Continuing to trade in turbulent times - addressing the legal challenges

Introduction

It has been suggested recently that companies who avail of the supports put in place by the Government are, as such, admitting to trading while insolvent, and that continuing to trade while insolvent could conceivably open up directors of the companies concerned to potential personal liability actions for reckless trading. Other commentators have noted that the most significant issue is not trading while insolvent but how the directors of these companies conduct themselves and the affairs of the companies concerned while insolvent. We would certainly concur with this view. In particular, there is an onus on the directors to act in the best interest of their creditors (including their employees) while insolvent; for many companies signing up to the Covid-19 wage subsidy scheme is in the best interests of their employees. Furthermore, the Chairman of the Revenue Commissioners, Niall Cody, has said that the Government’s Covid-19 wage subsidy scheme is not a declaration of insolvency, instead it should be considered a “mark of honour” in terms of trying to do the right thing by their employees. He has also noted that the purpose of the scheme is to place companies who avail of the scheme in such a position to facilitate them emerging into the recovery stage as valid and viable businesses.

There is no doubt but that availing of these supports is of key importance for most companies to assist them in weathering the current pandemic and with a view to ensuring that they have the means to survive into the future. Availing of these supports is not of itself to be considered an admission of insolvency; however, companies who are benefiting from these supports will most likely find themselves in a position where cash flow is tight and paying their debts as they fall due is becoming more and more challenging. Where companies are either insolvent or on the verge of insolvency, their directors must exercise continued vigilance with respect to the affairs of the company. Details of such measures to be undertaken by directors are outlined below.

In light of the fact that many companies have found themselves in an insolvent position or on the verge of insolvency due to the effects of the Covid-19 pandemic, this note considers the duties of the directors of a company where the company is trading whilst insolvent, explores the criteria required to support a claim for reckless and/or fraudulent trading and unfair preferences or fraudulent dispositions, and recommends measures to be taken by directors to assist them in acting honestly and responsibly in relation to operating the company’s business whilst insolvent. We also consider how certain proposed legislative changes to be adopted in the UK could assist companies in this jurisdiction.

Directors’ duties

In the normal course, the duties of directors which are set out in section 228 of the Companies Act 2014 (the “Act”) are owed to the company and the company alone in circumstances where the directors have a fiduciary relationship to the company. However, once the insolvency of the company becomes a real possibility and the directors are aware of the insolvency, the directors must act with due regard to the interests of the creditors of the company including the company’s employees. Where a company is insolvent, the company’s creditors become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and the directors to deal with the company’s assets; in effect, the company’s assets are those belonging to the creditors in an insolvent situation.

Where there is no prospect that the company can return to solvency then there is an obligation on its directors to wind up the company. However, where the company flits from a solvent to an insolvent position, there is no obligation on the directors to place the company in liquidation assuming there exists a reasonably held expectation that the company will return to solvency.

In addition, directors of an insolvent company must ensure that the company’s assets are preserved so that the maximum return for creditors can be achieved. The Supreme Court has held that once an insolvent company has to be wound up and its assets applied pro tanto in discharge of its liabilities, the directors have a duty to the company’s creditors to preserve the assets to enable this to be done, or at least not to dissipate them. Moreover, an insolvent company may not make payments which benefit connected companies or the directors personally to the detriment of the unsecured creditors.

If the directors fail to act with due regard to the interests of the company’s creditors, they could open themselves up to a claim for reckless or fraudulent trading (amongst other claims).

Reckless & Fraudulent trading

Having regard to the financial position of the company, the directors of the company should in all their decision-making bear in mind the provisions of section 610 of the Act. Where successfully claimed, this section provides for civil liability for fraudulent or reckless trading. If an officer of the company (which may include a director, shadow director, statutory auditor, liquidator or receiver) is found liable for reckless trading or fraudulent trading, a court may declare him/her personally liable for all or any part of the liabilities of the company. In addition, criminal sanctions apply in the case of fraudulent trading.

A director may be personally liable for the debts of the insolvent company where: (1) a director is ‘knowingly’ reckless (under section 610(1)(a) of the Act); or (2) a director can be ‘deemed’ to have acted recklessly (under section 610(3) of the Act).

An application under these provisions may be made by a liquidator, examiner, receiver or any creditor or contributory of the company.

Section 610(3) of the Act provides that a director of a company shall be deemed to have been knowingly a party to the carrying on of any business of the company in a reckless manner if:

1. he was party to the carrying on of such business and, having regard to the general knowledge, skill and experience that may be reasonably be expected of a person in his/her position, the person ought to have known that his/her actions or those of the company would cause loss to the creditors of the company, or any of them, or
2. the person was party to the contracting of a debt by the company and did not honestly believe on reasonable grounds that the company would be able to pay the debt when it fell due for payment as well as all its other debts (taking into account the contingent or prospective liabilities).

Section 610(8) of the Act provides that where it appears to the court that a director in respect of whom a reckless trading declaration has been sought, is found to have acted honestly and responsibly in relation to the conduct of the affairs of the company, the court may, having regard to all the circumstances of the case, relieve such director either wholly or in part from personal liability. This provision may prove of significant assistance to certain directors in that the Court is entitled to use its discretion to absolve directors of a guilty determination of reckless trading where it is satisfied that the directors have acted honestly and responsibly in relation to the conduct of the affairs of the company.

There is very limited jurisprudence concerning the reckless trading provisions/duty to creditors; this is in the main due to this provision being a relatively underutilised insolvency remedy with a high bar to meet in terms of evidence. One of the seminal cases is Re Hefferon Kearns Ltd [1] in which the High Court interpreted ‘reckless’ to mean gross carelessness – a very high bar – and held that for an officer to be held liable for reckless trading he must have been party to the carrying on of the business in a manner which he knew involved a serious and obvious risk of loss or damage to others and yet ignored that risk because he did not really care whether such others suffered loss or damage or because of a selfish desire to keep his own company alive.

The Court also remarked in this case that it “would not be in the interests of the community that whenever there might appear to be any significant danger that a company was going to become insolvent, the directors should immediately cease trading and close down the business. Many businesses which might well have survived by continuing to trade coupled with remedial measures could be lost to the community”.

In a recent Court of Appeal, Re Appleyard [2], a director who had been found by the High Court to be personally liable for reckless trading, successfully appealed to the Court of Appeal. In deciding whether or not to accede to an application to hold a director personally liable, the Court will require knowledge that the actions of the directors would in fact cause loss to creditors and not that they might so having regard to the general knowledge, skill and experience that may reasonably be expected of a person in the position of the director. The Court of Appeal held that the loss to the creditors must have been foreseeable to a high degree of certainty.

In this case, the company faced financial difficulties due to the financial crash and decreased demand. The directors had banking facilities with Ulster Bank, AIB and a private funder and attempted to trade out its difficulties. The company received money from a creditor and Ulster Bank subsequently withdrew its support for the company resulting in loss to a creditor. The High Court found that the directors acted reasonably until it extended its guarantee facility with Ulster Bank which the High Court said they did without due regard to the creditors. The High Court held that that the directors remained under an obligation to keep the overall position of the company under review given the fundamental insolvency of the company and to keep creditors interests to the fore. The High Court was also critical of the failure of the directors to take professional advice around the time it extended the facility with Ulster Bank (although the Court of Appeal noted that the directors had taken professional advice a few months earlier). However, in overturning the decision of the High Court the Court of Appeal found that although there was an “enhanced risk” of loss to the creditors, it was not the case that the director ought to have known that loss would be caused.

Personal liability may also be imposed where the director (amongst other persons) is found to have been guilty of “knowingly [been] a party to the carrying on of any business of the company with intent to defraud creditors of the company, or creditors of any other person or for any fraudulent purpose.” This claim has proven increasingly difficult to bring home given the obligation on a liquidator or other applicant to prove an intention to defraud creditors, which requires the directors to have been aware that there was no reasonable possibility of the creditors of the company being paid. To avoid a successful claim for fraudulent trading, company directors must, at a minimum, ensure that they do not allow a company to incur credit at a time when it is clear that the company will never be able to satisfy its creditors.

Unfair preferences

Directors should also be cognisant of the unfair preference provisions in the Act which provide that a wide range of transactions (such as payments, delivery of goods, mortgage or conveyance) by a company, which is at the time of the transaction unable to pay its debts as they fall due, to a creditor of the company will be deemed invalid if made with a view to preferring one creditor over another where the relevant transaction was entered into within six months of the company going into insolvent liquidation.

This six month look-back provision is extended to two years prior to the winding up if the preference is in favour of a connected creditor. A connected person includes a director/shadow director of the company, a related company, a person connected with a director of the company (including his spouse, civil partner, sibling or child of the director or a person in partnership with the director) or any trustee of, or surety or guarantor of those persons.

Unfair preference actions have proven difficult to successfully prosecute before the courts, one of the main reasons being the high burden of proof on liquidators. The liquidator must establish a dominant intention on the part of the person who made the transfer to prefer one creditor over another. However, where the transaction involves a connected person, there is a presumption, which must be rebutted by the respondent, that this was an unfair preference.

An intention to prefer may not be found where the creditor has put sufficient pressure on the company to pay the relevant debt so as to overbear the will of the company. A preferred payment may be later defended by pleading in collusion with the creditor that the payment was made under pressure. In addition, it does not follow that the absence of pressure or duress means there was a dominant intention to prefer. Intent must be proven, or the court needs to be presented with sufficient evidence so as to make an inference that there was a dominant intention to prefer.

In Parkes & Sons Ltd v Hong Kong and Shanghai Banking Corporation [3] a company’s controller caused the company to enter into a guarantee and provide a mortgage in respect of the debts of another company. The controller was said to have been pressed by the bank for information, had many meetings with the bank, had the appointment of a receiver threatened, and had his affairs monitored closely by the bank. The Court held:

‘It seems to me that the correct inference to draw from these facts is that [the controller] was concerned to save the claimant company and that this was his dominant motive in giving the mortgage. In view of the threat by the bank to put in a receiver, he had no alternative but to comply with their demand for further security. And while the giving of the mortgage may have taken some pressure off [his] personal guarantees, it did not relieve him from it or reduce his liability on it. In my opinion it has not been established that the facts are such that I should infer that [the controller’s] dominant motive was to reduce his liability on the guarantees.’

This case shows that personal gain to the person responsible for the company taking the decision to make a preference is not always the decisive factor in the court’s decision. That being said, where there exists sufficient evidence to show that the dominant intention for making the preference was for the purposes of furthering a director or controller’s personal interest, it is presumed that a Court would give significant consideration to any such behaviour in determining that a transaction was an unfair preference.

Fraudulent dispositions

Directors will also need to take account of the fraudulent disposition provisions under the Act which prohibit transactions which have the effect of perpetrating a fraud on the company or its creditors. While there must be some wrongdoing by the directors for this to apply, an intention to defraud does not need to be proven, only that the disposal transaction had the effect of perpetrating a fraud on the company, its creditors or members. Furthermore, evidence that the company was insolvent at the time of the disposition does not have to be provided nor that the disposition was made to a creditor, or that the disposition was made within a certain time frame. Accordingly, the bar is much lower when compared to that of fraudulent disposition.

Continuing to trade during the pandemic

The decision as to whether a company should continue trading is essentially a commercial one for the directors based on the available financial information and on their reasonable commercial judgment, having particular regard to the provisions in the Act relating to directors duties and reckless/fraudulent trading as set out above. Expert legal and financial advice should also be obtained where necessary.

The current cash-flow position of any insolvent company or a company on the verge of insolvency should be monitored closely and at regular intervals and the decisions of the Board and the commercial basis for those decisions (especially the regard had for the creditors and employees) should be recorded together with any professional advice obtained. It is clear that directors will need to ensure that any transactions entered into during the current crisis can be justified. Holding frequent board meetings to discuss and consider the state of affairs of the company is of key importance as well as assessing the company’s current costs, implementing essential cost saving measures and preparing appropriate cash projections to ascertain the level of funding required into the future, which we appreciate can be a difficult exercise in this climate. Efforts should also be made to keep financial information up-to-date and accurate to include preparation and on time filing of audited accounts and annual returns. The company’s viability also needs to be assessed very regularly by reference to the up-to-date financial information as well as the level of incoming trade to ensure that there is benefit in continuing to trade. Furthermore, business discussed at board meetings together with details of all cost savings and other essential measures undertaken should be clearly and comprehensively documented; this evidence may prove to be of vital importance in terms of being in a position to show a liquidator that the directors acted honestly and responsibly in relation to the affairs of the company where the company ultimately finds itself in liquidation.

Where necessary, legal and financial advice should also be taken especially when there are concerns that the company may no longer be in a position to trade out of the difficulties it finds itself in or where there is concern about undertaking certain transactions. Where the circumstances warrant engaging in an insolvency procedure, directors should act quickly to ensure the interests of the creditors of company are protected. Insolvency procedures such as examinership or formal or informal schemes of arrangement may prove to be of significant assistance to certain companies in terms of dealing with legacy debt and with a view to them preserving jobs and becoming viable businesses into the future.

The interests of the company’s creditors should at all times be prioritised where the company is insolvent; care should be exercised in paying creditors to ensure equality of payment between creditors. Directors should also be mindful of the provisions of Irish company law relating to unfair preferences and fraudulent dispositions before they make payments or transfers to creditors while insolvent in circumstances where certain transactions may be declared invalid if the company goes into liquidation or receivership within six months after the making of the said payment or transfer or 2 years in the case of a connected person transaction.

The question of reckless or fraudulent trading only arises following the failure of a company. Directors currently invigilating over insolvent business must be cognisant that their actions are likely to be assessed by a court with the benefit of hindsight and make every effort to act honestly and responsibly in relation to their dealings with respect to the affairs of the company. Although it has been stated by the Court as a principle many times that it will not substitute its own commercial judgment for that of businessmen, nonetheless in circumstances such as a case for reckless trading, the principle is sometimes lost, where inferences are drawn as to why the directors took actions as they did, in the absence of detailed written evidence and advice. Furthermore, even where sufficient proof to support a claim for fraudulent or reckless trading cannot be supported or is successfully defended, the risk of restriction is of significance where the company is ultimately wound up and its directors are found not to have acted honestly and responsibly with respect to the affairs of the company. Therefore, it is critical that directors consider their behaviour carefully where their companies are experiencing financial difficulty during these exceptional times.

UK legislative proposals

In response to similar concerns raised in the UK, the UK government has announced plans to make legislative changes to suspend the rules (for an initial 3 month period which may be extended) in relation to wrongful trading (the UK’s equivalent of reckless trading) which will have retrospective effect from 1 March. The proposed suspension is designed to ease the pressure on directors running their businesses whilst technically insolvent by removing the threat of personal insolvency in the context of wrongful trading. However, other measures will remain intact with respect to directors who continue to trade to the detriment of their creditors.

These are part of a suite of measures being brought in in that jurisdiction including moratorium on creditor enforcement action, a new court-based restructuring process based on the scheme of arrangement model and rules to prevent the cancellation of supplier contracts with companies who are undertaking insolvency measures. The aim of these measures is to protect companies during the pandemic and to give directors an opportunity to try to find solutions to the challenges faced by their business due to the impact of the Covid-19 measures with a view to aiding these companies’ recovery.

While the directors will still need to be mindful of their continuing company law duties and can still be held personally liable for breach of these duties and for fraudulent trading (as opposed to wrongful/reckless trading), these measures have been broadly welcomed in the UK as giving comfort to directors in these extraordinary times not of their making and with a view to avoiding a situation where too many companies enter insolvency procedures precipitously during the pandemic.

Conclusion

While a relaxation of the Irish rules relating to reckless trading would not appear to be strictly necessary, there may be a good case for an interim relaxation of these rules with a view to providing comfort to company directors in terms of giving them confidence to avail of the subsidies introduced by the Government and the EU and in an effort to assist companies to successfully trade through what is now, for some companies, a particularly difficult and potentially lengthy period of uncertainty. There is no doubt that the more companies that can continue to trade with a view to emerging into the recovery stage, then the quicker our economy will begin to reboot and recover.

Notwithstanding any future relaxation of those rules, however, extra vigilance will still need to be exercised by directors of insolvent companies who are continuing to trade and those on the brink of insolvency with respect to the company’s financial position for the reasons mentioned above. Directors will also need to engage in a heightened level of planning to ensure they act in the interests of the company with due regard to its creditors where the company is insolvent or appears to be on the brink of insolvency; documenting any decisions with respect to the affairs of the company as they are made is also of significant importance. In depth knowledge of their duties as directors as well as being cognisant of the law with respect to unfair preference and fraudulent dispositions and restriction is also of critical import. Legal advice should be obtained where necessary to help directors successfully traverse these turbulent times.