Prevention of Personal Liability... What are the problems being experienced?
Drawing Income (Dividends v PA YE)
It’s quite common for directors of limited companies to draw their income from a business through a mixture of PAYE remuneration (i.e. as an employee) and dividends (i.e. as a shareholder).
This does, however, produce two problems when the company becomes insolvent: -
l. When it is proven that the dividends drawn were illegal (i.e. there were insufficient profits to cover
same); and / or
2. If the director were to be made redundant and wish to make a claim for unpaid wages etc. (sometimes
met by the Redundancy Payments Office), their claim is only based on the PAYE remuneration element (and not the dividend element).
Withdrawing previously introduced Working Capital
As outlined in our previous seminars, many of the businesses we are seeing at present are good businesses, and
their directors have been in a position to introduce funds when the company required additional working capital.
These funds have often (innocently) been withdrawn by the directors (at a later stage) — if, however, the company were to later fail, there is a risk that the Insolvency Practitioner appointed may request the director
repay the monies withdrawn (as they were taken in preference to other creditors).
Innocent attempt at "trading through a difficult period "
As a director of a historically successful limited company, the first thought (when a business is struggling) is to try and "trade through" the situation (prior to considering formal insolvency options). A rule of thumb often adopted is that- so long as the general status quo of the business is unchanged — there should be no potential comeback on the directors.
Misfeasance (i.e. a breach of a director’s fiduciary duties) covers all sorts of issues — and as so many different businesses are struggling at present, when a company fails, there is now a greater emphasis on examining what has happened in the six months running up to the date at which the company enters into a formal insolvency process.
In particular: -
- suppliers look at goods ordered that have not been paid for (fraud?); and
- H M Revenue & Customs look to see whether the company has been utilising VAT or PAYE/NIC deductions to fund the business.
What if I ’m a sole—trader or in a partnership?
There’s an often misconception that "worst case scenario, I’ll declare myself bankrupt".
If an individual is found guilty of "Wrongful Trading" or any other misfeasance action, they may find that the duration of their Bankruptcy is increased — sometimes indefinitely.
When a non-corporate business is therefore struggling, they too need to be careful as to how they conduct themselves going forward.
Prevention of Personal Liability... But what can happen?
Illegal Dividends
If it can be proven that a dividend was drawn from a company where there were insufficient reserves or profits, the appointed Insolvency Practitioner has the ability to request repayment of same. There have also been instances where it is proven that dividends drawn where a company was "Balance Sheet” solvent were illegal.
The difficulty here — from the director’s perspective — is that the burden of proof is on the director / shareholder to prove that the company had profits at the time the dividends were drawn. In the majority of instances, although accounting records were maintained properly, there was still no evidence at given points that consideration was given to confirm available profits existed when dividends were drawn.
Often directors can find themselves having to repay back monies that were simply drawn to cover their living costs, or having to fund a litigation battle (with the Insolvency Practitioner) to defend why the monies were drawn.
Director Loan Accounts
When an Insolvency Practitioner is looking to prove that a payment was a "preference" — i.e. it was made to one individual above all others — he normally has to prove three things:-
- That the company was insolvent (at the time the payment was made, or as a result of the payment);
- That the payment was made within the required time period (prior to the date of insolvency); and
- That there was a "desire" by the directors to prefer the individual creditor.
If payment is made to an "unconnected party" (i.e. not a director or shareholder) — the timescale for the
preference payment is six months prior to the date of insolvency.
If payment is made to a “connected party" (e.g. a director or shareholder) — the timescale increases to two years and the Insolvency Practitioner does not have to prove there was a "desire" to prefer the creditor.
Should a director therefore withdraw monies (previously introduced to meet working capital requirements) within two years prior to the date of insolvency, there is a good chance that the Insolvency Practitioner could recover the monies from the director.
Misfeasance
All directors of limited companies have fiduciary duties, and unfortunately when there has been a breach of these duties, the directors can potentially be personally liable for any shortfall caused as a result of the breach (known as a misfeasance).
The most common type of action is Wrongful Trading, whereby a director trades an insolvent company that continues to make losses — if proven, the director can be ordered to make a repayment (personally) for an amount equivalent to the losses incurred.
Often, directors will take the view of “we’ll give it a few more months", but they are not fully aware that they
are effectively risking their own personal monies in doing so.
Cash on Delivery?
As mentioned earlier in the notes, there is an often misconception that “‘so long as the overall status quo of the company remains unchanged there should be no issue".
This is true as far as Wrongful Trading is concerned, but what about the debts incurred in the period shortly before the formal insolvency?
We are now seeing many instances where creditors are demanding that the Insolvency Practitioner look into debts incurred in the few months prior to insolvency — "did the director have any intention of paying for the goods / services when they were ordered‘?".
H M Revenue & Customs are also scrutinising the period prior to insolvency — we are seeing Company Voluntary Arrangements being rejected where a company has failed to pay across VAT or PAYE/N IC deductions in the six months prior to the Meeting of Creditors, as the Government considers that the business was "using them as a bank account".
"Culpable Bankrupts"
Under normal circumstances, when an individual declares themselves bankrupt (or is made bankrupt by a creditor) the duration of their Bankruptcy Order is twelve months.
lf the individual is found guilty of being a "culpable" bankrupt, however, they could be subject to a Bankruptcy Restriction Order, which effectively increases the duration of their bankruptcy from between two years (for minor offences) to fifteen years (for the more serious offences).
Some examples are: -
- Preferences (i.e. choosing to pay an individual creditor amongst all others);
- Transaction at an Undervalue (i.e. selling / gifting assets to third parties for less than they are worth); or
- Wrongful Trading (i.e. where an individual is aware they will, at some later stage, be made bankrupt yet they continue to trade an incur losses).
In some instances, where the Official Receiver (person initially appointed to deal with the Bankrupt’s affairs) is concerned with the lack of compliance by an individual, he may make Application to Court for an Order suspending the discharge of the Bankruptcy Order ~ i.e. it remains indefinitely until the Bankrupt succumbs to proceedings.
Incorporation of ailing businesses
In an attempt to protect a sole—trader / partnership business, there have been instances where steps have been taken to incorporate same, prior to the individual(s) being made bankrupt.
This is a very risky strategy for two main reasons:-
1. Often no formal valuation exercise has been undertaken, and the Trustee in Bankruptcy therefore commences proceedings against the (newly formed) limited company to recompense the Bankruptcy estate for the value of the business; and (more serious)
2. Often the spouse / member of family is appointed as Director of the newly formed company, and the (now Bankrupt) individual becomes an "employee" — if it is proven that the Bankrupt is acting as a "Shadow Director" (or in the management / otherwise running of the business), then this is a criminal Offence when trying to prove this, the burden of proof will be on the "Director" to verify that he / she is in full control of the company (and not the Bankrupt).
Prevention of Personal Liability... What can we do to avoid this happening?
Cashflow Forecasts
A Cashflow Forecast is one of the most fundamental documents for a business, as it: -
- provides a “guide" to confirm that the business will be able to meet its debts as and when they fall due;
- identifies where a business will need a capital injection (i.e. in the “lean months"); and
- is evidence to back up the director’s decision to continue trading.
I always suggest producing three forecasts:-
1. “Short” (i.e. over four weeks) to ensure the business can continue to meet immediate "weekly" payments;
2. "Medium" (i.e. over twelve weeks) to ensure that monthly payments can be met, together with the next VAT payment; and
3. "Long" (i.e. over twelve months) to ensure that the business can survive throughout the various trading periods (e.g. seasonal).
In the current climate, I also suggest that directors flex their forecasts, reducing same by 5%/ 10% often higher
(depending on confidence)- similarly, I also suggest they return to revise the forecasts on a periodical basis.
Monthly Management Accounts
Directors will often feel that the production of management accounts on a monthly basis is time-consuming and an expense they do not need to make — the reality is that Monthly Management Accounts are worth their "weight in gold" and certainly money well spent.
The problem with simply completing annual accounts (for the purposes of filing at Companies House) is you are often looking at an issue several months after it’s happened — production of monthly management accounts allow the directors to continually monitor the progression of their business (especially during the difficult times).
The accounts will also assist when evidencing there were profits / reserves at the point that dividends were
drawn, together with confirming that a company was "Balance Sheet" solvent at a given point in time.
Introduction of Working Capital
As outlined earlier in the notes, there are many pitfalls to a director when introducing funds into a company to
assist with cashflow requirements.
There are, however, a number of options that could be explored to minimise the risks previously discussed: -
- Take some form of security (e.g. a Debenture) — this will therefore ensure that the funds introduced by the director rank higher than other unsecured creditors; or
- Purchase some of the company’s assets — ensure that advice is taken on their value (see later) – this could produce an income stream on the funds introduced (i.e. introduce rental agreement) and the assets can be purchased back by the company at a later stage (to recover capital elements).
Repayment 0f Personal Guarantees
lf a company were to enter into a formal insolvency procedure, the company’s bank may serve demand upon the directors to repay the amount owed (by the company) under the terms of a personal guarantee previously provided.
A tip here is to seek legal advice (following repayment of the debt) in relation to whether the director is able to "subrogate" the bank’s security — i.e. effectively "step into the shoes” of the bank and take over the security previously available to the bank. This could be useful especially where the bank had been granted a Debenture over the company’s assets.
Cash on Delivery
As outlined earlier in this report, we are seeing more and more instances where creditors (and H M Revenue &
Customs) are examining the trading period shortly before the date of insolvency — their main concerns are that
credit is being incurred in the knowledge there was no prospect of it being repaid (i.e. fraud).
One way to ensure this does not happen is, where a director is concerned as to the viability of the business, to pay for goods as they are ordered.
There is a concern here that it "sends out the wrong signals" and effectively makes trade suppliers aware that the company is struggling — one tip here would be for the director to try negotiating a discount for cash payments (whilst also making an attempt to clear the older debt).
Fraud is a criminal offence, and deciding whether credit should be incurred (if we are aware our business is struggling) should therefore be taken very seriously.
Document Decisions
It is often useful for directors to document every decision they take — especially when they have concerns as regards the continuing viability of their business.
Regular (minuted) Board Meetings are a perfect way of dealing with this aspect — together with backing documents in support (e.g. Cashflow Forecasts / Management Accounts), as they provide the ideal evidence to show why decisions were made at given points.
Business Transfers
Whenever directors / individuals are looking to sell / transfer individual assets or whole parts of their business, they should take advice from an independent agent, who will provide a report in writing to back up values agreed (especially where the transactions involve associated parties).
All Insolvency Practitioners will take advice from an independent agent, and use same when deciding whether action needs to be taken — if a director can provide evidence (from a qualified third party), the risks are significantly reduced.
Legal Advice
As a rule of thumb — if in doubt seek legal advice!
Directors / individuals will consider this to be expensive, but compared to the potential expense of defending an action by an Insolvency Practitioner, it is again exceptional value for money.
Prevention of Personal Liability... Can you remind me of the various options?
Informal Options
There are many "non-insolvency" (as discussed at previous seminars) that should be fully explored prior to entering into a formal insolvency process.
Administration
Administration is a legal process, which provides a company with protection from its creditors, whilst the duly
appointed Administrator considers how best to proceed to ensure that the maximum realisation is made,
resulting in either: -
- The business being traded under the supervision of the Administrator to complete current contracts, and realise chattel assets (i.e. a controlled winding-down);
- A going-concern sale to a third party; or
- A CVA being proposed by the Administrator (following which the business is "handed back” to the directors).
There is always a risk in trading a company in Administration - the appointed Administrator has to be confident that doing so is to the benefit of creditors as a whole — if losses result, and the Administrator is unable to justify that it concluded in a better outcome than not trading the business, he can be held personally liable for the shortfall.
Individual / Company Voluntary Arrangements
An Individual or Company Voluntary Arrangement is effectively a formal "deal" between the individual / company and its unsecured creditors, whereby the business repa