Director's Duties - Reckless Trading
Director's Duties - Reckless Trading
Wednesday 25 March, 2020
Updated: 6 April 2020
There is huge uncertainty in the current environment due to the impact of COVID-19 and the unprecedented Level 4 ‘lockdown’ affecting businesses. Many companies will be facing cashflow difficulties and, unless they can source additional capital, directors will be in the difficult position of having to assess whether to continue to trade in circumstances where the company may not be able to pay all creditors when due.
Continuing to trade while insolvent may see a director charged with reckless trading resulting in personal liability for the debts incurred by the company. This article provides a brief overview of the law in this area and some practical steps directors can take to ensure they meet the required standards.
Section 135 of the Companies Act 1993 (‘the Act’) – reckless trading
- Under s 135 of the Act, a director of a company must not cause or allow the business of that company to be carried on in a manner that is likely to create a substantial risk of serious loss to the company’s creditors.
- The focus here is on whether the manner in which the company’s business is carried out has created a substantial risk of serious loss to creditors. The law distinguishes between legitimate business risks and illegitimate business risks. The fact that a company faces cashflow difficulties does not in and of itself mean that directors are required to cease business immediately. However, if a company is insolvent, or close to insolvency and the directors continue to operate the company in circumstances where there is no reasonable prospect of a turnaround and in a manner likely to create a substantial risk of serious loss to creditors, that will involve illegitimate risk-taking.
- Therefore, where a company is experiencing financial difficulties, its Board is required to complete ongoing “sober assessments” of the company, including the company’s future income and prospects and determine whether to continue to trade. Where circumstances exist that should draw the attention of an ordinary and prudent director to the possibility of serious loss to creditors (such as an inability to pay creditors on time, a working capital deficit, or negative cash flows), the Board must quickly respond to adverse changes in the company’s financial position and ensure that the position of creditors does not deteriorate over time. In those circumstances the interests of the company’s creditors are paramount.
What should a director do if the company is in financial difficulty?
- Thoroughly review the company’s financial position and prospects and take appropriate steps, which might include:
- reducing expenditure/establishing cost savings;
- restructuring bank debts;
- looking for other sources of financing or bringing in further investment; and
- negotiating longer payment terms with creditors.
- Seek external legal and financial advice about managing the current situation and implementing a credible plan moving forward (including on how to engage with the company’s bank).
- Closely monitor the execution of the plan and the company’s financial position, and adopt standards of governance sufficient to allow the Board to quickly respond to any future adverse changes in the company’s financial position.
The Government plans to make changes to the Companies Act 1993, which will apply retrospectively from 3 April 2020, by introducing a “safe harbour” for directors over the following six months, which will protect them from liability for reckless trading because they decide to carry on trading or incur new obligations, provided that they meet the following criteria:
- In the good faith opinion of the directors,
- the company is facing, or is likely to face, significant liquidity problems in the next 6 months as a result of the impact of the COVID-19 pandemic on the company or its creditors;
- it is more likely than not that the company will be able to pay its debts as they fall due within 18 months (for example, because trading conditions are likely to improve or they are likely to able to reach an accommodation with their creditors); and
- The company was able to pay its debts as they fell due on 31 December 2019.
However, the “safe harbour” legislation does not give directors licence to avoid their responsibility to act in good faith or dishonestly incur obligations to creditors.