10 Steps That Directors Can Take To Avoid Prosecution

Written by Ben Douglas-Jones QC, Edward Jenkins QC & Anthony Galvin

All Directors of any limited company have  statutory fiduciary duties to act in good faith. These include duties to the members (any shareholders), as well as duties to any creditors. It is important to remember than even when a company has one director, who is also the only shareholder, the ‘hat’ a director wears is different to the ‘hat’ a shareholder wears.  The responsible question that every Director should always be asking themselves whenever a company is going through difficult times, let alone now is:

“Can we pay our debts at least within a reasonable time after they fall due?”

This answer is crucial as it defines whether the company is a going concern (still fit to trade) or if it is in significant financial difficulties and cannot pay its debts.

It doesn’t matter how big or small the company is. Richard Branson has the same duty to answer this question truthfully as the director of a small pub.

If the answer to this question is no, then the company should cease trading unless it has reasonable means to believe it has access to alternative sources of finance. The access to finance in relation to COVID-19 Government backed finance schemes is a point that will be addressed later on.  If the directors allow the company to continue to trade, knowing it cannot access finance or pay its debts, then the directors run the risk of being locked up for a maximum of 10 years. If that were to happen, you would never complain about lockdown again.

A newish phrase for testing a business’s viability that is being used by the Government is an “undertaking in difficulty”.  This phrase has been used in the recent COVID-19 Bounce Back Loan scheme for small to medium sized businesses. It is used in EU law relating to state aid. For claimant companies established for more than 3 years, sustained losses exceeding share capital, entering into insolvency proceedings or previous receipt of rescue funds would qualify the SME as an “undertaking in difficulty”.  If your business qualified as an “undertaking in difficulty” at the end of 2019, the harsh reality of the current economic environment is that it is unlikely that the Government COVID-19 support packages will be available to your business.

If you are a director who continues to trade even though you have answered ‘No’ to the being able to pay debts, the principal offence you could be committing is Fraudulent Trading.

S.993(1) Companies Act 2006 provides: “If any business of a company is carried on with intent to defraud the creditors of the company or creditors of any other person, or for any fraudulent purpose, every person who is knowingly a party to carrying on the business in that matter commits an offence.”

It is important to be aware that this applies to not only directors but to anyone who has a controlling or managing function, and who takes some positive steps in carrying on the business. Senior managers could be held responsible and arguing that you were not an ‘officer’ of the company or you were not aware of your involvement is unlikely to amount to a good defence in law. Equally, accountants or bookkeepers who assist or facilitate a business to continue to trade fraudulently may face investigation about their participation in the activity or at least questions about their professional conduct from the regulator.

The reference to a business having being carried on dishonestly with intent to defraud its creditors or for any fraudulent purpose, is not accidental.  The extension beyond creditors to ‘any fraudulent purpose’ is purposefully included to catch any fraud on customers or counterparties who are not technically creditors of the company.

Frequently asked questions about directors’ payments usually revolve around directors’ loans and directors’ dividends.  At a very high level, any directors who seek to pay themselves significant funds via a director’s loan account knowing the company is in financial difficulties should be aware that these funds are a ‘loan’ and can be reclaimed from them personally as part of insolvency proceedings.  If directors pay themselves a dividend knowing the company is insolvent, there is likely to be an investigation as to why the directors made this decision and again, the liquidator will seek to reclaim these funds. Such actions will also amount to criminal offences under the Insolvency Act 1986.  Whilst the payment of a loan or dividend may seem like a good idea, please do believe us when we say, you are not the first to think of these routes and these are amongst the standard checks that any insolvency practitioner will check.

All Directors should be aware that they will be guilty of fraudulent trading if it is proved that they:

a] never intended that the company should pay its debts or

b] that when the company incurred the debts, they knew they had no good reason for believing that the company would have the money to pay the debts when they became due or shortly thereafter.

So how much can a Director rely upon UK Government COVID-19 related funding?

The provision of loans, furlough pay and deferral of HMRC liabilities are matters which a company can take into account when deciding whether it can pay its debts.

With some fanfare the Government has said it will suspend the wrongful trading provisions in S.214 and S.246ZB of the Insolvency Act with retrospective effect from 1.3.20 for 3 months. However, no legislation has been introduced so far.

It seems what the Government intended was in essence that those provisions enabled a court, on the application of the liquidator or the administrator, not to make a director of a company which has gone into insolvent liquidation or administration, personally liable if he knew or ought to have known that there was no reasonable prospect of the company avoiding going into liquidation or administration.

This has been welcomed by businesses, but will it make any real difference when tested in the courts?

In reality, there remains an abundance of laws to catch the unwary, even if the suspension is brought in and lasts beyond May. In addition, the Enterprise Act which criminalised cartels, does not appear to have been suspended. It should be noted that anyone who is contemplating cooperating with competitors on distribution, etc to reduce costs,  would be well advised to take advice and consult with the Competition and Markets Authority.

Directors of limited companies should be aware that there are still a myriad of remaining laws that have not been suspended.  The recent announcements should be treated with care and directors must be aware that their fiduciary duties still remain. COVID-19 is not a ‘free pass’ to act irresponsibly.  It is likely that in the following months and years as the economic fallout from COVID-19 is dissected, there will be new cases and legal precedents set, but directors should note that the following provisions have not been suspended.

Civil Liability – Fines and penalties will be issued.

  • 213/246ZA Insolvency Act: relating to fraudulent trading.
  • 423 Insolvency Act relating to transactions at an undervalue. This means a company asset has been transferred to a new owner for less than the market value. This amounts to a breach of the director’s fiduciary duties, as the sale of the asset was not performed in the best interests of the company or its creditors.
  • 172(3) Companies Act relating to the fiduciary duty of directors remains in place.

Criminal Liability – Directors could go to prison.

  • 993 Companies Act 2006: fraudulent trading
  • 9 Fraud Act: individual trader and partnership liability for fraudulent trading.

10 Steps That Directors Should Now Be Taking

  1. To protect yourself as a director, you should document all decisions to show you were acting reasonably in the light of the circumstances.
  2. Contemporaneous board minutes should be taken and it would be reasonable to expect a number of additional extraordinary board meetings may be needed to agree key decisions.
  3. Review the documents your company will retain. Most companies will only retain key documents for 6 years.  If you are ‘relying’ on some documents e.g. the notes of a call you had with a lender, these are likely to be outside your normal retention policy but these will need to be retained, as directors could be investigated any time within 6 years by HMRC.
  4. Be aware of how not getting advice from a professional advisor could look to HMRC or the Police in 3 or 4 years’ time. Many accountancy firms and bookkeeping services are already under pressure due to the sudden economic changes. Many are doing a phenomenal job to support their clients but those that are less technologically advanced or adaptable may not have been able to support clients with key information that has been required. A gap in records from this crucial time, may look suspicious to an HMRC or Police officer inspecting these in 4 years’ time, especially if your decisions are being questioned.
  5. It is likely this increased period of activity will continue as constantly updated management accounts will be crucial supporting evidence of honest director decisions. Such accounts can be prepared on the going concern basis and not through the fire sale valuations sometimes used by over-zealous prosecutors. It will also be critical to document all additional actual and potential sources of finance and capital injections. Minutes of telephone notes with lenders (if you can get through to a person) will also be of significant value.
  6. Directors must consider whether but for the Pandemic the company would have been able to continue to trade on the basis of the usual going concern test. If the Company was going under in any event, then it must stop trading and not try and hide behind the pandemic as the government has made plain. The government has cited 1st Feb 2020 and 31st Dec 2019 as dates that other decisions will be based on and it would be advisable for directors to be cognisant of these dates.
  7. Ensure all steps are taken to reduce costs of business and avoid paying bonuses and dividends. Directors and senior managers have ended up in difficulty where standard operating procedures have been followed and not questioned during difficult times. When reviewed by  Prosecutors in 4 years’ time, the image the officer forms during their investigation is important. As an example, in the 2008 financial crisis, several US executives were taken to task for flying on private jets to US Government hearings where they were seeking government bailout funds.  It was done because that was how they had always operated.  It hadn’t occurred to them or their PAs, etc, that maybe they should have flown via a commercial airline to present the correct ‘image’.
  8. Ensure creditors where possible are kept fully informed. It goes without saying that keeping your suppliers involved in discussions, is advisable.  The courts may be struggling to deal with a number of matters, but creditors can still issue statutory demands and winding up petitions. Debt enforcement is tricky at this time as bailiffs are having to observe COVID-19 social distancing and many of the standard practices to enforce a debt, are currently not possible.  Additionally, taking legal action related to debts that are due as a result of the current restrictions, is an extra unwelcome expense for many businesses, and many suppliers are entering into additional time to pay agreements.
  9. Take advice generally and, in particular, as to the actual meaning of government announcements. None of them amounts to a licence for an unviable company to trade. This has been made very clear.
  10. Even if the Company is viable in the short term that will be no defence to not making necessary adjustments for the future, as BA has done by announcing 12,000 redundancies. The indications are that social distances and Covid19 will be with us for many months to come. The next 18 months will be a very different trading environment and business will need to take rapid steps to adjust.

Currently the government is providing substantial funds to help corporates and individuals and the UK is fortunate that it can do so. Many other nations have not been able to provide similar support or do not have the infrastructure to issue such support.  It is inevitable that the grass will always be greener and there are some schemes in other countries that have been highlighted as being successful but there have also been others than have had their own problems. It would be unreasonable to expect unlimited financial support but it is certainly not a parched desert, which is the landscape businesses are facing in some other nations.

Directors of entities that are in financial difficulty would be well  advised to take formal advice at an early stage. With the level of support funding that is being provided by the government,  there will be a number of investigations as to  whether these funds were legitimately being used, to reduce the financial impact on the tax payer. HMRC have already said that complaints of illegal use of Government funds have been received and are subject to investigation.

Whilst the wrongful trading provisions contained in S.214 have been suspended, this is of comparatively little importance and is more akin to saying that you will not be prosecuted for having no driving licence but you can still be prosecuted for dangerous driving!

Lastly, do not forget when reopening, directors must have in place a “pandemic” safe system of work or they will commit a multiple offences under the Health and Safety Work Act or even manslaughter were an employee to die.