As a Business Owner will your Corporate Governance stand up to hindsight scrutiny?

This article is for background education only and does not constitute legal or financial advice. People who are uncertain over their own particular circumstances should always seek the appropriate advice from a suitably qualified solicitor or accountant.

When you become a Director, Companies House send you a very nice letter congratulating you on the appointment. It would be better if send you a red warning letter saying "beware, do you realise what you might have signed up to, and here are all the risks you have taken on"!.

This is said slightly tongue in cheek, but it is a very serious point, as most Directors are also the shareholders of their business and have never had any formal training of what it means to be a Director, so don't understand the risks.

When the Directors and Shareholders are one and the same the distinction between them can blur due to the actions of the Director inadvertently acting in their own best interests when they should be acting as a Shareholder or acting as the Company by its Director. Often this is only identified when insolvency has unfortunately been reached, as no-one was bothered beforehand, and there was no real checks and balances.

With the rise in litigation funding, which is being used by Administrators or Liquidators, Directors, who are also the Shareholders, can find themselves with an increasing risk of a claim for recovery of the past value they have extracted from the Company due to poor Corporate Governance.

Regardless of the merits of the claim there will be a time and cost to solving it.

Hopefully your business will always be successful but if it isn’t, and insolvency is rising, then these are some, not all, of the areas where you could get caught out.

Paperwork and Record Keeping

Foremost it is about paperwork and record keeping.

The Shareholder, Director and Company are all 3 distinct persons’, even though they may all be the same voice. ?Being only one person wearing three hats you will find yourself talking to yourself, a lot!

A transaction (e.g., cash, borrowing of goods or services, taking of equipment) between any one of them must be documented at the time it happens. Failure to do this immediately opens the possibility of recovery of that value later.

Any decision by a person acting in one role that impacts another role must be documented, with the reasons why.

Any discussions with professional advisers that constitutes advice should always be documented. Keep a diary!

Remember the Company’s money is not your money, either as a Director or Shareholder until it has been properly and appropriately transferred.

Do not joke or write things in haste in email that you may later regret

Fiduciary Duty

Fiduciary Duty or duty of care is the Director’s statutory duty under the Companies Act 2006 to always act in good faith and the best interests of the Company, and the duty to operate with the skill and care of a Director. By acting in the interests of the Company this means in simple terms acting in the interests of anybody who interacts with your Company, be it shareholders, employees, customers, suppliers, community, etc.

If a Company becomes Insolvent or is at as Real Risk of Insolvency (a complex subject) then you as a Director still owe a duty to the Company and the Company acting by its Directors must begin the balance the interests of the creditors as a general body with that of the Shareholders. The greater risk of insolvency the more the interests of creditors outweigh the interest of shareholders. It becomes about protecting creditor value.

If your Company is in a position where it cannot pay amounts to its creditors (and technically as soon as you cannot pay one within terms you are in this position) then as a Director it become crucial that you document everything you do, and the reasons why they have been done, make sure you understand the financial position at all times and if in doubt you seek advice.

Breach of your director's fiduciary duty can lead to a claim against you by the Company.

Authority to make the transaction.

Does the person undertaking the transaction have the authority to make the transaction? ?

The Articles of Association of the Company govern what decision the Directors may take and what actions the Shareholders may take. As an example, Directors may have decided to make a loan to themselves, but the Articles may reserve that decision for the Shareholder. This is because a Director may not be able vote on a decision in which they are an interested party. Same decision may be made but different hat, and most importantly different paperwork.

Get it wrong, and it can lead to problems later.

Salary v Directors’ Loans

Each month the Director may take a small salary (often annual personal allowance/12) which is operated through the payroll, and correctly declared to HMRC. They then take a further sum each month which is to be converted to a dividend once the final profits are known. At the point they take it, it is not a dividend.

Pitfall is that until a dividend is properly declared, and paperwork completed the loan is an asset of the company and subject to repayment.

Remember the company is a 3rd party, and just like any other 3rd Party if you take cash from it must be repaid.

Consider whether it would be less risky for you as the director to receive a market rate salary for the role you are performing under a contract of employment.

Expenses

How good are you at keeping expenses of the costs incurred by you as a Director. Remember that you are entitled to recover all costs "incurred wholly and necessarily for the purposes of the business”. Keep receipts and recover expenses monthly, either in cash or against your Director’s Loan Account,

Do not let expenses build up for long periods as you are at more risk of losing receipts, and the expenses being declared as a transaction for no value.

Dividends

Any dividends, final or interim can only be taken from realised profits. Interim dividends can be declared by Directors and are essentially part payment for the final dividends that are approved by Shareholders after approval of the final accounts for the prior year.

To declare a dividend, you should ensure you that you hold the correct meetings, with the correct notice or waiver of notice (board meetings for interim, shareholder’s meeting for final), pass the appropriate resolutions, prepare the correct minutes to record decisions made, ensure all dividend vouchers are properly prepared and record the transactions in the Company books.

Most importantly you must ensure that you satisfy yourself as a Director that the company’s cash flow can support the dividend by reviewing the latest forecasts and ensuring that the Company will be able to meet it obligations based on all the evidence reasonably foreseeable to you at the time you made the decision.

A dividend is a distribution to Shareholders, and if the Company becomes insolvent this is money that could have gone to creditors. They will want it back!

Transactions at an undervalue.

A transaction at undervalue is one which is undertaken by the company on terms which are not favourable to the Company, and which do not otherwise make good commercial of business sense. Remember a dividend is a transaction as it is transferring value from the Company to another party because they are a shareholder, so can be classed as transaction at undervalue.

In the event of insolvency an Administrator can look back at transactions between the Director or Shareholder and the Company, assess whether they parties are connected and if so go back 2 years, and seek a court order to recover the value of the transaction. Family shareholders are nearly always considered connected parties, so dividends to spouses could be recovered.

The burden is on the shareholder or director to prove that it wasn’t a transaction at undervalue, not on the Administrator or Liquidator to prove that it was at an undervalue.

Properly document decisions made by the company, ensure that proper records are kept, both historic and forecasts, and that the Company can show the reasoning behind every decision. This way it can be demonstrated that it was not “reasonably foreseeable” that the Company would become insolvent at the point of the transaction.

Preference

Similar to a transaction at an undervalue with a similar process, but where a Director or Shareholder have, often by naivety, improved their position in the winding up of the Company.

When the Company gets into difficulty it is better as a Shareholder or Director to seek appropriate advice prior to entering any new or varied transaction with the Company so that you can identify whether it would be at risk of showing preference. You do not want to look as though you had done it deliberately.

Remember the if you are experiencing difficulties the earlier you seek advice the more likely it is that a business can survive.

Stewart Renfrew has worked with privately owned & PE backed SME business’s owners for over 20 years in Financial, Operational and Managing Director positions. He has been a business owner himself and is currently founder and majority shareholder in an IoT start up business. He offers empathetic, pragmatic and practical management and leadership support for business owners who may be experiencing some stress or who want to grow. He seeks to work with a small number of select owners on a part-time basis to increase their business value by assisting in sorting out short term issues, and then focusing on the medium to long term strategy. He is always happy to have a no obligation discussion and can be contacted at [email protected].