Corporate governance in a cash flow crisis
The lock down has caused havoc for many companies as they have been forced to quickly adapt to different ways of working and often significantly reduced or no cash flow for a period.
The board of directors has ultimate responsibility for the management of the company and each director has duties under the Companies Act 1993 (Act) and common law. This article considers the duties of directors in the context of a cash flow crisis.
Summary of directors’ duties
The duties of directors set out in the Act include:
good faith: a duty to act in good faith and in the best interests of the company;
proper purpose: a duty to exercise a power for a proper purpose;
compliance: a duty to comply with the Act and the company’s constitution;
reckless trading: a duty to not agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors;
obligations: a duty to not agree to the company incurring an obligation unless the director believes that the company will be able to perform the obligation; and
duty of care: a duty to exercise the care, diligence and skill that a reasonable director would exercise.
The above is not an exhaustive list of the duties of directors. For example, a director has duties under the Health and Safety at Work Act 2015, which are also relevant in the context of COVID-19. In addition, the Act provides other duties in respect of certain disclosure requirements, restrictions on the use of company information, and other administrative obligations.
The duty of good faith
Section 131 of the Act states:
“…a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company.”
This duty is subjective in nature and requires directors to act honestly and with a proper motive. Generally, it is presumed that the actions of directors have been made in good faith, unless those actions are ones that no director with an understanding of fiduciary duties would make.
The actions of directors will still be assessed against how people of business might be expected to act. Even if a director has an honest (but mistaken) belief that their actions are in the best interests of the company (and so may have a defence to a claim that they were in breach of the duty of good faith), such actions might be a breach of one of the director’s other duties to exercise the care, diligence and skill that a reasonable director would exercise.
Reckless trading
Section 135 of the Act provides that a director must not agree, cause or allow the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.
While this provision appears to be broad and onerous for directors, the Courts have held that the provision is concerned with substantial risk, rather than simply mere risk. Risk taking naturally accompanies the carrying on of any business. The preamble to the Act recognises this by stating that the purpose of the Act is: “to reaffirm the value of the company as a means of achieving economic and social benefits through the taking of business risks”. Accordingly, when applying this provision, the Courts have drawn a distinction between “legitimate business risks” and “illegitimate business risks”. However, unlike the duty of good faith, this duty is objective. Subjective belief by a director that they are not trading recklessly is irrelevant.
While not an exhaustive list, several questions to be considered by directors at this time include:
Are directors fully aware of the current financial position of the company and the company’s likely prospects? Have proper and thorough enquiries been made?
Is the company insolvent or close to insolvent? If so, in what sense is the company insolvent or close to insolvent (i.e. do liabilities exceed assets and/or is there an inability to pay debts as they arise)? Is the insolvency minor or substantial?
What are the proposed actions? Do they include continuing to trade while insolvent, and if so, when will the company likely become solvent again?
Will the proposed actions lead to a major risk of the company failing? If so, will there be a major deficiency on liquidation?
How is the company capitalised? Is there sufficient financial support from shareholders? Is the support legally binding or not?
Has legal and accounting advice been sought?
Obligations
Section 136 of the Act states:
“A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.”
This duty has some overlap with ‘reckless trading’ and actions against directors will often argue breaches of both duties (among other breaches).
However, this section is not focussed on risk taking and the general conduct of directors when carrying on the business. Instead, it focusses on whether a director reasonably believes that the company will be able to perform specific obligations in relation to particular transactions and arrangements. Although, if insolvency is an issue, then this provision might apply more broadly to all transactions and arrangements.
If an action is brought against a director, the Courts will scrutinise both the director’s subjective beliefs and the reasonable objective grounds for holding such beliefs.
Directors can rely on certain information and advice
Section 138 provides that a director, when exercising powers and performing duties, may rely on reports, statements, financial data, certain information and professional/expert advice (together, advice), provided that certain requirements are met. This includes advice that is prepared and given by:
an employee of the company whom the director believes on reasonable grounds to be reliable and competent in relation to the matters concerned;
a professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person’s professional or expert competence; and/or
any other director or committee of directors upon which the particular director did not serve, provided that it is in relation to matters within the other director’s or the committee’s designated authority.
The director must also act in good faith, make proper inquiry where the need for inquiry is indicated by the circumstances, and have no knowledge that such reliance is unwarranted.
While not an exhaustive list, we provide several suggestions of actions that should be considered:
These are particularly difficult times for many businesses and directors are facing issues which they have not experienced before. Navigating these issues will be outside the skillset and knowledge of many directors. Be humble and recognise your limitations and the need for advice from others.
While the section allows directors to rely on employees, directors and committees of directors, this may not be an option if there is insufficient competence within the business. In addition, it may not be possible to establish reasonable grounds of reliance as those employees or directors who are being relied will be acting within difficult circumstances themselves, which may cloud their judgement (e.g. prospects of redundancy or loss of income, conflicts of interest, a tendency for directors to simply delegate (which does not absolve responsibility), and so on.
Given the above, expert advice from independent professional advisors (i.e. lawyers, accountants, valuers, etc) may be the only advice that can be relied on. Such advice should be specific and tailored to the individual circumstances of the business (rather than general advice). When instructing advisors, directors should be honest when providing information and must not base such information on assumption which the director cannot rely on.
Once advice is received, critically assess, question and test that advice and continue to do so. Directors cannot indiscriminately rely on advice, even when provided by experts.
Reliance on advice for the purposes of attempting to limit one’s liability will unlikely be made in good faith. Consider your motives in obtaining advice.
Exercise due diligence. Review your corporate and business systems and your director’s duties, follow up and monitor management to make sure that advice has been put in place, obtain further advice or second opinions where required.
Create a thorough paper trail. Retain instructions to advisors and the advice received. Document the reasoning behind why the particular advice was sought, why the particular advisor was appointed (e.g. their qualifications and credentials, enquires that were made to establish competence, etc), how you critically assessed the advice received, how you implemented the advice and continued to monitor, and so on.
Remedies for breaches of directors’ duties upon liquidation
There are wide remedies available against current and former directors of companies upon liquidation. Broadly speaking, if it appears to a Court that a current or former director has been involved in misconduct in respect of the company’s money or property, or has been negligent, or breached a duty in relation to the company, then the Court has wide powers. This includes making inquiries, repayment of money or property (with interest), or ordering directors to contribute to the company by way of compensation (which in some limited instances have exceeded the total losses of creditors plus liquidation and court proceeding costs).
The Act provides other remedies to various parties, including prior to liquidation. In addition, a breach of directors’ duties may be an offence and significant penalties may apply.
Specific changes in relation to COVID-19
The current situation will present obstacles and directors may be unable to fulfil all their obligations and duties. The Government has recognised this and has rolled out (and continues to roll out) a package of schemes to assist businesses. At the time of publication, some schemes are in place (but have been revised) and others are yet to be implemented. Some of the changes still require legislation to be drafted and passed into law. Some of the changes will apply retrospectively. Accordingly, the summary below is only interim and directors should continue to monitor these developments.
By way of summary, some of the changes include:
Safe harbours in respect of insolvency related duties: Proposed changes will create safe harbours for directors in insolvency circumstances. This is intended to provide a platform for businesses to continue to trade through and out of the COVID-19 crisis rather than prematurely winding up as a result of it. The changes will allow directors to decide to continue to trade over a six-month period without breaching their duties (in respect of reckless trading and obligations (discussed above)), provided that certain requirements are met. This includes: that the company was able to pay its debts as they fell due on 31 December 2019, and that the directors hold, in good faith, the opinion that the company faces or is likely to face significant liquidity problems over the next six months as a result of the COVID-19 crisis but that it is more likely than not that the company will be able to pay its debts as they fall due within 18 months. Other duties, remedies and offences will remain in place.
Business Debt Hibernation Scheme: Under the proposed scheme, debtor companies (and other entities) will be able to make a proposal to its creditors, provided certain (currently unknown) thresholds are met. Creditors will then have a one-month moratorium period to vote on the proposal and creditors will be unable to enforce debts during that time. If 50% of creditors (by number and value of debts) vote in favour of the debtor’s proposal, then it will apply (subject to any conditions imposed) and the debtor will have a further six-month moratorium where debtors cannot enforce debts against the debtor. The Act currently provides similar options, although it is presumed that this will be more ‘debtor friendly’.
Compliance with the Act and the company’s constitution: There will be temporary relief for companies (and other entities) who are unable to comply with certain obligations under the Act and the company’s constitution (if any). For example, allowing the use of electronic meetings (even where the constitution does not allow for it). In addition, powers will be given to the Registrar of Companies to extend deadlines under the Act (e.g. dates for AGMs, filing annual returns, etc) and in relation to carrying out functions (e.g. processing times).
Business Finance Guarantee Scheme: This scheme will provide short-term credit of up to $500,000 to small to medium sized businesses with turnover between $250,000 and $80,000,000 at the end of the 2019 financial year, provided that certain criteria are met. Broadly speaking, this includes that the business meets standard lending criteria of the lender, have exhausted other lending facilities (with the exception of certain types, such as, credit card debt, and trade finance loans), the business have urgent liquidity or bridging financial needs, the lending is not used to refinance debt (unless agreed by the lender), and is not related to certain excluded activities (e.g. property development and investment, processing whale meat, supplying recreational cannabis, weapons, tobacco, forms of agriculture, among others). In addition, there are several excluded purposes, including capital assets and projects (with some exceptions), financing dividends or on-lending outside the businesses’ guaranteeing group, among others. Under the scheme, the Government will guarantee up to 80% of the loan shortfall, however, the lender will first need to pursue 100% of the shortfall from the borrower (and/or guarantors) and realise any security given in relation to the borrowing.
Voidable transactions: There are proposals to change the claw-back period from two years to six months for non related-party transactions.
Again, some of the changes above are still to be drafted and passed into law. Accordingly, directors should continue to act within their existing duties and obligations until it is clear what the exact details of the changes will be. In addition, regardless of these changes and any relaxation of director duties, directors will still need to act in good faith and in the best interests of the company and exercise reasonable care, diligence and skill.
Even though the schemes above may be available, directors will need to consider whether these will assist the business to trade through the crisis or simply delay (and increase) the inevitable failure.
Recommended steps
The impact of COVID-19 has been significant and is rapidly changing. This may force directors into situations where they need to make decisions quickly. However, now is the time for directors to make a “sober assessment” of their company’s potential future income and prospects. Make sure that cash forecasting is undertaken to properly understand the prospects. Risks are high and such assessments should be thorough and repeated. Take enough time to fully and cautiously consider all options available to them (including having regard to their duties) and to take legal, tax, accounting or other advice where required. Decisions and the reasoning behind decisions should be thoroughly documented. Also, discuss the situation with stakeholders, including employees and banks.
Now is also the time to check your insurance policies (i.e. business interruption, credit insurance, D&O cover or other relevant policies). Notify your insurer as soon as possible (even if you are unaware of the loss) and follow their steps so as not to unintentionally void cover.
The decisions of many directors during the COVID-19 crisis will come to be scrutinised in the near future.
Get in contact
If you would like advice about your duties as a director, or you would like our assistance with another legal matter you are facing, please contact your usual point of contact at Kemps Weir or contact us here.
Disclaimer: This publication should not be construed or acted on as legal advice. It is brief and general in nature. Specific advice should be sought.