Knowledge Highlights 29 April 2020
Covid-19 is challenging and disruptive. Public health considerations take precedence over business considerations. Many companies, including otherwise healthy ones, must consider any adverse impact which Covid-19 may have on their finances.
How should directors of companies respond to this global crisis? In particular, how should directors discharge their duties if the company is insolvent or near-insolvent, or is otherwise in a parlous financial state? What protective measures are there to protect directors personally? The following is a roadmap for any director navigating this landscape.
What is insolvency?
Sun Tzu, the great military strategist, spoke of the importance of knowing your enemy and knowing yourself. If insolvency is an enemy, it is an enemy within the company itself. Directors, in discharging their duties to the company, should be familiar with the concept.
Broadly, insolvency is concerned with the inability of a company to meet its liabilities. In general, there are two tests to ascertain such inability, namely:
- the cash flow test, where the debtor company is unable to pay its debts and liabilities as they fall due (whether or not the its assets exceed its liabilities); and
- the overall balance sheet test, where, on an overall basis, the debtor’s assets are insufficient to discharge its liabilities (including contingent and prospective liabilities).
A company will be regarded as insolvent if it fails either of these tests. It is important to note that these tests may differ from normal accounting treatment. For instance, a normal accounting balance sheet, which is snapshot of the company’s assets and liabilities as of a certain date, may not capture all contingent liabilities of the company. Such contingent liabilities (which may include guarantees issued by the company) may be off-balance sheet items. The overall balance sheet test for insolvency requires an evaluation of such contingent liabilities. This may, on the face of it, be daunting, as the face value of guarantees and other contingent liabilities may tip the company into insolvency. This is where the law also allows to be taken into consideration the company’s contingent rights of recovery e.g. via an implied indemnity which the company as guarantor may have against the principal debtor (for whose benefit the guarantee is given). As a director, you would then have to evaluate the company’s recourse against the principal debtor, and the financial position of the principal debtor.
Why should directors be concerned with the financial position of the company?
Responsibilities and duties of directors could be triggered even if the company were not technically insolvent. Going back to the basics, a director’s duty is to act in the best interest of the company. In the case of a financially healthy company, the interest of the company is very broadly that of the interest of the shareholders as a whole. However, in the case of an insolvent or near-insolvent company, discharging the duties to the company would entail the director acting in a manner which takes into consideration the interests of creditors.
Potential personal liability may be triggered if directors ignore the interests of creditors, when such interests should have been considered. For example, where the director causes the company to sell or transfer property at an undervalue, to unfairly prefer certain creditors, to enter into unduly onerous contracts, to incur debts which the company has no reasonable prospect of repaying, or to pay dividends with a desire to prefer the shareholders to the detriment of creditors.
How may directors discharge their duties?
Directors are required to act honestly, with due diligence and care, for proper purposes and in the interests of the company (which, as discussed above, would include the interests of the creditors).
As a start, directors should take proper steps to be familiar with the activities and the financial position of the company. It is no defence to potential liability that a director did not know of the insolvency or near-insolvency of the company. A director’s duty to have regard to interest of creditors also apply when a director ought to have known that the company was insolvent or near-insolvent.
Further, when undertaking certain transactions, a stricter requirement for establishing the solvency of the company may apply. For instance, when making a solvency statement in relation to a capital reduction or financial assistance in connection with acquisition of certain shares, the directors of the company must have formed an opinion “that, as regards the company’s situation at the date of the statement, there is no ground on which the company could then be found to be unable to pay its debts”.
Questions that directors need to be able to answer in order to be able to discharge their duties include the following:
- Is the company insolvent or near-insolvent? In making in such an evaluation, bear in mind the tests for insolvency discussed above. In considering the contingent liabilities of the company, take into account any possible claims or disputed claims that may be brought against the company.
- Are the interests of creditors of the company duly taken into account?
- What are the options for preserving or increasing the capital or assets of the company? For example, can more shares be issued, should interim dividends be cancelled (there is in general no legal obligation to pay interim dividends simply because they have been declared)? Can shareholder loans be of limited recourse or subordinated?
- Consider the position of counterparties, and if required, commence negotiations early. If Covid-19 has caused disruptions, consider if there are force majeure clauses in your contracts, or seek legal advice on whether the doctrine of frustration can be relied upon
- How can cash be raised now? Consider (a) securitising receivables and other assets, (b) structuring transactions so that they benefit from safe harbours from insolvency laws and hence give lenders more comfort to lend, (c) borrowing from banks involved in government-backed schemes, (d) tapping the debt capital market, etc.
- What steps can be taken to ensure business continuity if this climate continues, e.g. by contracting electronically?
- What grants or resources are available? Familiarise yourself with benefits under the Government’s Unity, Resilience, and Solidarity Budgets and other measures, if you have not done so.
- What procedures are there in law to help rehabilitate the company? If informal restructuring does not appear viable, consider judicial management and schemes of arrangement.
What steps should directors take to manage personal liability?
Steps which should be taken to manage the risk of potential personal liability of directors include:
Exercise due diligence, act in good faith, honestly and in the best interest of the company taking into consideration some of the matters set out above (including, where appropriate, taking into consideration the interests of creditors as a whole).
- Explore whether and to what extent the company can provide an indemnity or cover for a director’s potential liabilities. As a rule, a company is not able to indemnify directors against any liability in connection with any negligence, default, breach of duty or breach of trust in relation to the company. There are, however, some situations where an indemnity may be provided. For example, subject to certain limitations, the company may be allowed to provide third-party indemnities to its directors for liability incurred to a person other than the company. Further, for nominee directors, there could also be greater flexibility in the procurement of an appropriate indemnity from the appointor.
- Consider taking out directors’ and officers’ liability insurance. However, be aware that there are some common exceptions to this, e.g. when a director is sued by the company or some other insured person. This exclusion is there to help ensure there is independence of claims brought by one insured (e.g. the insured company claiming against another insured person, i.e. the director of the company). In appropriate cases, insurers have been willing to negotiate the terms of the policy, such that independence can be established. For example, where there is a court-appointed liquidator bringing an action on behalf of the company against the director. Pay attention to the terms of such policies and the extent to which more comprehensive coverage can be obtained.
- Section 157C of the Companies Act allows (subject to certain safeguards) directors to rely on reports, statements, financial data and other information prepared or supplied, and on professional or expert advice given by:
- an employee of the company whom the director believes on reasonable grounds to be reliable and competent in the relevant matter;
- a professional adviser or an expert in relation to the relevant matter, which the director believes on reasonable grounds to be within that person’s professional or expert competence; and
- any other director or any committee of directors upon which the director did not serve in relation to matters within that other director’s or committee’s designated authority.
However, note that these protections only apply if the director acts in good faith, makes proper inquiry where the circumstances indicate a need to make such inquiry, and has no knowledge that such reliance is unwarranted.
Legislation addressing Covid-19 crisis
The Covid-19 (Temporary Measures) Act 2020 (“Covid-19 Act”) has been enacted and its provisions take effect from various dates. Parts 2 and 3 of the Covid-19 Act came into effect on 20 April 2020 and provide temporary and targeted protection for businesses that are unable to fulfil certain contractual obligations because of Covid-19. Part 2 provides temporary cash flow relief for businesses who may otherwise have to pay damages. Part 3 increases the monetary thresholds and time limits for insolvency. Further, directors are temporarily relieved from their obligations to prevent their companies from trading while insolvent if the debts are incurred in the company’s ordinary course of business. However, the Ministry of Law has stated that directors would remain criminally liable if the debts are incurred fraudulently.
The global financial and economic landscape is uncertain, if not treacherous. With this roadmap, navigate with care, and with clear knowledge of where the potential pitfalls lie.
In addition, we have a cross-disciplinary Covid-19 Legal Task Force consisting of Partners across various practice areas to provide rapid assistance. Should you have any queries, please do not hesitate to get in touch with us at firstname.lastname@example.org.