Wake-up call: Avoid mistakes in the face of future liquidation

As the economy squeezes hospitality, directors should ensure they’re protecting themselves and their businesses, says Edward Ellis

The problem

Hospitality continues to face challenging times. Soaring energy prices and the squeeze on consumer’s discretionary spend have compounded the problems the sector was facing coming out of the Covid-19 pandemic.

Directors should be aware of the steps that they could potentially take to preserve the value of their businesses when facing financial distress. They should also be aware of the common mistakes that many directors make that could lead to their actions being challenged by a subsequently appointed liquidator.

The law

Generally, the directors of a solvent company owe their main duties to the company and to the shareholders of that company. The seven general duties of a director are set out in the Companies Act 1986 and include the duty to promote the success of the company for the benefit of its members and to exercise reasonable care, skill and diligence.

When a company is or may be about to become insolvent, their duties change significantly. Now the director’s duty is to protect the interest of the company’s creditors – this duty to creditors overrides all other duties.

It is not always obvious to directors that a company is insolvent and recent case law suggests that directors should follow the general rule of thumb that the greater the risk of insolvency, the more weight should be given to the interests of creditors.

If directors act in any way that contravenes their duties, then a liquidator has certain powers to pursue them. These principles are set out in the Insolvency Act 1986 (IA86). Insolvency practitioners are obliged to investigate the conduct of an insolvent company’s directors to ensure that they have not breached their fiduciary duty.

Actions that a directors may be liable for include misfeasance, wrongful trading, transactions at an undervalue and making preference payments.

Expert advice

What should directors be doing?

• Hold frequent board meetings. With strong economic headwinds, directors should be proactive and meeting regularly to consider the opportunities and threats that exist.
• Keep contemporaneous board minutes explaining why decisions are made. In times of financial distress directors are often engaged in multiple discussions with different stakeholders, including creditors exerting pressure. Where insolvency is likely, a company should treat all creditors equally. If one creditor’s interests are prioritised over another, directors could be personally liable for the payments made to the preferred creditor. If payment to a creditor is made, directors should keep a record of why it was deemed appropriate to make that payment. Typically, the rationale would be that making the payment preserves the value of the business and is therefore beneficial to all creditors.
• Perform regular, in-depth forecasting. Detailed forecasting helps inform decision-making and your position will be much stronger if you regularly update your forecasting to show the knock-on effect of any financial decisions made.
• Avoid making risky decisions. Directors can be tempted to ‘roll the dice’ in times of financial distress with the hope of recouping losses. This is a breach of directors’ duties and could result in their conduct being challenged.
• Keep your stakeholders updated. Keeping your creditors in the dark in the hope of a financial turnaround is never a good idea. It’s much better to have an open and honest line of communication with all your stakeholders, even if the news isn’t good. It will openly demonstrate that you are working towards their best interests and will restore faith.

Beware

Finally, and most importantly, where directors are concerned that their company is in the zone of insolvency, they should seek specialist advice. Licensed insolvency practitioners are well-versed in advising companies and their directors in times of financial distress. Typically, the earlier a practitioner is engaged the more likely the company is to survive. They can also assist directors in ensuring they are not breaching their duties and can provide clarity and reassurance in situations where directors are often overwhelmed.

Edward Ellis is a director in the restructuring team at the accountants Mercer & Hole www.mercerhole.co.uk

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