Facing financial difficulty? Here’s what every company director needs to know
When a business begins to struggle, directors often find themselves under immense pressure – firefighting urgent problems while hoping for a recovery. It’s during these moments that key responsibilities shift, often without directors realising. This article explains what happens when a company becomes insolvent, why directors’ duties change, and the four critical mistakes that must be avoided to stay on the right side of the law. It also explores how early advice from a licensed Insolvency Practitioner (IP) can protect directors from personal risk and, in many cases, help turn things around.
When does a company become insolvent?
Under section 123 of the Insolvency Act 1986, a company is insolvent when it cannot pay its debts as they fall due (the cash flow test) or when its liabilities exceed its assets (the balance sheet test). Insolvency might creep in gradually or strike unexpectedly, but the warning signs are usually clear: mounting debts, creditor pressure, missed tax payments, and dwindling cash reserves. Understanding the point at which insolvency occurs is crucial, because it marks a shift in directors’ legal responsibilities. Continue to act as if nothing’s changed, and the consequences can be severe.
What changes when a company becomes insolvent?
Before insolvency, directors must act in the best interests of the company and its shareholders. But once insolvency is reached, their duty switches and they must act in the interests of the company’s creditors. This change is not symbolic. It’s a legal obligation under common law principles and clarified by the Supreme Court in BTI 2014 LLC v Sequana SA [2022] UKSC 25, which confirmed that directors must consider creditor interests when insolvency is probable, not just when it has occurred. Ignoring this duty can leave directors personally exposed, with risks including disqualification, financial penalties, and even criminal charges.
What are the four key sins directors must avoid at Insolvency?
When a company is insolvent, there are four major pitfalls that directors must steer clear of. These are often referred to as the “four key sins” and breaching them can result in harsh consequences.
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Wrongful trading
Defined under section 214 of the Insolvency Act 1986, wrongful trading happens when a director allows the company to continue trading while knowing, or should have known, that there was no realistic prospect of avoiding insolvency. This isn’t about mistakes in hindsight. It’s about judgement at the time. Continuing to rack up liabilities, accept orders, or sign contracts when the business clearly can’t meet existing obligations is a serious issue.
What’s the risk? Directors can be held personally liable for losses incurred from the point they should have acted.
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Fraudulent trading
Covered by section 213 of the Insolvency Act 1986, fraudulent trading is when a director deliberately trades to defraud creditors or for any other fraudulent purpose. It might involve falsifying financial records, hiding assets, or knowingly misleading suppliers and HMRC. Intent is the key difference – fraudulent trading is not an honest mistake or a lapse in judgement. It’s deliberate.
What’s the risk? Directors can face disqualification, criminal prosecution, fines, and even a custodial sentence.
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Preferences
Under section 239 of the Insolvency Act 1986, directors must not give preferential treatment to one creditor over others once the company is insolvent, unless there’s a valid commercial reason. Giving preferential treatment to a friend, family member, or connected party can be challenged and reversed.
What’s the risk? T
Preferential transactions can be unwound, and directors may face personal liability for any resulting losses.
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Transactions at undervalue
Defined in section 239 of the Insolvency Act 1986, this refers to selling company assets below their true value, particularly in the run-up to insolvency. Transferring assets to a related party at a knockdown price, or giving away stock or intellectual property, are common examples. Thus, any transaction involving the disposal of a company’s assets must be at ‘arms length’ and for full value.
What’s the risk? Such deals can be reversed in court. Directors may be held personally liable and face disqualification.
What happens if a director breaks one of these rules?
The consequences of breaching these duties are serious, and can include:
- Director disqualification under the Company Directors Disqualification Act 1986, for up to 15 years
- Personal liability for company debts under the Insolvency Act 1986
- Compensation Orders, if director behaviour caused creditor losses
- Criminal charges, especially in cases of fraud
- Reputational damage, affecting future employment or business prospects
These penalties are not rare. Insolvency practitioners are required to report director conduct to the Insolvency Service, and enforcement action is increasingly common — especially where government support schemes have been misused.
How can an Insolvency Practitioner help directors avoid trouble as Insolvency approaches?
Engaging an Insolvency Practitioner (IP) early can transform outcomes. While some view IPs as the people who are appointed when a company is already insolvent, they’re equally skilled at helping businesses recover. Here’s how Antony Batty & Company can help:
- Assessing viability: Our IPs can quickly establish whether the business can be saved
- Clarifying director duties: We’ll explain exactly what directors must do to stay compliant
- Exploring options: From cost-cutting and debt restructuring to formal rescue procedures. Liquidation is not inevitable.
- Managing communications: Engaging with creditors and HMRC professionally and transparently
- Avoiding missteps: Ensuring asset sales, payments and decisions are legally sound
Above all, we can help directors regain control. And in many cases, avoid insolvency altogether.
Why does timing matter so much?
Delaying action is one of the most common mistakes directors make. It’s natural to hope things will turn around, but in our experience, the earlier directors speak to an Insolvency Practitioner, the wider the range of options available. Rescue becomes possible. Creditors are more cooperative. And directors can protect both the company and themselves.
Final thoughts for directors in difficulty
Financial pressure is daunting. But ignoring it only makes things worse. By recognising when a business is insolvent, understanding how duties change, and avoiding the four key sins, directors can safeguard their future. Better still, engaging with an Insolvency Practitioner early may mean insolvency never has to happen at all.
