Construction, Insolvency, Directors and Liability
Robert Foote
Partner at Spencer West LLP - BVI and English Dispute Resolution, Insolvency and Restructuring
Construction, Insolvency, Directors and Liability
As a result of the pandemic, rising inflation and interests rates, supply chain issues, a lack of demand and rising costs of operation
The Market
The temporary pandemic protections are no more and Red Flag Alert has expressed concern that more than one hundred building firms will go bust every week in 2023. The pressure is coming from unpaid bills, inflation, interest rate rises, staffing and supply chain issues.
In the construction industry there is usually a delay between work being completed and payments being received. This payment delay is exacerbated by the fact that contracts provide for stage payments in arrears, which can result in significant work in progress and cash flow issues. Late payments are the main insolvency triggers in an competitive sector where the lowest price often wins the work and where contractors are working with minimal margins in circumstances where unexpected delays and increased costs can significantly reduce profits. The solvency position of contractors can have a real and significant negative impact
These considerations, taken together with the rising cost of operations and economic uncertainty is likely to mean that 2023 will be a perfect storm for insolvency in the construction industry. It is hoped that the government will step in offer support but before that happens, assuming it does, it is going to be incumbent on directors of construction companies to identify, understand and deal with existing and anticipated insolvency issues in order to protect themselves, their companies and stakeholders.
When is a Company Insolvent?
A company is insolvent if it is unable to pay its debts as they fall due or if the value of its liabilities (including prospective and contingent liabilities) exceeds its assets. In either case, the company can be placed into insolvent liquidation or insolvent administration.
In a liquidation, a liquidator is appointed to realise the value of the company’s assets for the purpose of distributing them to the company’s stakeholders in accordance with the priority established by the insolvency legislation. This typically results in the company’s creditors receiving less than the amount of their debts (if anything) and the company’s shareholders not receiving anything.
In an administration, an administrator is appointed to rescue the company as a going concern. If this cannot be achieved, the administrator must try and achieve a better result for the company’s creditors as a whole than they would otherwise receive if the company went into liquidation. If neither of these objectives can be achieved, the administrator must try and realise the value of the company’s property to make a distribution to one or more secured or preferential creditors. As with liquidation, administrations often result in creditors receiving less than the amount of their debts and shareholders receiving nothing.
Insolvency and the JCT Standard Building Contract
Insolvency does not give rise to a breach of contract but it can be relied on by a counterparty to treat a contract as having come to an end irrespective of whether the contract contains a termination provision. Under the JCT Standard Building Contract (“the JCT Contract”) a company is “insolvent” where a recognised insolvency procedure has been commenced (including liquidation and administration or where the company has entered into an arrangement or comprise with creditors). It follows therefore that although a company that is unable to pay its debts will not be insolvent as a matter of contract under the JCT Contract, if a creditor commences a recognised insolvency procedure the company will be insolvent for the purposes of the JCT Contract.
What are Warning Signs of Insolvency
Warning signs that a contractor, subcontractor or employer might be insolvent may include one or more of the following:
a.??????Where there appears to be cash flow issues such as the late payment of or a failure to pay supply chain invoices and/or the wages of employees;
b.??????General talk in the market that a company is in financial difficulties;
c.??????Pressure from creditors such as demands for payment and statutory demands;
d.??????Attempts to negotiate changes to payment terms;
e.??????The late filing of accounts at Companies House;
f.???????Claims being issued against the company or judgments going unsatisfied;
g.??????The threat or issue of winding up proceedings by a creditor or shareholder of the company;
h.??????Work being suspended without good reason; and
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j.????????Workers being removed from site unexpectedly.
Who are Directors?
For the purposes of the insolvency legislation, the word “director” extends to “any person occupying the position of director, by whatever name called”. This definition not only includes de jure directors (directors that have been formally appointed as such) but extends to include de facto directors (people who assume responsibility to act as a director although they have never been formally appointed) and shadow directors (people in accordance with whose directions or instructions the directors of the company are accustomed to act). For the purposes of the insolvency legislation, there is no difference between executive and non-executive directors.
What can Happen to Directors?
Directors of companies that are facing financial difficulties and which go into insolvent liquidation and insolvent administration face potential claims and may face criminal liability, as more fully set out below.
a.??????Wrongful Trading. If a liquidator or administrator is appointed over a company, the liquidator or administrator is bound to review the actions that the directors took before they were appointed. If it appears that a director knew or ought to have concluded at some point before the commencement of the liquidation or administration that there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the liquidator or administrator can seek a declaration from the Court that the director contribute to the company’s assets.
b.??????Fraudulent Trading. If, during the currency of a liquidation or administration, it appears that any business of the company has been carried on with the intent to defraud creditors, or for any other fraudulent purpose, the liquidator or administrator can seek a court declaration that anyone who was knowingly party to the fraudulent business contribute to the company’s assets. Fraudulent trading is also a criminal offence.
c.??????Misfeasance or Breach of Fiduciary Duty. If, in the course of winding up, it appears that a current or former director has misapplied or retained, or become accountable for any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty, the court may order the director to repay, restore or account for the money or property with interest or contribute to the company’s assets by way of compensation.
d.??????Common Law Duty. Where a company’s directors form the view that their company is insolvent or likely to become insolvent, their duty to act in the best interests of the company is supplanted by a duty to act in the best interests of the company’s creditors. This would mean, for example, that an otherwise lawful distribution to creditors or shareholders could amount to a breach of fiduciary duty, exposing a director to suit.
e.??????Fraud in Anticipation of Winding Up. Where a company is wound up, a director would have committed an offence if he or she has, within twelve months of the commencement of the winding up: (a) concealed any part of the company’s property; (b) fraudulently removed any part of the company’s property; (c) concealed, destroyed, mutilated or falsified any book or paper affecting or relating to the company’s property or affairs; (d) made any false entry in any book or paper affecting or relating to the company’s property; (e) fraudulently parted with, altered or made any omission in any document affecting or relating to the company’s property or affairs; or (f) pawned, pledged or disposed of any property of the company which has been obtained on credit and has not been paid for. A director that is privy to any of these actions may also be deemed to have committed an offence.
f.???????Transactions in Fraud of Creditors. Where a company is being wound up, a person is deemed to have committed an offence if he or she was a director of the company and (a) made or caused to be made any gift or transfer of, or charge on, or has caused or connived at the levying of any execution against the company’s property; or (b) has concealed or removed any part of the company’s property since, or within two months before, the date of any unsatisfied judgment or order of the payment of money obtained against the company.
g.??????Misconduct in the Court of Winding Up. Where a company is being wound up, any director of the company commits and offence if he or she (a) does not to the best of his or her knowledge, disclose to the liquidator all of the company’s property, and how and to whom and for how much and when any company property was disposed of; (b) does not deliver up company property in his or her custody or control to the liquidator; (c) does not deliver up to the liquidator all books and papers in his or her custody and control; (d) fails to inform the liquidator of any false claim being made in the liquidation; and (e) prevents any book or paper relating to the company’s property or affairs being produced.
h.??????Falsification of the Company’s Books. Where a company is being wound up, a director commits and offence if he or she destroys, mutilates, alters or falsifies any books, papers or securities, or makes or is aware of the making of any false or fraudulent entry in any register, book of account or document belonging to the company with intent to defraud or deceive.
i.????????Material Omissions from Statement Relating to the Company’s Affairs. Where a company is being wound up, a director commits an offence if he or she makes any material omission in any statement relating to the company’s affairs. He or she also commits an offence if, before the winding up, he or she has made any material omission in any such statement.
j.????????False Representation to Creditors. Where a company is being wound up, a director commits an offence if he or she makes any false representation or commits any other fraud for the purpose of obtaining the consent of any creditor to an agreement with reference to the company’s affairs or the winding up. He or she is also commits an offence if, before the winding up, he or she made a false representation, or committed any other fraud, for that purpose.
k.??????Reviewable Transactions. Creditor pressure on an insolvent company may lead directors to cause their companies to take steps to alleviate the company’s trading problems, which amount to reviewable transactions thereby exposing the directors to claw back claims if the company goes into liquidation or administration. Such transactions may include, for example: (a) granting security to an unsecured creditor supplier in respect of debts incurred for goods previously delivered; (b) acceding to new supply terms from an existing supplier on more onerous terms; (c) granting new security to an existing lender in respect of the same debt; (d) paying preferred unsecured creditors ahead of other unsecured creditors; (e) the making of severance payments to senior employees or directors; (f) causing the company to repay a debt that has previously been guaranteed by a director; and (g) making a gift of company assets.
l.????????Director Disqualification. If a director is disqualified from acting as a director, he or she may not be a director of any company or in any way, directly or indirectly, be concerned or take part in the promotion, formation or management of a company for a period specified in the disqualification order without the Court’s permission. A disqualification order must be made against a director of a company that goes into liquidation or administration if that person’s conduct as a director makes him or her unfit to be concerned in the management of a company (including where the director in question has been found liable for fraudulent or wrongful trading). The minimum disqualification period is two years and the maximum is fifteen years.
How can Directors Protect Themselves?
There are a number of ways that directors can protect themselves:
a.??????Board Meetings. If the company is in financial difficulties the directors should call regular full board meetings and ensure that all commercial decisions are recorded in full in the company’s minutes. It is also important that the directors reach their commercial decisions independently based on current financial and legal information available to them.
b.??????Current Financial Information. In order to be best placed to exercise their commercial judgment and to ensure that the directors discharge the fiduciary duties that they owe their companies, they must ensure that they are working with current financial information. The directors should not be waiting for an external event (such as a winding up petition to be issued) to alert them to the fact that the company is in financial difficulties. In this way directors can make sure that they are monitoring compliance with financial covenants in contracts with third parties, including lenders.
c.??????Take Advice. As soon as a director becomes at all concerned that there may be no reasonable prospect of avoiding insolvent liquidation or insolvent administration, he or she should raise this with the board with a view to taking immediate, independent legal or financial advice
d.??????Resignation. Directors cannot avoid liability by resigning and the Courts are likely to see resignation as a director’s abrogation of responsibility. However, where a director forms the view that there is no reasonable prospect of the company avoiding insolvent liquidation or administration but is unable to persuade the board to that view, this may justify resignation. Before taking that step the director should seek independent advice, have his or her concerns noted in board minutes and communicate those concerns to the board in writing.
The issues relating to the duties and culpability of directors of insolvent companies are complicated. The above provides only a broad outline of the the principal issues that directors should have in mind if their companies are insolvent or they form the view that their companies may become insolvent. Directors are strongly encouraged to take timely advice from an appropriately qualified professional in order to minimise the chances of civil, criminal and/or director disqualification proceedings being taken against them.