Bruce Jones considers some of the risks for directors of distressed companies which are surviving against the odds. (This article was originally written for the July/August 2011 edition of M&A magazine).
On 26 January 2010, The Telegraph reported Bank of England Governor, Mervyn King, as saying that the UK economy had shrunk by five percent in 2009, the largest fall in output since 1931.
Fast forward to the present day and things scarcely seem any better. According to a report in The Guardian on 20th June 2011, household finances in Britain are deteriorating at their fastest rate since the depths of the recession in 2009. Yet according to recent statistics produced by the Insolvency Service, the liquidation rate amongst UK companies remains low both compared to the peak in 1993 and to the average over the last 25 years. The figures would seem to be borne out by experience: on the high street for instance, there have been a handful of high profile casualties - Woolworths and more recently Habitat spring to mind in particular - but large scale failures of smaller businesses have not occurred in the way one might have expected in such a difficult trading environment.
Why is this?
Small businesses in particular will not be slow to tell you about the difficulties they have in raising bank finance at the moment. However, for struggling businesses with loan facilities already in place, anecdotally, the banks appear more reluctant than historically to force businesses into administration or liquidation.
For lawyers and other professionals this means that the restructuring work which normally comes to the fore in a recession is rather different this time round. There is still work to be done around administration, and pre-packs in particular remain popular, but one seems to spend much more effort advising directors of companies being fed an unexpected life-line by bank creditors about the nature and scope of their duties.
The difficulty, of course, for directors of companies teetering on the brink is the ever present risk of wrongful trading allegations. Wrongful trading under section 214 of the Insolvency Act 1986 occurs where a company has gone into insolvent liquidation and at some point before the commencement of the winding up, a director of the company knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation.
The fact that a bank is continuing to offer support to a failing company is not sufficient for the directors to conclude without more that the company will necessarily be able to trade its way out of difficulty. The best one can say is that the court would not make an order for wrongful trading against a director of a company that ended up in liquidation if the director, knowing that there was no reasonable prospect that the company would avoid going into insolvent liquidation, nonetheless took every available step that he ought to have taken to minimise the potential loss to the company's creditors (Section 214 (3) of the Insolvency Act 1986). This is to be assessed by the standards of a reasonable diligent person having both the general knowledge, skill and experience that it is reasonable to expect of someone carrying out the functions carried out by the director in question, and the general knowledge, skill and experience which that director actually has. In other words, it is both a subjective and an objective test.
The upshot is that directors need to tread a fine line if they wish to continue to trade in circumstances where the outlook for the company would otherwise seem bleak, notwithstanding the apparent support of its bank. Regular (often daily) board meetings and careful and thoughtful minuting of decisions made are essential.
Trading in such circumstances is a challenge, but distressed businesses seem to be surviving for the time being at least. Don't say it too loudly, but perhaps a social conscience is resting somewhere in the banking system after all.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.