Most directors know that a limited company is designed to protect personal assets from business debts. In general, that is true. The company is a separate legal entity, meaning directors are not usually personally responsible for what the business owes. However, when a company starts experiencing serious financial difficulties, that protection can quickly become less certain. In his latest article, Associate, Paul Newbon  explores this key issue in more detail.

When Can Directors Become Personally Liable?

Personal liability can arise if a director:

• Breaches their duties under company law;
• Continues trading when insolvency is unavoidable;
• Misuses company money or assets;
• Gives personal guarantees;
• Causes losses to creditors through misconduct; or
• Faces disqualification proceedings that lead to compensation orders.

In short, directors who fail to act responsibly during financial distress can find their own finances at risk.

Directors’ Duties

Directors must act in the company’s best interests, exercise reasonable care and skill, avoid conflicts of interest, and look after company assets properly. They should also keep adequate records and seek professional advice where appropriate.

A breach of these duties can lead to claims for compensation, disqualification from acting as a director for up to 15 years, and in serious cases, criminal penalties.

When Financial Problems Begin

As a company’s financial position worsens, directors must start paying greater attention to the interests of creditors rather than shareholders.

The courts have made it clear that once insolvency becomes likely, directors cannot simply focus on saving shareholder value. The closer a company gets to insolvency, the more important creditors’ interests become. Once insolvency is inevitable, the creditors’ interests take priority.

Directors can still pursue genuine rescue plans, but they must avoid taking unrealistic risks that make the situation worse. Professional advice is important, but directors remain responsible for the decisions ultimately made.

Wrongful Trading

Of all the risks facing company directors, the best known is wrongful trading.

A director may face personal liability if they continue trading when they know, or should have known, that insolvent liquidation was unavoidable and failed to take every reasonable step to minimise losses to creditors.

Common warning signs include:

• Continuing to trade without justification
• Taking further credit with no prospect of repayment
• Failing to act on clear red flags (e.g. tax arrears, CCJs, loss of key customers)

Where a director can demonstrate that they have taken all reasonable steps to protect the creditors’ interest, a defence is available, but it is a high bar, and the onus will be on the director to prove his case.

Fraudulent Trading and Misfeasance

Fraudulent trading is more serious and involves deliberate dishonesty, such as misleading creditors or abusing company funds, with a recent example being the illegal acquisition or misuse of government-backed financial relief funds created during the COVID-19 pandemic, such as the Bounce Back Loan Scheme. It can result in personal financial liability and criminal sanctions with a director facing an unlimited fine and up to 10 years in prison.

Misfeasance covers a wide range of misconduct, including misusing company assets, breaching duties, or favouring certain creditors unfairly. Liquidators frequently investigate these issues after insolvency.

There is no limitation period for liquidators to bring a claim for misfeasance against a director, and the director may be ordered to restores or account for company assets. For more serious breaches, there is also the risk that a director could be disqualified with bans ranging from 2-15 years.

Transactions That Can Be Challenged

Liquidators can review transactions entered into before insolvency and seek to reverse them.

Common examples include:

• Transactions at undervalue – selling assets for less than they are worth;
• Preferences – repaying one creditor ahead of others;
• Transactions defrauding creditors – moving assets out of reach of creditors; and
• Paying unlawful dividends when sufficient profits did not exist.

Directors involved in such transactions can face claims personally.

Director Disqualification

Directors who engage in misconduct may be disqualified from acting as a director for up to 15 years. Moreover, since 2015, the courts may order a director to compensate creditors personally.

Practical Steps to Reduce Risk

The best protection is good governance and early action.

When a company is solvent, directors should:

• Keep accurate records;
• Document key decisions;
• Manage conflicts tranparently; and
• Avoid unnecessary personal guarantees.

If insolvency becomes a possibility, directors should:

• Hold regular board meetings and keep accurate minutes;
• Prepare up-to-date cash-flow forecasts;
• Prioritise creditor interests;
• Avoid selective payments to creditors;
• Stop or restrict trading unless a credible turn around exists; and
• Obtain specialist legal and insolvency advice at an early stage.

Key Takeaway

Limited liability offers directors considerable protection, but it is not a complete shield. Once financial difficulties emerge, directors must act carefully, keep proper records, and make decisions with creditors firmly in mind. Those who take advice early and follow a well-documented decision-making process are far less likely to face personal liability if the company ultimately becomes insolvent.

If you are looking for more information on this or any other legal matter, our friendly team of specialist legal advisors is here to help you. Please don’t hesitate to contact Paul today on paul.newbon@andrewjackson.co.uk or speak to the team on 01482 325242.