Breach of Duty in Corporate Form

The corporate form as a trading vehicle is the preferred business model for entrepreneurs as it provides a corporate veil over the element of risk and exposure that trading as a sole trader or partnership can attract. It can provide appropriate tax advantages as well as the all encompassing principle of limited liability.

A director is a person who occupies the position of a director in the company. [1] The general duties of directors are owed by a director of a company to that company. [2] The director is deemed as an agent to the principle (company) in the context of a fiduciary obligation. Concern has been to control the directors from misuse of their position and power. The policy objective is based on addressing the prophylaxis that can be given birth to from the directors’ misconduct. [3] There are a number of responsibilities and standards that have to be adhered to by the company directors, instilled by statute, society and by common law principles.

The directors of Cheesy Chips Limited have obligations and duties that they must always consider and comply with. The Companies Act 2006 imposes higher standards on company directors; some are realistically achievable, whilst others remain to be subject to test. [4] Sections 171 to 177 of the 2006 Act provides that directors must; (1) promote the success of the company; (2) exercise independent judgment and skill; and (3) exercise care and skill in the decision making process. The duties are not considered separately rather conjunctively. [5]

i) Cross Guarantees

The facts state that Adam has a relatively short fuse, acts without consulting other directors, and is hostile of any criticism. Such conduct can lead to a relatively apprehensive atmosphere in any boardroom. In relation to the two companies that have the benefit of cross guarantees; Adam appears to have withheld this information from his fellow directors. He is under an obligation to ensure that no secret profits are derived from activities undertaken for the connected companies. [6] By breaching his obligations, he has placed himself in a situation where a conflict of interest arises and he should not be acting without declaring it. [7] Unless permitted, he should withdraw from any board meetings where matters of a personal interest are to be discussed. [8] The cross-guarantees have been entered into without the consent of the entire board and Adam has potentially applied pressure on a relative or connected individual to agree to the guarantee being executed.

Owen should not have approved the guarantee and was effectively acting without appropriate care and skill. [9] Furthermore, Owen is under a duty to make appropriate enquiries as to whether the guarantee has been made aware to and approved by the board. [10] Directors signing the cross-guarantees have to show that it was in the best interest of the company. [11] Unfortunately, it would be difficult for both Adam and Owen to demonstrate this.

The guarantees will be binding on the Company as the bank or other creditors would have been dealing with the company in good faith. There would be no presumption that those dealing with Adam and Owen would have to make enquiry as to whether the entire board were aware of the matter in hand. [12] The Company could pursue Adam and Owen for any losses or liabilities that the Company incurs as a result of this breach of duty. [13] Their fellow directors would not be responsible for the obligations that arise as a result of this breach of duty. Nevertheless, there is an argument that the directors have not exercised sufficient diligence to supervise the actions of all directors which has resulted in an obligation arising on the company. Also the issue of cross-guarantees are deemed to be the collective responsibility of the board. [14] As such, there is a likelihood that in any disqualification proceedings brought; all directors could have sanctions imposed on them as a result of this breach. [15]

ii) The Accounts

All directors, no matter what role they play in the organisation, have an ongoing obligation to consider the financial position of the corporation. [16] The directors that prepare the financial statements, in particular those with specific skills, are under an obligation to ensure that the use of those skill sets in relation to the company are the same standard that they would use if acting in their professional and independent capacity. [17]

The provisions of section 174(1) of the 2006 Act impose a higher standard of care and skill on directors. In exercising their function; a director is expected to have: “(1) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company [18] ; and (2) the general knowledge, skill and experience that the director has.” [19]

In the circumstances, Peter has considered and prepared the accounts in his capacity as a director whilst being a qualified chartered accountant. Peter would be expected to have the knowledge as an accountant in executing his functions within the Company. He is expected to tenaciously identify any material errors and irregularities in relation to the accounts that he has prepared. Such a position would be obvious had he diligently exercised his skill. Had Peter not been aware of the financial position of the Company or that the profits had been dramatically overstated, he is under an obligation to make appropriate enquiry accordingly. [20]

Peter failed to exercise his duty and has negated his general duty to act with care and skill alongside failing his common law obligation to act diligently. Accounts of a corporation are considered to be relatively important to the company’s trading prospects; Peter as well as the other directors owes a duty to the creditors, to ensure that the accounts are accurate, correct, and free from all material errors and omissions. [21] Hence, it is likely that Peter could face sanctions and may be barred from acting as a director as a consequence of his failure to act in a diligent and skilful manner. [22] Peter’s fellow directors may not face liability in this regard but the level of the sanction that may be imposed would vary depending on the involvement with the company’s financial statements.

iii) The Dividend

Company directors are trustees of company property or anything that comes into their possession that would ordinarily belong to the corporation. [23] Adam has declared a dividend based on incorrect accounts, which have then been agreed at board level and shareholder approval has been obtained. Looking behind the veil of incorporation, [24] Adam is, effectively, the company and, therefore, has declared a dividend for his own benefit. Directors are duty bound to ascertain the financial position of the company before the declaration and payment of a dividend. Equally, directors should ensure that there is sufficient distributable profit in order for a dividend to be first declared and then secondly paid. [25]

In the absence of such a position being approved, any dividends paid will be considered illegal. If the dividend has been paid, such monies or property that has been handed to the shareholders will be considered as held on trust for the benefit of the company and, therefore, repayable or returnable to the company itself. [26] Thus, the £10,000 that has been paid to Adam would need to be repaid with Adam being under an obligation to reimburse the Company with the money. The liquidator may be able to retrieve the sum Adam partly used to settle the debts of the other two companies from them provided they had knowledge or constructive knowledge of the dividend paid to Adam were illegal.

There’s also a question as to whether an equal dividend on a pro rata basis has been paid to Penelope. This appears to be unclear and it requires to be appreciated that unless the board has obtained waivers from appropriate members of the company prior to the declaration of a dividend, the dividend needs to be made to all members of the company and not just a particular person or class (subject to restrictions in the articles). [27]

The dividend in question is not only illegal, but also a breach of the directors’ duties to act with reasonable care and skill at board level. Furthermore, for the reasons given the dividend is misleading and Adam can be disqualified even though he is not a qualified accountant. [28]

2. Fraudulent or Wrongful Trading

A director will not be permitted to hide behind the corporate veil in order to avoid personal liability in cases of fraud or wrongful trading. Civil liability stems from the imposition of section 213 of the Insolvency Act 1986 which provides that in the event of winding up a company if it appears that business is continued with the intention to defraud any interested party, the court may impose personal liability on persons who were knowingly party to the continuation of the business and order for contributions to the company’s assets as the court thinks fit. The meaning of fraud has been defined as involving real ‘dishonesty’ according to commercial persons of the present day with real moral blame for the purposes of the 1986 Act. [29] However, actual dishonesty has to be proved. [30] Although continuing to trade may amount to sufficient evidence of dishonest intent, it is not conclusive. [31]

Adam’s persuasion to continue trading raises the question whether the belief was ‘genuine’ in respect of coming out of the company’s financial difficulties. This further poses the question; did Adam and the directors genuinely believe that all is well? [32] Was this belief reasonable? [33] The test for fraudulent trading is ‘dishonesty’ according to normal standard of people – did the directors discharge their duties according to that standard? [34]

It could be argued Adam’s motive was to continue to trade due to the cross-guarantees he has given for his other two companies even if it meant he had the knowledge that there were no real prospects of recovery. [35] Furthermore, by slowing the rate of paying creditors implies that there was intent to defraud [36] or the continuity of wrongful trading as this method allows credit to accumulate which points to the fact that perhaps it was inevitable the company would run into liquidation and with the debt increasing the prospects of recovery becomes slim. On the facts, it can be asserted the continuation of trading has left the company’s position worse; hence the company has less money to pay its creditors. [37]

Owen could be held liable because he had taken positive steps by signing the deeds for the cross-guarantees. [38] It can be argued, that he only signed the deeds because his father had already signed. All the directors should have exercised due diligence and looked into the matter with careful consideration before following Adam’s lead. Although Adam can be said to be the main perpetrator here, the court by virtue section 213 or 214 of the Insolvency Act 1986 may hold all directors responsible to a lesser extent than Adam as the Act gives the court discretion for it to impose contributions to the losses of the company’s assets. In this regard, Peter could be held to be more culpable too because of his knowledge as an accountant he ought to have contended to Adam’s suggestion to continue trading and highlighted the financial pitfalls (as stated above) [39] .

Given the difficulty in establishing fraud [40] and the fact that section 213 of the 1986 Act requires proof of dishonest intent, the claim for reckless continuation of trading is not caught, liquidators prefer the route through section 214 of the 1986 Act which addresses the loophole in section 213.

A director is under an obligation to ensure that the company to which he or she is a director of is not trading while it is insolvent otherwise there is a potential for liability in relation to the debts and obligations of the company under wrongful trading. Directors are under a duty to act in the best interests of the company, shareholders and creditors in the event of insolvency. [41]

The question, therefore, revolves around whether the directors of Cheesy Chips Limited are facing any personal liability as a result of the company trading while insolvent.

Section 214 of the Insolvency Act 1986 imposes a liability on directors where they knew or “ought to have known” that their conduct was resulting in an insolvent situation and that the company was continuing to trade when it had no real prospects of being able to “trade out of” insolvency and could not avoid going into insolvent liquidation. [42]

If the principle customer withdraws custom, then to continue to trade is deemed by the courts to be wrongful trading. [43] Waitflower, the principle customer informed Hugh that they are withdrawing their custom with immediate effect. This professes to the presumption that there was only a faint prospect of sustainable trading; hence it decreases any chance of recovery. Where insolvency is inevitable all the directors must take steps to minimise loss to the creditors [44] which they failed to do. Peter and Adam failed to exercise reasoned financial control of the company, continued to trade while insolvent and were aware that the company had little or no prospects of success. Furthermore, the remaining directors were under a duty and an obligation to ensure that they had sufficient information about the trading prospects of the company to come to a reasoned judgment as to whether the company could continue to trade. [45] Therefore, all the directors could be held personally liable for the losses of the company. Nevertheless, had all the directors sought legal advice from professionals and carried on trading they could have avoided personal liability. [46]

However, it is not clear from the authority of cases or the statutory regime how far down the scale does a company has to deteriorate before a company ceases trading. The potential danger this poses is that businesses may close down too early without earnestly trying to recover from financial difficulties “to avoid the risk of wrongful trading liability. However, any more precise methods of predicting insolvency should be welcomed in the intended process of protecting the interests of unpaid creditors.” [47]

Liquidators are placed in a predicament as the expense to bring proceedings for wrongful trading (especially where the remainder of the company assets is not substantial enough to fight for) and it is not worth pursuing directors where there is lack of personal assets. Rather than pay court fees most creditors would like to cling on to whatever dividend is available.In this light, only few cases have been brought to court under wrongful trading. Hence, the liquidator will objectively assess the remainder of the assets of the company and personal assets of all the directors to decide whether or not to bring an action. It will very much depend upon the assets that are available for the liquidator to pursue on behalf of the Cheesy Chips Limited’s creditors.

3. Disqualification

If it can be established under section 6 of the Company Directors Disqualification Act 1986 that a director was aware of the financial position of the company and caused the “company to continue to trade” when in their reasoned opinion and judgement there was no prospect of the company succeeding. The company should have ceased trading and a director that agreed to the continuation of the company in such a situation would be considered as being unfit to be “concerned in the management of a company” in the future [48] . Whether a director is fit to act as a director will hinge on whether they have the ability to demonstrate independent thought and reasoned judgment. [49] As demonstrated, it is sufficiently clear that all the directors have failed to comply with this requirement.

The directors cannot escape liabilities by deferring responsibilities and duties; [50] neither can they discharge duties just by turning up to meetings. Therefore, Hugh, Owen and Penelope could be held liable and on this ground with a strong presumption for disqualification.

From the principles set out in the case of Polly Peck [51] ; it is highly probable that disqualification orders will be made against the directors of Cheesy Chips for wrongful trading and breach of director duties as per Polly Peck together with Secretary of State for Trade and Industry v Goldberg.

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Bibliography

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