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Guidelines for directors of companies in financial distress

20 November 2008

In the last 18 months, the credit crunch has had a devastating effect on the financial sector.  The crisis is now spreading from finance into the real economy.  In these difficult times it is vital that directors be aware of their legal obligations and duties and even more critical that they understand what they should be doing both to protect themselves and to preserve enterprise value.

The purpose of this article is to identify the key practical steps that directors should take when a company is in financial difficulties.

Key practical steps

Board engagement

Directors must take proper steps to guide and monitor the management of the company.  They cannot abdicate responsibility or leave it to other directors and management to deal with issues.

Directors must:

  • continually evaluate and monitor the company’s actual financial performance, position and future prospects, and
  • continually assess whether the company is financially viable.

The Board should meet regularly and require immediate update if there is any material change in the company’s position.

Reporting, budgets and cash flows

Directors should ensure that:

  • budgets and cash flow forecasts are prepared regularly (at least monthly) and the balance sheet similarly updated
  • the financial performance of the company should be regularly compared against the cash flows and forecasts, and
  • controls should be placed on expenditure, and costs reduced where prudent.  Methods of enhancing liquidity (e.g. by sale of receivables) should be considered.

External advice

The directors should appoint an independent expert to review and report on the company’s financial and operating position and forecasts.

The expert should report in person to the Board and the directors should ask questions of the expert so that they can satisfy themselves that the expert is basing its reports on the correct facts and appropriate assumptions and that they understand the nature and basis of the expert’s conclusions and recommendations.

There is often a reluctance for a cash-starved company to spend money on specialist advisers.  Often, the company’s general advisers will not have the experience necessary to really make a difference.  However, this reluctance must be balanced against the twin realities of potential personal director liability and the ability of respected and genuinely experienced professional advisers to make a significant difference.

Directors are entitled to rely on advice received from expert professional advisers.  Any reliance on an external expert must be reasonable i.e. directors must form their own judgment and make their own decisions.

Informing creditors

Directors of a potentially insolvent company must have regard to the interests of the company’s creditors.  It is vital that the company communicate with its creditors.  Informed creditors are more likely to support recovery plans. 

Lenders

If there are actual or likely breaches of financial ratios or other covenants in loan or security documents, the directors should seek a waiver of those provisions (or at least agreement by the lender to an appropriate period of notice before exercise of enforcement rights), to avoid enforcement of security without adequate warning.

Future commitments

Directors can be personally liable if a company trades recklessly or while insolvent.  Specifically:

  • to avoid liability for reckless trading — Directors should not authorise any future financial or other commitment of the company unless they have reasonable grounds to believe that the company will be in a position to meet (on the due date) both that financial commitment (including any interest and expenses) and all of its other commitments and obligations (including contingent commitments).
  • to avoid liability for insolvent trading — Directors should not allow the company to be run in a manner that creates a substantial risk of serious loss to creditors, i.e. they should only take legitimate business risks.  Relevant factors include whether the conduct of the directors is in accordance with orthodox commercial practices and whether the directors have, in the circumstances, done what reasonable directors would have done. 

Company records

The directors should satisfy themselves that company books and records are being kept up to date.  Detailed Board papers should also be prepared and decisions of the Board (and the reasons for those decisions) properly minuted. 

Trading whilst insolvent

A company does not need to cease trading immediately on becoming balance sheet insolvent, but neither should it trade indefinitely when insolvent.  The key factor is when or if it becomes apparent that the company cannot trade its way out of difficulties.  There is no fixed rule, but the period is likely to be weeks rather than months.  Continued trading is justified where the company can demonstrate that it has the continued support of its creditors (on an informed basis).

If directors elect to continue trading whilst insolvent then many of the points outlined above, and in particular the requirement that the directors continually re-evaluate the decision to continue trading, take on added significance.

Conclusion

These are some of the steps that should be taken by directors of a distressed company.  However, given the impact on stakeholders if a company is unable to trade its way out of difficulties, and the potentially significant personal liability that can fall on its directors, we would recommend that any company encountering financial difficulties seek specialist legal advice at the earliest stage.

Our thanks to Chris Liddall for writing this article.

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