Stepping into the Director's Chair: The Landscape of Risk in Distressed Companies – Misfeasance Trading
This article discusses the risk that a director is exposed to in England and Wales, in particular in relation to the liability in respect of misfeasance trading that may form the basis of a claim against directors at the helm of companies in financial distress. We also look at how to guard against that risk.
Directors of companies that enter an insolvency process have long been potentially liable for claims brought by an administrator or liquidator in respect of wrongful trading or fraudulent trading. In certain circumstances there may also be claims in respect of antecedent transactions where the directors or director cause the company to enter into a transaction either disposing of the company’s assets for less than the value of those assets, or preferring one or more creditors over the rest of the company’s creditors.
In the BHS case1, for the first time, the court found the directors liable for misfeasance trading. The limited case law to date suggests that an insolvency practitioner may be able to bring a successful claim against a director for misfeasance trading in circumstances where a claim for wrongful trading under section 214 Insolvency Act 1986 (IA 86) would not succeed. Depending on the circumstances, the remedy for misfeasance trading may be as severe as the remedy for wrongful trading.
What is misfeasance trading?
Misfeasance trading refers to a finding by the court that a person who is or has been an officer of the company or who is or has been concerned with the promotion, formation or management of the company has been guilty of misfeasance or breach of duty in relation to the company. The first reported instance of misfeasance trading, in the BHS case, related to a breach of the directors’ duty set out in section 172(3) of the Companies Act 2006 (CA 2006), to consider or act in the interests of the creditors of the company in certain circumstances (the Creditor Duty).
A finding of misfeasance trading may be made where the Creditor Duty is engaged and the directors fail to consider the interests of creditors and continue to trade. Directors cannot delegate the Creditor Duty. The board shares the responsibility to comply with the Creditor Duty, regardless of the particular expertise of certain members of the board, or the relative inexperience of other members of the board.
Key to understanding the risk of misfeasance trading is ascertaining when the certain circumstances apply, that is the point at which the Creditor Duty is engaged.
When is the Creditor Duty engaged?
It is very difficult for any director or board of directors to know, especially in the moment, when the Creditor Duty is engaged. The leading authority in this area is the Sequana case2, and the five Justices of the Supreme Court could not agree on the exact formulation of the test as to when the Creditor Duty is engaged. The rule is now considered to be that the Creditor Duty is engaged when the directors know or ought to know of the company's insolvency or imminent insolvency, or when an insolvent liquidation or administration is probable.
Following the BHS decisions, if directors fail to address that shift from the interest of the members of a company as a whole to creditors early enough then a director may face a claim for misfeasance trading, much earlier than a claim for wrongful trading would arise. This is because the Creditor Duty is engaged earlier than the test for wrongful trading. A director cannot be found liable for wrongful trading until they ‘knew, or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation or entering insolvent administration’.
The Creditor Duty requires attention and addressing much earlier, when insolvency is just probable. The board needs to properly document that it has, and how it has, considered those interests, as discussed further below.
Remedies for misfeasance trading
Wrongful trading has historically been an unpopular claim to bring, because of the difficulty in showing that the directors knew or ought to have known that there was no reasonable prospect of avoiding insolvency. The outcome of the wrongful trading claim in the BHS case was that the defendants were ordered to pay £6.5m each.
The wrongful trading claim in BHS centred around 6 knowledge dates, the allegation being that on those dates, the directors should have known that the company was past the point of no return. The judge found that the knowledge condition necessary for wrongful trading was only met on the final knowledge date. Accordingly the wrongful trading claim failed on the earlier 5 dates.
In respect of the misfeasance trading claims, the two directors were held jointly liable for approximately £150m. The court found that the directors were liable for allowing the company to continue trading when they knew or should have known that insolvency was probable. The measure of equitable compensation payable was based on the increase in the net deficiency of the company's assets as a result of the directors' actions, the same measure used for wrongful trading remedies.
How has the BHS misfeasance case changed the risk to directors?
The risk going forward is that if the board cannot demonstrate that they considered the creditors’ interests where insolvency was probable, they may be liable to face an order for a contribution in any claim brought by a liquidator or administrator on the basis of misfeasance trading.
After BHS, wrongful trading is firmly back on the map. However, the new misfeasance trading claim may be an easier claim for insolvency practitioners to bring in addition to or instead of wrongful trading. The bar is therefore lowered and crucially, the sanctions may be no less in comparison to wrongful trading. In fact, they are highly likely to be more, as the loss will be greater, the line having been crossed at an earlier stage. Not only is a director’s potential liability greater, but they may be more likely to be on the receiving end of a claim as insolvency practitioners (or funders) may be more incentivised to bring such claims in light of the potentially greater recoveries available, and the perceived easier test.
It is notoriously difficult for a director to pinpoint, whilst focusing on the day to day job of running a company in financial distress, when the Creditor Duty arises.
Misfeasance Trading and Non-Executive Directors (NED)
Of particular interest and significance for NEDs, who are unlikely to be as involved in the day to day running of the business and may not have the same degree of knowledge as directors ‘on the ground’, is that a NED has no additional protection to that of an executive director. NEDs should ensure that they read and interrogate all board papers and request more information should they require it. It is not a defence for a NED to say that their role was limited, for example because they were only paid for a few days a year or that they were not required to attend certain meetings. If the company is not willing to pay them for sufficient days to do their job effectively, they should not accept the role.
NEDs may consider trying to do their role as consultants to circumvent the liability that directorship brings, but the risk remains that a de facto or shadow directorship arises.
How to guard against the risk of misfeasance trading claims
Obtain proper professional advice
Directors should obtain professional financial and legal advice at as early a stage as possible if a company starts to encounter financial difficulties. It is essential that any such advice is properly targeted and tailored to the relevant circumstances, and given by advisors who are fully apprised of the facts, and kept up to date with those facts as they change.
Rely on that advice
A director will not avoid liability simply by demonstrating that advice was obtained. The court will interrogate the professional’s instruction, and the extent to which that advice was relied on.
Document the advice
Board minutes must constitute a precise, contemporaneous record of the meeting and fully and accurately reflect the reality of directors' discussions, considerations and rationale for the decisions ultimately reached. Pro forma statements in the board minutes to the effect that “the directors consider that they are acting in the best interests of the Company’s creditors” are likely to be given no weight.
Even where decisions are being made outside of a board meeting, a paper trail of the considerations and rationale must be kept.
Ensure that all directors are involved in decisions
All directors must actively participate in the decision-making process of the board and ensure that such decisions are appropriately documented. Even if it has been agreed by the board that a particular director’s responsibilities are limited to a specific area, this will not absolve that director of their wider duties to the company and its stakeholders nor protect them from a claim by an insolvency practitioner.
If a director disagrees with the position the rest of the board are taking, the advice is that the director should not resign but should carefully document the disapproval.
Ensure that each director is qualified for the role
Directors must ensure that they are able to carry out the role for which they are appointed. A director’s conduct will be judged against both the objective standard3 and subjective standard4 of skill, care and diligence. On that basis, a director will not be spared liability by their honest conduct and good intentions. Directors should regularly assess whether they feel qualified to be undertaking the role they are in.
Directors’ and Officers’ Insurance
The critical importance of D&O insurance is routinely not prioritised. All policies should be reviewed and the limits increased, in light of the increased risk profile for directors resulting from the misfeasance trading decision in BHS.
What impact does the BHS misfeasance case have on the decision of whether or not to take a seat on the board?
Investment comes in different forms, for example, an angel investor, venture capital or distressed private equity. Venture capital investors are likely to be minimally affected because of the nature of the businesses they invest in. Conversely, a distressed private equity investor is more likely to be affected but is also more likely to have their eye on insolvency in any event. The fundamental issue is how much risk an investor wants to take versus the amount of control that they want and how much time they are prepared to dedicate to the company.
Concluding Remarks
In terms of managing the risk, all directors need to be alive to it. In light of the liabilities if the board has not realised that the Creditor Duty has been engaged at a certain point in time, it may be tempting to play it safe and assume it has. However, directors need also to consider the potential liability of ceasing trading too early.
Directors need to be seeking professional advice as soon as there is any concern around solvency. Directors should not be trying to consider as a board whether the Creditor Duty has been engaged without legal advice, and that legal advice will need to be ongoing, with those providing the advice being kept up to date at every turn, to tailor the advice to the ongoing trading position of the company.
Our expertise
With offices in many of the world’s major financial centres, including London, Paris, Geneva, Zurich, Dubai, Hong Kong and Singapore, we are ideally placed to work with you to advise in respect of companies in financial distress, whatever the law, language, rules, industry sector. Our dedicated multicultural and multilingual specialists advise and act for directors and insolvency office holders under both common law and civil law systems.
Please contact the authors or your usual Charles Russell Speechly LLP contact if you would like to get in touch.
1 Wright & Ors v Chappell & Ors [2024] EWHC 1417 (Ch) and Wright & Ors v Chappell & Ors [2024] EWHC 2166 (Ch)
2 BTI 2014 LLC v Sequana SA, [2022] UKSC 25
3 The objective test requires a director to exercise the care, skill, and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill, and experience that may reasonably be expected of a person carrying out the functions of the director in relation to the company.
4 The subjective test requires a director to exercise the care, skill, and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill, and experience that the director actually has.
