As a director you should be aware that your legal duty might change from protecting the company and shareholders to protecting creditors.
Under normal circumstances a director must act in the best interests of the company. This is defined in the Companies Act 2006 in this way, “Directors have a duty to promote the success of the company and must act in the way that they consider, in good faith, is most likely to promote the success of the company for the benefit of its members as a whole”.
That is pretty much what you would expect – a director does his/her best for the company. It does mean that the director also has to ensure that the company complies with legislation such as employment law, health & safety, tax etc.
The situation changes if a company becomes insolvent. When a company is insolvent, a director has a duty under law to act in the best interests of the creditors (the people/businesses to which money is owed).
Directors can be personally prosecuted if they fail to do this and this may give an opportunity for an unhappy creditor to try to obtain redress from a director personally.
A company is insolvent if its balance sheet, prepared as accurately as possible, is negative. This means that total assets are less than total liabilities.
However, a company may also be considered insolvent if it fails the “cash flow test”. This looks at the ability of company to meet its short term cash requirements. A company can be solvent using the “balance sheet test”, particularly if it has assets which it would be difficult to sell and turn into cash quickly.
Realistically, a company should be able to demonstrate that short term assets exceed short term liabilities and will therefore be able to pay creditors within a reasonable time.
A director doesn’t have to stop a company trading if it is insolvent, using either of the tests, but a director must be able to show that actions taken were in the best interests of the creditors. It may be that negotiations are taking place to sell the business or part of it or to sell an asset. It may be possible to come to an agreement with a creditor or creditors to defer payment if the longer term future looks brighter.
Whatever decisions are taken during a period of insolvency, it is good practice to record the decision and the reason for it – and how it helped protect creditor interests.
This is only one of the regulations which many directors aren’t aware of. We help businesses grow so, hopefully, they are never insolvent. Let us give you help and support in running your company. Our range of business support services, including, accountancy, bookkeeping and tax will give you the best chance of being successful.
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