Directors at risk when trying to save their companies

Persistence and determination are always needed if a person is to succeed in business.

Unfortunately, those qualities can sometimes work against directors who are battling to keep their firms afloat in difficult times.

They may fail to recognise or refuse to accept that their business has no chance of avoiding insolvency. They may have emotional attachment to a firm they have set up themselves and feel a tremendous loyalty to their staff. Or they may be trying to avoid having to pay back company loans which they have personally guaranteed.

The trouble is that if they soldier on trying to rescue a business which has no chance of survival they could be accused of wrongful trading and run the risk of financial ruin as they become liable for the debts of their business - even if it is a small limited liability company.

As soon as a company becomes insolvent, directors have a legal duty to protect the interests of creditors. When formal insolvency procedures get underway, the behaviours of directors over the previous few years could come under investigation.

They could become liable for wrongful trading if it's found that they continued entering into contracts or accepting credit after they knew or should have known there was no reasonable chance of avoiding insolvent liquidation.

The court could then order them to use their personal assets to help settle the company's debts.

Directors of insolvent companies are also obliged to treat all creditors equally so they must not give preferential treatment to friends or a company that is threatening to sue them.

Many directors find it difficult to recognise or accept the point at which they become insolvent so they should seek professional help as soon as problems start to emerge.

People who run their business as a partnership could be even more at risk because they could be personally liable for debts if their firm becomes insolvent. It can mean they not only lose the business they have spent years building up, they may also lose their personal savings and even their homes in some cases.

The answer could be to consider restructuring the business as a Limited Liability Partnership (LLP). There are several advantages to becoming an LLP - including possible tax benefits - but the main one in the current economic climate is that it helps to ensure that liability lies with the business itself rather than with the individual partners.

The personal assets of each partner should be protected in most circumstances if the business fails, although they would still have to meet their other legal responsibilities as we have seen.

Directors also have a legal responsibility to take action if they discover other directors are acting fraudulently or dealing inappropriately with company funds - an issue that could easily emerge as a business starts to fail. In a recent case involving a large family business, two sisters were ordered to pay more than £75m in compensation because they failed to take action to stop their brother's dishonest behaviour.

The brother had been responsible for the misappropriation of nearly £60m over a four-year period using fictitious director's loan account, false facility letters and other methods. He had forwarded some of the misappropriated funds to the sisters although they did not profit from them in anyway.

The company, which is now in administration, sought orders that the two sisters should pay compensation for the losses because they knew that their brother had been convicted of dishonesty offences in the past and they should have insisted that he explains some of his current current business dealings.

The company submitted that as a the brother had not provided them with a satisfactory explanation, the sisters should have notified other non-family directors and the company auditors so the dishonesty could have been identified and prevented. They did not do this and the company was successful in obtaining judgement establishing the sister's accessory liability.

The court found that they had breached their fiduciary and common law duties of care to the company through their failure to take action against their brother while they were directors.

The sums involved in this case may be enormous but the legal principles involved apply across all companies of all sizes. Directors must take action if they suspect other directors of dishonest or irregular behaviour. Failure to do so can render them liable for subsequent losses.

For more information call Peter Sutherland on 0115 947 0641.