Cashflow problems? What not to do to avoid the storm

Director shareholders are often of the belief that they can declare any dividend and make any payments they decide. But directors do not actually have that level of discretion, as they need to reserve funds required to pay company debts as they fall due, and as a Director of your company you must ensure you are acting in the best interests of the Company, and not your own. If you cannot show best interests, then the director will be in breach of their duties, and could face claims for:

•  Restitution of profits
• Restoration of property
• Injunctive relief
• Rescission of a contract
• Damages

These claims can be a means to bring money or other assets back into the company’s estate, which increases the pool of assets from which a distribution can be made to the company’s creditors.

We look at the three typical areas where problems can arise and directors will face personal liability :-

• Preference payments
• Trading whilst insolvent
• Paying out larger dividends than the business can afford

Preference payments

We recently helped clients who found themselves in this difficult situation. Cash was tight and under pressure and they paid some creditors in preference to others. We advised our client that they should ensure there is a clear record of the reasons as to why they paid some creditors ahead of others. Luckily, our client held regular board meetings where payments were discussed, and when the liquidated questioned the rationale for the payments they made, we were able to demonstrate that they were based on commercially justifiable reasons, and that they had been clearly thought through and evaluated. The liquidator decided not to pursue the directors personally for the funds.

When a company is considering picking which creditors to pay, it should do the following :-

•  Properly evaluate the decision to pay creditors, discuss the reasons at a board meeting, and keep detailed minutes of the discussion.
• Record any reasons for making payments to particular creditors.

It is trickier to absolve yourself from liability if you make preferential payments to companies or individuals that you are connected to. The connection triggers a presumption that the company’s decision to pay a connected party before other creditors was influenced by a desire to put the connected creditor in a better position than it would otherwise be in, should the company become insolvent.

Although not a failsafe way of enabling a company to make payments to certain creditors ahead of others, if it can be established that the directors based their decision on commercially justifiable reasons and genuinely held beliefs, then they could relieve themselves of some liability. A commercially justifiable reason could be, for example, making payments to a critical supplier, without whose continuing support the company would fail. Making a payment to your mate’s company, because they promised you a nice dinner on Friday night, won’t cut it.

Trading whilst insolvent

Trading whilst insolvent means that a company continues to trade when it cannot pay its debts. As a director you can be protected from the consequences of a failed company, provided that you acted reasonably, responsibly, and within the law.

If the company is insolvent and continues to trade, the directors can become personally liable for the debts of the company owed to creditors. The reason being, when a company is insolvent, the directors have a duty to act in the best interest of the creditors and not to make the situation worse. This is known as wrongful trading.

It might be tempting to think you can trade your way out of the issues you are facing, however doing so could potentially open yourself up to personal liability.

Paying out larger dividends than the business can afford – i.e. an unlawful dividend

Our client is the sole shareholder and director of his company, typically taking a healthy dividend each year. When establishing the amount that could be distributed as a dividend for the financial year, the Director/Shareholder met with an accountant for an informal discussion. A quick calculation on the back of a napkin considering the company’s book value, assets and liabilities, suggested distributable reserves of £100,000.

Our client therefore approved a £100,000 dividend payment. Later in the year, when there was a cash flow storm and the company was left unable to pay its debts as they fell due, it was placed into liquidation. Subsequently the £100,000 dividend payment made to the Shareholder came under scrutiny. The creditor of the Company is now seeking repayment of these funds in order to enable the Company to pay its debts, claiming that the Company was not in a financial position to make such a payment to its shareholders.

After reviewing the options available to our client, it was established that the position our client found themselves in was not particularly strong one and it was a case of damage limitation and managing risk for our client.

Our client’s case was that the dividend was lawfully declared and was approved by the use of interim accounts to justify the dividend amount, and so he owes no further money to the Company. Under the Companies Act 2006, where interim accounts are used to justify a dividend, those interim accounts must be accounts that enable a reasonable judgement to be made as to profits, losses, assets and liabilities, share capital, and reserves).

Insolvency investigation defences

There are limited defences available to company directors under the Companies Act. The director needs to show that he acted honestly and reasonably and with regard to all circumstances of the case. In our case, there was no defence. So we suggested mediation to cut the best possible deal with the liquidator.

Mediation is an effective tool in settling disputes. Not only is mediation an effective means of keeping costs down (it is far cheaper than a long litigation process), but it also has an extremely high success rate. Around 9 out of 10 commercial disputes which are mediated will settle on the day of mediation, or soon thereafter. In a case such as this, mediation had an excellent chance of succeeding and ultimately avoiding the need for litigation altogether.

At mediation, we secured a deal which settled the claim for a sum that, while substantial, was affordable, and was to be paid in regular instalments over several years. The agreement allowed for “flex” – in good times the client could pay more than the minimum instalments, and thereby gain a protective buffer against any failure to pay future instalments. The agreement also settled any further claims the liquidator might have had, effectively allowing the client to move on with his next business venture.