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Directors Duties and the Dangers of Trading whilst Insolvent

27/03/2014 | Jon Lovitt

Directors will be familiar with the dangers under the Insolvency Act 1986 (“IA 1986”) of trading whilst a company is insolvent.  In such circumstances there are a number of offences that can be committed resulting in personal liability for the director, the two most well-known being wrongful and fraudulent trading.

However, as highlighted by the recent case of Hellard & Ors (Liquidators of HLC Environment Projects Ltd) v Carvalho [2013] EWHC 2876 (Ch) directors should also be careful not to breach any ‘fiduciary or other duty in relation to the company’ under section 212 IA 1986.

Background

In this case the claimants were the liquidators of an insolvent company called HLC Environmental Projects Ltd (the “Company”) previously run by Mr Carvalho (“CV”). The liquidators brought proceedings against CV, as the Company’s principal director, for misfeasance pursuant to section 212 IA 1986 and for breach of CV’s director’s duties under the Companies Act 2006 (the “CA 2006”).

The Company began trading in 1998 when, following two public procurement processes, it was the preferred bidder on two separate projects to build Material Recycling and Energy Centres (the “Projects”). Although CV claimed that the Company was still trading in 2008, the court found that the Company had experienced several issues with the Projects and that a board meeting had taken place in 2005, at which the appointment of an administrator was discussed.  Further to this, it was held that in 2005 there was no evidence of any attempt by the Company to obtain new contracts and no serious or genuine belief that such could be obtained.

The liquidators sought relief in respect of payments made by CV through the Company between 2005 and 2008.  It was submitted that the payments made were in breach of CV’s common law duties and the court considered two of these:

1   under section 172 of the CA 2006, his duty to act in the best interests of the Company and its creditors; and

2   under section 171(b) of the CA 2006, the duty to exercise powers for the purpose for which they were conferred.

Section 172 Best Interests Test: Subjective or Objective?

The court’s examination has given us a useful set of guidelines by which to interpret the above statutory duties of directors.

The court examined the duty to act, pursuant to section 172 of the CA 2006, in the best interests of the Company.  It was stated that although the duty is generally considered subjective, being the director’s personal perspective of the situation, there were qualifications to that general rule, three of which were relevant to the claim:

1   When the duty includes a consideration of the creditors’ interests, those interests are paramount when examining a director’s exercise of discretion.

2   The subjective test is only applied when there is evidence that the director actually considered the best interests of the company. If he did not, an objective test is to be applied as follows:

whether an intelligent and honest man in the position of a director of the company concerned could, in the circumstances, have reasonably believed that the transaction was for the benefit of the company.
3   The objective test must also be applied where a material interest, such as a large creditor’s interest, is unreasonably overlooked, as the failure to take into account a material interest goes to the validity of the director’s decision-making process.

The court held that CV chose which creditors to pay (including himself and his family members) and which to leave exposed to a risk of being unpaid, which was not in itself a failing. However an intelligent and honest man could not have reasonably believed that the payments he caused to be made were for the benefit of the Company or its creditors. CV was thus ordered to pay back substantial sums to the Company.

Comment

The case helps to clarify the circumstances in which a director will be in breach of his duty to act in the best interests of his company and its creditors and whether this can be tested on an objective basis. Where there is no real evidence that the director took the best interests of the company into account, or where a large creditor is overlooked, the court won’t examine the director’s subjective understanding, but will look at how “an intelligent and honest man” would have acted.

To minimise the risks of trading whilst insolvent or prejudicing creditors, company directors should review their company accounts frequently, as well as holding regular board meetings to discuss company performance.  All decisions should be recorded, before filing with the company records.

This bulletin should not be taken as definitive legal advice. Please contact Jon Lovitt on 020 7955 0880 or jonl@rosenblatt-law.co.uk for further advice.

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