Understanding Creditor Duties for Directors

Many directors fail to realise the innate duties and obligations that exist to creditors, especially when the company is insolvent or nearing insolvency.

This is part of what is called ‘fiduciary duty’, and is often a subject that comes under scrutiny during the directorial investigations undertaken by insolvency practitioners as part of their remit.

Here are the essential duties to creditors, that directs should be aware of:

  • Duty to Act in the Best Interests of Creditors: Under Section 172 of the Companies Act 2006, directors are generally required to act in the best interests of the company’s shareholders. However, when a company becomes insolvent or is on the verge of insolvency, the duty shifts towards protecting the interests of creditors. This shift is essential to ensure that creditors can recover as much as possible from the remaining assets.
  • Duty to Avoid Further Debt: According to the Insolvency Act 1986, particularly under sections 213 and 214 concerning wrongful trading, directors must refrain from incurring further debt when there is no reasonable prospect of the company paying its existing debts. Engaging in further borrowing under these circumstances can lead to personal liability for directors.
  • Duty to Consider Liquidation: If the company is irretrievably insolvent, directors are expected to consider initiating an orderly liquidation process. This action is guided by the principle of maximising returns to creditors, as opposed to continuing operations that may increase losses and reduce the amount that can be distributed to creditors.
  • Duty Not to Prefer Certain Creditors: Directors must treat all unsecured creditors equally and avoid favouring one over another. This duty is stipulated under the rules against preferential payments in the Insolvency Act 1986, which ensures equitable treatment of all creditors and prevents the dissipation of assets to the detriment of the collective creditor pool.
  • Duty to Preserve Assets: Directors have a duty to preserve the company’s assets. Actions contrary to this can be challenged under the provisions related to transactions at an undervalue or fraudulent trading within the Insolvency Act 1986. Directors must manage company assets responsibly to prevent further losses.
  • Duty Regarding Dispositions: Antecedent transactions, transfers, or dispositions of company assets by directors when the company is insolvent may be reversed or “clawed back”. These are scrutinised under the provisions dealing with transactions at an undervalue or fraudulent preferences within the Insolvency Act 1986.

The overarching principle is that when insolvency looms, directors must prioritise creditor interests over those of shareholders to ensure creditors receive the maximum repayment possible from the remaining company assets. Breaching these duties can lead to personal liability for directors, with serious legal and financial repercussions.

Legal Implications of Creditor Duty

Case Study Analysis: Hunt v Singh [2023] EWHC 1784 (Ch)

In the landmark case of Hunt v Singh [2023] EWHC 1784 (Ch), the English High Court scrutinised the conduct of directors at Marylebone Warwick Balfour Management Limited as the company faced insolvency. The primary issue was whether the directors had breached their duty to consider the interests of creditors during a period of financial struggle.

While the initial ruling in 2022 found in favour of the directors, the 2023 appeal judgment reversed this decision, specifically noting breaches of duty from September 2005 onwards.

The court clarified that the director’s duty to protect creditors’ interests is triggered when the company is facing probable, not just potential, insolvency.

This case has become a notable reference in understanding directors’ duties in insolvency contexts. It provides clear guidelines on when the duty to creditors arises and the expectations for directors’ conduct under such circumstances. The ruling serves as a critical warning to directors to adjust their management strategies and focus on creditor interests as insolvency becomes probable.

Practical Guidance for Directors:

Directors must adopt a cautious approach when their company reaches the trigger point for creditor duty.

Actions should include:

  • Conducting a thorough review of the company’s financial status to assess solvency risks.
  • Consulting with financial and legal advisers to understand the full scope of their duties.
  • Ceasing any activities that could further jeopardise creditor returns, such as disposing of assets below market value.

Strategies for Minimising Personal Liability

To minimise the risk of personal liability, directors should:

  • Ensure all decisions are well-documented and clearly justified in terms of creditor interests.
  • Maintain transparent communication with creditors about the company’s status and potential recovery plans.
  • Implement robust internal controls and oversight mechanisms to prevent fraudulent trading or wrongful actions.