Trading through the Coronavirus – issues for directors
By Douglas Hawthorn
Updated on 31 March 2020
Coronavirus (COVID-19) has become the key concern for businesses across the full range of industries, in many cases adding further pressure to already-stretched trading situations. This article considers the commercial impact of Coronavirus, the implications of disrupted trade for directors, and steps that businesses can take to protect themselves.
On 28 March, the Government confirmed that the wrongful trading regime for distressed and insolvent companies was to be temporarily relaxed (retrospectively from 1 March). While this will offer some comfort to directors faced with difficult decisions, directors' duties and certain trading offences remain in place and we would recommend that directors continue to trade very cautiously during this period. This article, and our specific article on Coronavirus and changes to the insolvency regime, reflect this position.
Directors' duties during periods of company distress
Under normal circumstances, directors of a company owe their duties to the members of that company as a whole. However, where a company is, or is likely to become, insolvent, those duties realign, and the interests of the company's creditors take priority. Breach of duties to creditors can attract personal liability, disqualification and requirements for the directors to make good improper transfers of assets. These duties will remain in place regardless of the temporary relaxation of the wrongful trading regime and so the ability to say, with reasonable certainty, whether a company is in fact insolvent is, therefore, crucial, particularly as commercial decisions in the interests of creditors may be dramatically different to decisions benefitting members.
Is the company insolvent?
Establishing insolvency is not always a straightforward process. There are two tests: the cashflow test considers whether a company is unable to pay its debts as they fall due, while the balance sheet test looks at whether a company's liabilities outweigh its assets. The cashflow test is not concerned simply with debts which are presently due, but also with debts falling due from time to time in the reasonably near future. Beyond the ‘reasonably near future’, any attempt to apply the cashflow test will become speculative and, at that point, a comparison of present assets with present and future liabilities becomes the only sensible test for insolvency. A company that meets either or both the cashflow and balance sheet criteria will be deemed insolvent, and risks being placed into administration or wound up.
The application of the balance sheet test requires an evaluation of whether a company has sufficient assets to have a reasonable expectation of meeting all of its liabilities, including prospective and contingent liabilities. This assessment has to be made in the light of the available evidence and circumstances of the particular case. This includes an acknowledgement that the more distant the liabilities, the greater the likelihood that intruding uncertainties will cause a company to fail the balance sheet test.
Wrongful trading and voidable transactions
The wrongful trading regime engages where a company has no reasonable prospect of avoiding insolvent administration or liquidation. Although the regime has been temporarily relaxed, the offence of fraudulent trading (incurring liabilities that the directors know will not be settled before the company enters an insolvency process) remains in place, and knowledge of the company's solvency will have a direct bearing on any director's potential liability for that offence.
Certain transactions may also be impugned under the insolvency legislation, including a company entering into transactions preferring one or more of its creditors over others; transactions for no, or insufficient, value; and transactions defrauding creditors. All of these will continue to apply during the wrongful trading suspension window, and require careful analysis on an ongoing basis. Directors' duties must be assessed on a company-by-company, rather than group, basis.
Business planning for Coronavirus disruption
While uncertainty remains over the scale and duration of the Coronavirus outbreak, directors can take steps to prepare, both on the commercial front and in order to insulate themselves from inadvertent breaches of duty. Well-prepared and well-advised boards occupy a far better position in the event of a company's insolvency.
- Consider the availability of Government-backed aid (including the Coronavirus Business Interruption Loan Scheme for SMEs, the Covid Corporate Financing Facility for large companies and the Coronavirus Job Retention Scheme). Our article on managing Coronavirus disruption – practical steps for businesses contains further information on these. The Government-backed loans are just that, and so consideration should be given to repayment, particularly once the interest-free period on any such loan lapses.
- Ensure an intimate understanding of where and how each aspect of the business's supply chain operates, and how disruption to one component may impact others, including any alternative fulfilment channels.
- Review key contracts for, among other things, force majeure clauses.
- Maintain dialogue with suppliers over their contingency planning, to reduce secondary exposure to risk further up the chain.
- Continue to carry out forecasting, insofar as possible, modelling shutdown periods of varying length and hypothetical recovery periods on resumption of trade.
- Where appropriate, seek specialist advice on contingency options. Obtaining advice of this kind should give directors better visibility on the likelihood that they are in wrongful trading territory, and may lessen the chances of liability should the company ultimately enter an insolvency process.
- Seek legal advice, independently from the company's or group's advisors, particularly where a business is at risk of collapse as a result of the ongoing situation.
- Hold regular board meetings, and carefully minute conclusions reached in them, setting out the justifications for trading and other decisions.
- Review the terms of any banking documents to establish whether, or when, financial covenants may be breached, or if other default provisions have or will be engaged; consider whether to open dialogue with creditors.
Michelmores' Banking, Restructuring & Insolvency group has extensive experience advising the boards of distressed corporates, including recent work on Stobart, Flybe, Four Seasons Healthcare, Galapagos, Toys 'R' Us and Mothercare.
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This article is for information purposes only and is not a substitute for legal advice and should not be relied upon as such. Please contact our specialist lawyers to discuss any issues you are facing.