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The Insolvency Act 1986 and the Company Directors Disqualification Act 1986 brought into force new measures that provide an opportunity for penalising company directors who abuse the privilege of limited liability. The legislation enables action to be taken against directors who, either through misconduct or incompetence, have caused loss to creditors in general and the public in particular, by rendering them personally liable for their actions or preventing them from dealing through limited liability companies.

 

This Brief summarises these implications and examines the grounds that may give rise to a director or shadow director being disqualified and, in some cases, being made personally liable to contribute to the insolvent company’s assets.

The definition of a director is ‘any person occupying the position of director, by whatever name is called’ (s 741, Companies Act 1985 and s 22(4), Company Directors Disqualification Act 1986). All directors of a company must be noted in the company’s register and details must be registered with the Registrar of Companies.

 

A shadow director is defined as ‘a person in accordance with whose directors or instructions the directors of the company are accustomed to act’. Although this concept was included in the Companies Act 1948, it was not until 1980 that the description ‘shadow director’ was applied and only with the introduction of the Insolvency Act 1986 and the Company Directors Disqualification Act 1986 has the term gained universal recognition. The use of the word ‘person’ does not restrict a director or shadow director to being a natural person. A shadow director may, therefore, be not only an individual who effectively controls the management of the company without the label of ‘director’, but also a parent company that controls the decision making of a subsidiary company’s board or even a financial institution that effectively controls a company’s decision making. The law makes a clear exemption from the definition of shadow director for a person or body that merely gives advice to the directors in his or its professional capacity.

A disqualification order may be made by the court and has the effect or preventing a person, without leave of the court, being a director of a company or being in any way involved, either directly or indirectly, in the promotion, formation or management of a company. The periods for which an order may be imposed vary with the grounds (see below) but can be for up to 15 years.

 

If a person acts in breach of a disqualification order he may be liable to imprisonment or a fine and is personally liable for the debts of the company incurred during the period in which he so acts. The liability is joint and several with that of the company and any other person who has acted on his instructions knowing that he was disqualified. Similar provisions apply in relation to an undischarged bankrupt acting as a director.

A director or shadow director can be disqualified for general misconduct on any of the following grounds:

 

(a)   conviction of an indictable offence (e.g. fraud) in connection with the promotion, formation or management of a company (maximum 15 years);

(b)   persistent default in filing returns, accounts or notices with Registrar of Companies (maximum 5 years);

(c)   where the company is in liquidation, appearance of being guilty of fraudulent trading (whether or not convicted) or of any fraud or breach of duty as a director (maximum 15 years). In this context, fraudulent trading refers to the criminal offence set out in s 458, Companies Act 1985 whereby ‘if any business of a company is carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, every person who was knowingly a party…is liable to imprisonment or a fine, or both’.

A director will be disqualified for unfitness if he is or has been a director of an insolvent company and his conduct makes him unfit to be concerned with the management of a company (minimum 2 years, maximum 15 years). The company may have become insolvent after he ceased to be a director and his conduct as a director of other companies can be taken into account.

 

A company becomes insolvent in this context if it goes into liquidation when its assets are insufficient to pay its debts and the expenses of liquidation, or if an administrator or administrative receiver is appointment.

 

The Company Directors Disqualification Act 1986 sets out the following criteria for the court to consider in determining whether a person is unfit to be a director:

 

(a)   misfeasance or breach of any fiduciary or other duty;

(b)   misapplication or retention of assets;

(c)    involvement in transactions of defrauding creditors;

(d)   failure to comply with the statutory requirements relating to books, records, returns and accounts;

(e)   the causes of the insolvency;

(f)    the company’s failure to supply any goods or services which have been partly or fully paid for;

(g)   any transaction at an undervalue or preference that can be set aside; and

(h)   failure to comply with the statutory obligations in insolvency (calling a meeting of creditors, statement of affairs, delivery of property and co-operation with officeholder etc).

 

The application for disqualification of a director or shadow director is made by the Secretary of State or the Official Receiver acting in the public interest. Every liquidator, administrator and administrative Receiver must report to the Secretary of State if is appears that a director is unfit to hold office and the application for disqualification must be made within two years of the commencement of the insolvency procedure. 

 

It is quite normal that in any insolvent company there will be monies due to the Crown for PAYE, NIC and VAT. In reported cases where the application has been made to the courts for a disqualification order, judges have not always been consistent in their views on the seriousness of the non-payment of substantial Crown debts although all of them have considered it to be improper. The current thinking, expressed in a case which reviewed judges’ comments in earlier cases, appears to be that the use of Crown monies to finance the continuation of an insolvent company’s business is more culpable than the failure to pay commercial debts.

 

The Secretary of State is also empowered to apply for a disqualification order in the public interest following a report by investigators appointed under ss431/432, Companies Act 1985 or s94 or s177, Financial Services Act 1986 or from information or documents obtained under ss447/448, Companies Act 1985 or s105, Financial Services Act 1986. The maximum disqualification period is 15 years.

Where an administration order has been made against an individual under the County Courts Act 1984 and that individual fails to make a payment as required, he can be disqualified for up to two years from being a director or from having any direct or indirect part in the promotion, formation or management of a company. Contravention can lead to imprisonment for up to two years and/or a fine.

The liquidator or any creditor or (with the consent of the court) any shareholder can apply to the court for an examination of the conduct of a director or shadow director who appears to have misapplied money or property of a company or been guilty of misfeasance or breach of duty in relation to the company. The court may compel the director to repay, restore or account for the money or property or to pay compensation. Misfeasance or breach of duty, as stated above, is one of the criteria for determining whether a person is unfit to be a director.

 

A case before the Court of Appeal dealt with a director who personally guaranteed the bank overdraft of an associated company and deliberately transferred funds between companies immediately before liquidation in order to reduce his guarantee liability. The director was found to have given a fraudulent preference in his own favour and thus to be guilty of misfeasance and breach of duty. The court ordered him to repay the sum involved together with interest.

As previously stated, a director or shadow director guilty of fraudulent trading can be disqualified and can be liable to imprisonment and/or a fine under the provisions of the Companies Act 1985 and the Company Directors Disqualification Act 1986. Under the provisions of the Insolvency Act 1986, if the company is in liquidation, the court can also make him liable to contribute to the company’s assets.

A director or shadow director can be made personally liable and can be disqualified if the company goes into insolvent liquidation and he held office at a time when he knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. A director can avoid liability if, as soon as he becomes aware of the situation, he makes every attempt to minimise the potential loss to the company’s creditors.

 

A director will be taken to have known that the company could not avoid going into insolvent liquidation if that would have been the conclusion of a reasonably diligent person having both the general knowledge, skill and experience that might reasonably be expected of a person carrying out that particular director’s duties with the company and the general knowledge, skill and experience actually possessed by that director. The onus is on the director to ascertain all the information about the company’s standing that his position requires.

 

An application to the court for a declaration of wrongful trading by a director can be made only by a liquidator. The liquidator is more likely to pursue a charge of wrongful trading that fraudulent trading because the burden of proof in the former is comparatively easier. If a director considers that there is no reasonable prospect of the company avoiding going into insolvent liquidation, but his fellow directors are not of the same opinion, he should ensure that his views are fully minuted and, if necessary, take legal advice. Resignation by the director will not resolve his problem in respect of any wrongful trading prior to his resignation because he will not then be taking any steps to reduce the potential loss to the company’s creditors.

 

As shadow directors are potentially liable under the wrongful trading provisions, care needs to be taken by parent companies and financial institutions as well as individuals. Directors of a parent company and/or the parent company itself may be seen as shadow directors, and the directors of the subsidiary company may be in breach of their duty if they act on the parent company’s instructions where that is not in the best interest of the subsidiary.

When a company goes into insolvent liquidation, its directors and shadow directors during the previous 12 months are prohibited from any involvement with a similarly named company for the next five years (other than with the leave of the court or in the circumstances listed below). The restriction applies to any name by which the company was known in the previous 12 months and to any name that suggest an association with it. Contravention can lead to a personal responsibility for debts incurred during the person’s period of involvement and imprisonment and/or a fine.

 

The circumstances in which a person can be a director of, or be involved in the management of, a company with a prohibited name are as follows:

 

(a)   where the whole, or substantially the whole, of an insolvent company’s business is acquired under arrangements made with an insolvency practitioner and notice is sent within 28 days to all known creditors of the insolvent company giving details relating to the acquisition, the company names involved (including proposed names) and the name of any director or shadow director of the insolvent company who might be a director of the successor company or otherwise be involved in its management;

(b)   where he applies to the court, within seven days of the company going into liquidation, for leave to act and that leave is granted by the court within six weeks of the date of liquidation. (The director’s exposure in a situation where he has acted in accordance with this provision but his application has been refused by the court is not dealt with in the legislation, although technically he would have been in breach of the law);

(c)    where a company has a name or similar to that of a company that goes into insolvent liquidation and has had that name for the previous 12 months and has not been dormant at any time within that period. This may well be the case within a group of companies.

In addition to offences detailed above for which the penalty is imprisonment and/or a fine in conjunction with other penalties, the following offences are penalised only by imprisonment and/or a fine – unless they are associated with other offences:

A director or shadow director can be imprisoned and/or fined if, in the 12 months prior to liquidation or during the liquidation, he has (unless he can prove that he had not intent to defraud):

 

(a)   concealed or fraudulently removed company assets of at least £500; or

(b)   concealed, destroyed, mutilated or falsified any documents relating to the company’s affairs; or

(c)    fraudulently parted with, altered or made any omission in any documents relating to the company’s affairs; or

(d)   pawned, pledged or disposed of any company property that was obtained on credit but not paid other than in the ordinary course of business; or

(e)   been privy to any of the above offences by others relating to documents.

A director (but not a shadow director) is deemed to have committed an offence if he concealed or removed any property since, or within two months before, any unsatisfied judgement against the company or, in the five years before liquidation, he made a gift or transfer or, or caused a charge to be made on, company property unless he can prove that he had no intent to defraud the company’s creditors.

A director or shadow director may be imprisoned and/or fined if he intentionally does not disclose to the liquidator all the company’s property, books and papers or fails to inform the liquidator of any false debts that are being proved or prevents the production of books or papers, or if he attempts to account for any of the company’s property by fictitious losses or expenses after the commencement of the liquidation. An intentionally material omission from the statement of affairs is liable to the same penalty as is false representation to creditors either before or during the liquidation.