In the second article in our series on the legal implications of the economic downturn, we look at the risk to directors if their company goes under

These days it seems that there is no longer solid ground under anyone’s feet. Company directors, who are already wrestling with a range of new duties, are having to feel their way in radically altered business conditions.

In particular, they will need to keep an even closer eye than usual on the financial health of their organisations. This is because as a director of an insolvent company, you may face liability for the entire debts of the company if it fails and you have not taken the action required by law. Executive directors are most obviously in the firing line but this can happen to non-executives too.

In normal circumstances – that is, unless you have given a personal guarantee of any kind – your exposure as a director in the event of insolvency will be limited to the value of any company shares you may own. That said, there are four specific cases in which statute provides for directors to be made personally liable, and as part of the investigations that may follow insolvency, your conduct during the months or years before the company’s failure is likely to be subject to scrutiny to establish whether any of these grounds arise.

The first is the most straightforward. If, despite disqualification from acting as a company director, you nonetheless take office again and the company fails, you will face personal liability for all of its debts.

The other grounds are more complex. They are (in the jargon) wrongful trading, conducting transactions at an undervalue and preferences.

Dealing with these in turn, liability for wrongful trading arises if a court is satisfied that at a point when you knew or should have known that the company stood no reasonable prospect of avoiding insolvent liquidation, you failed to do everything you ought to have done to minimise the potential losses of creditors.

The best advice to any director must be to get advice and ensure you create an audit trail.

As soon as you become aware that you may face difficulties, you need to look into the company’s finances and monitor the position closely, if necessary with outside professional help. It may be that this exercise will throw up ways of minimising creditors’ losses other than insolvent litigation by, for example, selling assets or restructuring debts.

Even if the board concludes that there are no reasonable prospects of avoiding insolvent litigation, your duty to minimise creditors’ losses may require steps other than immediately ceasing to trade. Informed advice as to the way forward is crucial.

It may be that the rest of the board does not share your concerns. In that event, resignation alone will not protect you from personal liability. You owe a duty to creditors to try to talk your colleagues round. For your own protection it makes sense to put your views in writing. If you cannot change their minds, the only course open to you is to resign in writing, clearly stating your reasons for doing so.

Turning to the next head, undervaluing, the purpose is to prevent the transfer of assets out of the company to put them beyond the reach of creditors. If such a transaction takes place in the two years preceding liquidation, and the court is satisfied that the company was unable to pay debts at the time of the transaction or as a result of it, the court can unwind the transaction and also impose personal liability on the directors concerned.

The principle underlying the law as to preference is a similar one: to help ensure that all creditors are treated fairly. A so-called preference arises if a company takes any action with the intention, in the event of insolvency, of improving the position of one creditor, surety or guarantor at the expense of others. An example could be paying a creditor in full while others remain unpaid. If this was done for a proper commercial reason – for example, to secure essential supplies of raw materials – then a court will not intervene. If not, and if undertaken within certain time limits, the court can set aside such transactions and make findings that could lead to personal liability for directors.

As readers will appreciate, this article cannot do full justice to what is a difficult area. The best advice to any director must therefore be to take nothing for granted, get advice throughout and ensure you create an audit trail that demonstrates the steps you have taken. Inevitably this right comes at a price – compensation for the contractor, usually based on loss of profit.