Covid-19 and Changes to Insolvency Legislation

April 2, 2020

By Carly Sandbach and Katherine Traynor (commercial pupil)

Overview: 

On 28 March 2020 the Secretary of State for Business, Energy and Industrial Strategy announced that he would temporarily (and retrospectively) introduce new insolvency measures from 1 March 2020 – for an initial period of 3 months – to suspend wrongful trading provisions, to protect businesses hit by the coronavirus outbreak.[1]

The unprecedent move to relax insolvency rules, has been met with reservations by the Insolvency and Restructuring trade body R3, who express the view that a blanket suspension could risk abuse, and leave creditors exposed – contrary the principles of the wrongful trading provisions. The intention of the move is to allow companies that were viable before the outbreak, a better chance of emerging intact when the immediate crisis is over. Importantly, these measures do not impact the existing laws relating to, for example:

• Fraudulent trading;[2]
• Transactions defrauding creditors;[3]
• Misfeasance;[4] and,
• The general duty of directors to act in the way they consider, in good faith, would be most likely to promote the success of a company for the benefit of members as a whole, or when there is a heightened risk of insolvency, to instead consider or act in the interests of its creditors.[5]

The above, together with the threat of director disqualification will remain in force, acting as a deterrent against any misconduct, minimising the risk of abuse.

The intention of the measures is to allow time for government support packages to reach these businesses, before imposing measures that would typically force business to immediately cease trading.

In 2018 the UK government proposed the introduction of a restricting moratorium, that would be available to companies in financial distress (preventing creditor action), and based on the government’s announcement on 29 March, it would now appear that in addition to the relaxation on wrongful trading, the government intends on fast-tracking these proposed reforms.[6] Although, the government is still considering various proposals to deter hostile creditor action, and further assist directors of businesses negatively impacting with the Covid-19 pandemic.

For reasons set out in this article, it does however, remain vital that directors continue to have regard for their overriding duties and obligations as directors, and to the interests of creditors, notwithstanding the new legislation.

Timing: 

The UK government has not announced when the legislation will be in force, and with Parliament in recess until 21 April 2020 the exact timing of the legislation remains uncertain, however, it is understood that the government’s plan is to effect these changes “at the earliest opportunity”, and that the legislation will have retrospective effect from 1 March 2020.

Wrongful Trading – an overview

The wrongful trading provisions in the Insolvency Act 1986 (“IA86”), namely, S.214 and S246ZB,[7] concern themselves with situations wherein directors fail to take reasonable steps to minimise the losses to creditors when insolvent liquidation or administration is unavoidable. It is the risks associated with these provisions, that commonly lead directors of companies registered in England and Wales to conclude they need to file for formal insolvency, under procedures such as administration or liquidation.

Wrongful trading provisions apply to any individual who is, or has been a director of the company in question. Section 214 of the Insolvency Act 1986 provides, that once a director or directors of a company conclude (or should have concluded) that there is no reasonable prospect of the company avoiding an insolvent liquidation or administration they have a duty to minimise potential loss to the company’s creditors and cease trading. The standard of proof under the IA86, both objective and subjective – being that of a reasonably diligent director, having both the experience and skill reasonable expected of an individual carrying out the functions of a director, and the actual skill and experience of that director. There is no reasonableness qualification on the steps that ought, and should be taken, and wrongful trading does not require dishonest, nor fraudulent intent.

In circumstances where it appears the director has failed to comply with this duty, the court can impose personal liability on the director, requiring him to contribute to the assets of a company, following an assessment of whether any loss was suffered as a result of the wrongful trading. In doing so the court will consider the company’s net deficiency has increased over the relevant period, and whether the director undertook all steps to minimise the potential loss to the company’s creditors. Any award made is compensatory in nature, as opposed to punitive and the recovery will be credited towards all of the assets available for all creditors. A director held liable for wrongful trading may also be subject to a disqualification order under the Company Directors Disqualification Act 1986, with the minimum period of the same being 2 years and the maximum 15 years. In order to avoid personal liability, and any such disqualification order, the directors would need to demonstrate that they took every step which a reasonably diligent person would have taken with a view to minimising the losses to creditors.  Whilst this does not necessarily mean that directors have to cease trading immediately, the directors’ exposure to personal liability from wrongful trading provisions is one of the key reasons behind a company being put into liquidation or administration.

The dilemma facing a director of a company which is at significant risk of going into insolvent liquidation or administration, is whether to carry on trading or put the company into administration or liquidation or to invite the appointment of receivers. This announcement essentially provides that the legislation which governs directors personal liability in this regard will be suspended for 3 months, so as to allow directors of companies to pay their staff, and suppliers even in circumstances where there are fears the company may be insolvent. The rationale behind this legislation, is to protect directors from threats of personal liability for doing all they can to save companies, and jobs during this turbulent time.

Although, the government has stated that the proposed changed will have retrospective effect, as above there is no date as of yet for when this legislation will come into force. Therefore, it remains that directors should continue to carry out a careful evaluation of the situation and seek advice from profession advisors to establish the best course of action, if they are facing insolvency or could face insolvency despite the government support.

Insolvency of a Company

A company may face insolvency proceedings in the event it is unable to pay its debts. Under S.123(1)(e) a company is deemed unable to pay its debts, if they are unable to pay its debts as and when they fall due, i.e. they are cash flow insolvent. Under S.213(2), a company is also deemed unable to pay its debts if the value of the company’s assets is less than the amount of its outstanding liability, taking into consideration any prospective and/or contingent liability i.e. they are balance sheet insolvent. Notwithstanding, the proposed temporary legislative changes, and government support packages, directors must consider the company’s present, prospective and contingent liability, identifying whether or not these proposals will assist in their emergence from this pandemic. Whilst, cash flow insolvency concerns short term liabilities, balance sheet insolvency requires a longer-term view, and directors ought to be mindful of the long-term effects of Covid-19 when considering whether the company has sufficient assets to have reasonable expectations of meetings its liabilities.

In circumstances involving group companies, directors must assess each company’s solvency on an individual basis, and as detailed below, directors’ duties are owed to each individual company, shareholder and its creditors, not to the group as a collective.

Restructuring Moratorium

The proposed new regime provides for a stand-alone moratorium supervised by a qualified insolvency practitioner and officer of the court, for up to 28 days with a possible 28-day extensions provided the applicant can meet certain requirements. Essentially, this proposal allows for business that were previously financially sound – with no historic winding up petitions, and/or debt issues – who have been impacted by Covid-19 need time to emerge from the current period of economic inactivity. For businesses in these circumstances, the new Restructuring Moratorium will likely be an important tool, whilst they manage their current cashflow issues, and/or wait on government funding to become available.

Whilst the specifics of the Restructuring Moratorium are yet to be confirmed, the 2018 proposals and consultation papers suggested that the new regime would be modelled on the existing Administration Moratorium, with the same being triggered by an out-of-court filing. In the circumstances, this would allow directors who meet the specific requirements to instigate an immediate moratorium. The 2018 proposed criterion were:

• ‘Prospective Insolvency” of the company;
• Genuine prospects of rescue; and,
• Sufficient funds available for the company to carry on its business during the moratorium meeting both current, and new obligations as and when they fall due.[8]

It is widely accepted that protecting businesses, and their directors is the right thing to do in this crisis, government ought to be cautious with these new measures, and take steps to ensure they do not increase the impact and severity of Covid-19 on the supply chain. Covid-19 has already had a considerable financial impact on creditors, creating an enforced forbearance landscape for those seeking ages debts, with petitions being delayed beyond the 56 days. In that regard, government ought to be careful when implementing this new legislation and should take steps to ensure the enforcement powers in respect of aged debts pre-dating Covid-19 are not curtailed beyond what may be reasonable in respect of court facilities and availability.

Directors’ Duties – a brief summary

Even in light of, the proposed legislation directors ought to remain diligent in respect of their own obligations arising under the Companies Act 2006 (“CA06”). During these unprecedented times, directors are obliged to continue to exercise reasonable care and skill in the management of their company’s affairs.

In circumstances where a company is solvent, its directors are under a continuing duty to act in the best interests of the company and its shareholders. However, when a company becomes insolvent – in accordance with the definitions above – its directors duty shifts, providing that their duty is to act primarily in the interests of the company’s creditors.

It is important to note, that the obligations on directors as detailed above, and more generally outlined under the CA06 apply not only to statutory director, but also to de facto and shadow directors.

Immediate Steps – brief guidance

As has been evident thus far, the national response to Covid-19 is evolving, and it is likely the decisions directors’ take will inevitably evolve in accordance with the changing situation. In that regard, and even though the government has made these proposals as detailed above, directors should carefully record all decisions made, and the reasons for these decisions during this pandemic – just in case they come under scrutiny in the future.

In circumstances where a director is unsure of their company’s ‘solvency’ and the next best steps for the company, its shareholders and/or creditors, they should seek independent advice from an insolvency practitioner and/or specialist.

Summary

The current economic climate is unprecedented, and ever evolving, at this stage we do not know how long this pandemic will last, nor do we know what the final legislative changes will look like – but any steps taken by the government to help businesses emerge from this storm, whilst also protecting creditors from bad debtors should be cautiously welcomed.

It is a concern for directors, and creditors that we are operating in exceptional circumstances; meaning, all parties should exercise caution when making decisions in relation to creditors best interests, and insolvency procedures. Whilst, economic and financial stability for as many companies and businesses as possible should be the aim, any potential ripple effect on creditors, pushing them themselves in to the insolvency procedures must be avoided.

In circumstances of uncertainty directors and creditors ought to seek advice from an appropriate insolvency practitioner and/or legal advisor.

1 April 2020

 

[1] L. Hughes., “UK to change insolvency rules to protect businesses”, (Financial Times, 28 March 2020).

[2] S.214 Insolvency Act !986, and S.246ZA Insolvency Act 1986.

[3] S.423 Insolvency Act 1986.

[4] S.212 Insolvency Act 1968.

[5] S.172 of the Companies Act 2006.

[6] J., Payne., “The Government announces radical changes to the UK debt restricting regime”, (University of Oxford, Business Law, 11 September 2018).

[7] (n 2).

[8]Insolvency and Corporate Governance, Department for Business, Energy and Industrial Strategy, 26 August 2018 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/736163/ICG_-_Government_response_doc_-_24_Aug_clean_version__with_Minister_s_photo_and_signature__AC.pdf