Directors duties and liabilities are put under the spotlight in cases of financial distress. At the recent Parliamentary Inquiry into the collapse of Carillion, the outgoing Chairman said his responsibility was "full and complete, total - no question in my mind about that. Not necessarily culpability but full responsibility". He is right in drawing the distinction between culpability and responsibility, directors are always responsible, but culpability is a different matter in legal terms. What follows looks at the principles that divide the two and how the directors should address potential liability.

What are the duties owed by directors of companies in financial difficulty?

Directors are not generally personally liable for a company's debts and losses (unless they have given personal guarantees/indemnities). It is where they have acted improperly, negligently or in breach of their duties that culpability and the risk of personal liability arises.

The directors' attention must shift away from the shareholders towards protecting the interests of creditors when a company enters the ‘zone of insolvency’, as discussed below. There are certain 'heads of liability' which need to be considered within this context particularly (1) wrongful trading and (2) fraudulent trading, as provided under the Insolvency Act 1986. This article will begin by setting out the context in which a director will need to consider potential liabilities and then provide some practical advice which may be followed in order to try and avoid legal risk.

The Zone of Insolvency

Sometimes, it will be clear that the company cannot avoid formal insolvency and a duty to 'take every step' to minimise losses to creditors will apply. At others, a company may face financial difficulties but it's not yet so certain that there is no reasonable prospect of avoiding insolvency.

In any event, a prudent board should seek to minimise losses to creditors as a whole. In some cases, that can only be done by immediately filing for insolvency - for example, where the company needs a moratorium to protect it from creditors.  In other cases, ceasing trade too early may be value destructive and exacerbate the risk.

Wrongful trading

English insolvency law exposes directors to personal liability for 'wrongful trading' under the Insolvency Act 1986.

Wrongful trading is continuing to trade at a time when there is no reasonable prospect of avoiding an insolvent liquidation or administration.

If a director concludes or should have concluded that insolvent liquidation or administration is inevitable and does not then take every step to minimise potential loss to creditors, liability may arise.

• This is an absolute test (i.e. 'every' step - not 'every reasonable' step).
• The test is both objective and subjective. A director will be deemed to have a reasonable degree of competence which is sufficient for her or him to judge the company's position. The court will also take account of her or his own experience. For example, a director who is also a qualified accountant will be expected to appreciate financial information at a higher level.
• Liability will be assessed with full hindsight by the court, based on the evidence put before it.

Directors must consider the interests of creditors as a whole, and not just the interests of any individual creditor or class of creditors, even where the director is appointed as a representative of a particular creditor.  However, if creditors would on any analysis be 'out of the money' (e.g. if unsecured where there are secured creditors who will not recover in full)  it would be difficult for the (unsecured) creditors (in that example) to bring a claim against the directors as they have not suffered a loss.

Both liquidators and administrators can pursue a director for wrongful trading, and may assign the right of action to a third party who can finance actions where the company (and the liquidator/administrator) don't have sufficient resources.

Fraudulent Trading

The concept of fraudulent trading under the Insolvency Act 1986 imposes civil and criminal responsibility on any persons who have knowingly been party to the carrying on of a company's business with intent to defraud creditors. To establish liability, a liquidator/administrator must prove, on the balance of probabilities, that the relevant officer knowingly caused the company to incur credit that would not be paid. Given the requirement to establish dishonesty, fraudulent trading cases are very rare.

Liability for wrongful or fraudulent trading is also a ground for disqualification of a director as it is evidence of unfitness.  Taking appropriate action with professional advice at an early stage can minimise directors' criminal and civil exposure.