secondly, whether the payment to Interiors of the debt created had been a breach of:

  • the directors’ duties to act in a way they considered in good faith would be most likely to promote the success of Micra pursuant to CA 2006, s 172—where the company is of doubtful solvency this duty extends to consideration of the interests of creditors and their interests must be paramount, and/or
  • the duty to exercise reasonable care, skill and diligence (CA 2006, s 174)

The test to be applied in deciding whether there has been a breach of the CA 2006, s 172 duty is subjective in that a court will ask itself whether the director in question honestly believed the act was in the interests of the company. Although, this only applies where there is evidence that the director actually considered the best interests of the company. Where there is no such evidence the proper test is objective, namely, whether an intelligent and honest man in the position of the director could, in the circumstances, have reasonably believed that the transaction was for the benefit of creditors.

It was accepted that the CA 2006, s 172 duty was fiduciary in nature. It was argued by the liquidators that the fiduciary nature of this duty impacted on the evidential burden of proof and once it was established that the directors were the beneficiary of the payments the burden shifted to the directors to show that the payment was proper.

The CA 2006, s 174 test is both subjective and objective, in that a director’s skill and care will be judged by the care, skill and diligence that would be exercised by a reasonably diligent person with:

  • the general knowledge, skill and experience of a person carrying out the functions of the director
  • the general knowledge, skill and experience that the director has

What were the main arguments put forward?

The liquidators argued that the recharge, being unsupported by any documentary evidence, was false and/or not vouched for. Secondly, the liquidators argued that the off-setting of the recharge, if genuine, was not a transactional process undertaken for the benefit of Micra. Thirdly, the payment to Interiors was a clear preference (in the factual not statutory sense) and in breach of duty.

The directors argued that the recharges were genuine and that the effect of automatic set off and rule 4.90 of the Insolvency Rules 1986, SI 1986/1925 was that the same exercise would have been undertaken automatically on liquidation in any event. They further argued that no loss was caused to Micra. On the facts they argued that the payments were made in good faith to enable further work to be undertaken on the building contract, as was demonstrated by them paying not only Interiors but also different unconnected creditors approximately £500,000 at the same time.

What did the Registrar decide, and why?

The Registrar found that the evidential burden was on the directors to establish that the exercise they carried out was genuine. She found that they had done so and that the recharges were indeed genuine. They were not properly explained in the witness statements and were only clarified by the evidence of Micra’s bookkeeper at the trial.

As to the payment she found that this was made in breach of the duty set out in CA 2006, s 172. There was no commercial benefit to Micra to calculate the inter-company balance before the end of the financial year which was the previous practice when the calculation was carried out at the year end. Nor had any cash payments been made before. Nor had the sums due from Interiors been set off against the loan. The entire exercise bore the hallmarks of shutting up shop and the recharge exercise was the first step in a rapid informal liquidation. There were simply too many firsts for this to be anything else.

The Registrar further held that the payment was clearly not in the ordinary course of business.

Further the Registrar found that the directors were under a duty to have regard to the interests of the creditors as a whole, but rather than do that they had emptied Micra’s bank accounts paying selected creditors. She found that on the subjective test the directors were not acting in what they believed to be the best interests of creditors. Applying the objective test in the alternative she also found that no intelligent and honest man in the position of the directors could have believed that the netting off process and the payment was in the interests of the creditors as a whole.

Having found that there was a breach of duty under CA 2006, s 172, the Registrar did not make any finding under the claim made for breach of duty under CA 2006, s 174.

She ordered that the directors pay £72,225.66 plus interest to Micra.

To what extent is the judgment helpful in clarifying the law in this area?

What this judgment demonstrates is that the courts are becoming increasingly willing to look to the interests of the creditors as a whole when a company is insolvent. It further shows that those interests are paramount. It clarifies the fiduciary nature of the duties contained in CA 2006, s 172 and the consequential evidential burden on directors as fiduciaries to justify the payments made by them. It also highlights the necessity of ensuring that the assets of a company are distributed fairly between all the creditors. Directors cannot carry out an informal liquidation paying off selected creditors and ignore the interests of others.

What practical lessons can those advising take away from the case?

Evidentially this case was unusual. There were three respondent directors, yet only one director put in evidence in the form of a witness statement said to be made on behalf of all three directors. The two who chose not to give evidence agreed that they would ‘live or die’ by the responses given by the director giving evidence. The court inferred from this that they did not, themselves, wish to get into the witness box. This conscious decision not to answer the allegations against them was a factor which weighed against them.

What does not come across from the judgment is the extent to which the written evidence relied upon by the directors was in legalese. That again did not assist as the real picture only emerged when oral testimony was given. In particular, in relation to the recharges, this was the first time they were adequately explained. This had an impact on the eventual costs order and the directors were ordered to pay the liquidators’ costs in full.

Christopher Brockman acted for the applicant liquidators in this case.

Interviewed by Susan Ghaiwal.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Further Reading

If you are a LexisPSL subscriber, click the link below for further information:

Powers, duties and liabilities of directors

A summary procedure under section 212 of the Insolvency Act 1986 and the process for bringing a misfeasance claim

Witness Statement in support of an application commenced under Insolvency Act 1986, section 212 for a declaration that the respondents have breached their duties

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First published on LexisPSL Restructuring and Insolvency

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