A company’s financial troubles can grow gradually or within a short period of time. In either case, a director must be keenly aware of their duties when making critical and urgent decisions for which they might be civilly and criminally liable.
THE BALANCING ACT
Ordinarily, directors have a duty to act in the company’s best interest and in respect to shareholders, ensure a return on investment. However, directors of a company in financial difficulty must consider the interest of creditors and where a director forms a view that the company is insolvent, the director has a duty to act primarily in the interest of the company’s creditors.
A company is deemed insolvent if its is unable to pay its debts. Under section 384 of the Insolvency Act No.18 of 2015 (the Insolvency Act), a company is unable to pay its debts:
- when a creditor has served a written demand to pay a debt and after twenty-one days the debt is not paid, or the company fails to secure or compound the debt to the satisfaction of the creditor;
- a judgement, decree or order of a court in favour of a creditor is not satisfied by the company; and
- if it is proved to the satisfaction of the court that the company is unable to pay its debts.
A company can therefore be insolvent due its inability to pay its debts as they fall due (cash-flow insolvency) or when its liabilities exceed its assets (balance sheet insolvency).
WALKING THE TIGHT ROPE
Directors have several options for dealing with financial strain before and at the early stages of company insolvency, such as:
- re-negotiating trading and payment terms of existing contracts
- procuring letters of credit or guarantees from a financier.
- redundancy and retrenchment of staff.
- invoice discounting, which involves pledging outstanding invoices for financing. This is a particularly viable option for companies at risk of or experiencing cash-flow insolvency.
- sale and lease back arrangements, which is utilised to improve a company’s liquidity by realising the value of an asset whilst retaining it for use.
- exploring additional financing and refinancing options.
- debt to equity swaps. This involves swapping of debt or a portion thereof, for a stake in a company’s capital, with the aim to keep the company operational.
- divestiture of assets and/or divisions in a company. This can include the sale of physical assets, intangible assets (such as intellectual property e.g. patents), a subsidiary or even a division of a company. The purpose is to raise funds to either keep the business going or to pay creditors, if the company is being liquidated.
Where a company is facing significant financial difficulty, directors can explore additional options such as:
- entering into a company voluntary arrangement, which requires directors to make a repayment proposal to creditors for their approval (with or without modifications). If, the proposal is approved by a majority of the creditors taking into account their debt held, it shall be binding on all creditors of the company.
- placing the company in administration, whereby directors cede control of the company to an administrator. A moratorium is usually obtained from a court, suspending claims for payment by a company’s creditors. The principal aim of administration is the survival of a company and not its liquidation.
- enter into voluntary liquidation. Shareholders can approve a resolution to liquidate the company. The liquidation process can either be a member’s voluntary liquidation, where the company is liquidated as a solvent entity or a creditors voluntary liquidation, where the sale of a company’s assets are distributed amongst its creditors, subject to their priority as secured or unsecured creditors.
Ultimately, the action taken by directors should aim to:
- minimize or prevent the company from accruing additional debt unless deemed necessary and in the company’s best interest;
- prevent the company from breaching its financial covenants under its loan agreements;
- prevent creditors from instituting court proceedings or obtaining liquidation orders; and
- in relation to liquidation, prevent transactions entered into by the company being challenged by the liquidator and set aside by a court.
DIRECTORS WATCH YOUR STEP
If there is a reasonable prospect that a company shall be unable to avoid insolvency, the first steps of a director should be to:
- express their view to the board. It is especially important for directors that run the day to day affairs to notify the rest of the board members.
- immediately obtain legal and financial advice to assess the financial state and the legal options available. If necessary, the board (or a director as an individual) can procure external advisory services, to minimize the risk of bias or prejudice tainting the advice given.
Directors can be held culpable for their actions (or inaction) under the Insolvency Act on the ground of:
- wrongful trading. This arises when directors allow the company to trade when there is no reasonable prospect that it shall pay the amount charged.
- fraud and false representations. This encompasses the fraudulent concealment, removal, transfer or pledge of company property, the falsifying, concealment, destroying, making false entries or making an omission in any document affecting or relating to a company’s affairs or property. During liquidation, it includes failure to deliver or provide property and documents requested by the liquidator, failure to inform a liquidator of a false debt that has been proven, amongst others.
- fraudulent trading. The offence is committed when the business incurs additional liabilities and it is proven in court that the intent was to defraud creditors or was for other fraudulent purposes.
- a transaction undervalue. If an asset is transferred for a sum considerably lower than its’s market value or for no consideration, a liquidator can investigate and file an application for the court to set aside the transaction.
- a preference. A preference arises when a creditor to the company receives favouritism on payment to or transfer of an asset to, a creditor. It also includes, the granting of security to a previously unsecured creditor. If proven, the court can order for the transaction to be set aside, the asset to vest in the company, and release or discharge of the security granted.
In addition to the above, directors can also be held personally liable for the debts of a company under personal guarantees, which are granted as part of general banking practice by directors of private limited companies as part of security for a company’s borrowing.
THE NOOSE: OFFENCES AND PENALTIES
Directors found guilty of insolvency related offences face fines of up-to KShs. 5 million, imprisonment for up-to 5 years, or both a fine and imprisonment. Furthermore, a court can issue:
- an order to repay, restore or account for money or property, with interest at a rate the court considers appropriate;
- an order to contribute such amounts to the company’s assets as compensation for breach of fiduciary duties and misfeasance, as the court considers fair and reasonable; and/or
- disqualification orders barring a person from being a director of a company for a period of up-to 15 years.
Directors of family owned and closely held companies are at a greater risk of being held civil and criminally liable for their decisions, in comparison to directors of public listed companies. Public listed companies are required to, publish their financial statements, furnish statements and valuations by auditors and experts. On the other hand, family owned or closely held companies, have no such requirement. In most instances, liability shall attach due to:
- failure to comply with governance requirements, as directors may not retain a record of meetings detailing the discussions held, approvals and authority granted;
- bona-fide transactions between members being scrutinized by liquidators to assess whether there has been a breach of duty, fraud or collusion to defraud creditors; and
- reluctance to obtain professional legal and financial advice when making decisions.
It is imperative for directors in businesses facing financial difficulty to take financial and legal advice at the earliest stage to minimize criminal and civil liability. Such action shall also provide a company with a variety of options that consider its financial state, the size of its business, the interest of shareholders and the extent to which the company can leverage its relationship with its creditors.