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Law for Business

Knowhow - guidance - precedents

21 JUN 2013

Ten things every director needs to know – Part 5

Ten things every director needs to know – Part 5

Creditors are at the heart of the company law regime.

(June 2013)

This is the fifth in a series of articles in which we explore the role of a director from various angles, some of them slightly unconventional.  Each article identifies a fact of which directors need to be aware - whether concerning their duties, their relationship with other key players or their responsibilities under the Companies Act 2006 - and uses it as a starting-point to illuminate a particular aspect of their role.

This article discusses the impact on directors of the company law regime's efforts to protect creditors' interests.

As a matter of common sense, when a company fails and cannot pay its debts, either the shareholders will have to make up the shortfall or the creditors will not get their money back.  When shareholders opt to limit their liability for the company's debts, therefore, they are not causing the risk associated with the possibility that the company might fail to vanish, but simply transferring it to the company's creditors.

Having given shareholders this power to expose creditors to risk, company law seeks to redress the balance somewhat by imposing numerous obligations on companies and directors which are designed to ensure that creditors are not left completely unprotected.  Many of these measures take the form of requirements to publish information, so that creditors will be able to make an informed decision as to whether they wish to do business with the company.  Others are more intrusive, preventing companies from acting in particular ways and requiring directors actively to turn their minds to the interests of creditors rather than shareholders.

  • Publicity requirements
In Salomon v A Salomon and Co, Ltd (1897) - the most famous case in English company law - the House of Lords held that an individual who had transferred his business to a company which he controlled was not liable for the company's debts when the business failed soon thereafter.  As far as the plight of creditors was concerned, the court felt that those who deal with a company have an obligation to research the company's affairs from the information contained in the public record.  As Lord Watson put it:  "in my opinion, a creditor who will not take the trouble to use the means which the statute provides for enabling him to protect himself must bear the consequences of his own negligence".

The publicity requirements under the Companies Act 2006 are extensive.  The most important of them is the obligation to publish accounts.  Not only do accounts have to comply with detailed requirements as to content and format, but in many cases they have to be audited, and they also have to be filed with the registrar within a specified period (in the case of a private company, nine months after the end of the financial year).  The rationale for imposing strict rules as to a company's accounts is obvious.  Take the case of a bank which is considering making a loan to a company.  Since the bank will not be able to recover the amount of the loan from the company's shareholders in the event that the company fails, it seems only fair that it should at least have enough information about the financial status of the company itself to enable it to make an informed decision as to whether or not to entrust it with the loan.

Other publicity requirements which are designed, at least in part, with the interests of creditors in mind, include the following:

  • the obligation to file articles of association with the registrar
  • the obligation to file special resolutions, details of changes to the composition of the board and details of changes to the company's share capital (inthe form of statements of capital)
  • the obligation to file an annual return, which provides information on matters such as the identity of the company's shareholders
  • the obligation, under the trading disclosures rules, to specify certain corporate               details on letters, order forms, emails and websites
  • the obligation to keep comprehensive internal records, some of which may be                inspected by third parties.
  • Other requirements
The Companies Act 2006 imposes severe restrictions on a company's freedom to act where its capital is concerned.  (Capital, in this context, refers to the money which shareholders have paid to the company in exchange for its shares.)  For example, dividends may only be paid out of profits (section 830), a formal reduction of capital may be undertaken only if certain conditions are met (section 641) and public companies may not allot shares otherwise than for cash unless the consideration has been independently valued (section 593).  Underpinning the restrictions is the notion that the company's capital should be ringfenced and protected, so that it is available to pay off the company's debts in the event that it fails.

Possibly of even more interest from a director's perspective are the rules requiring directors to consider creditors' interests in their day-to-day management of the company.  When a company is on a sound footing financially, directors will normally be acting primarily with the shareholders' interests in mind.  Thus, the success duty in section 172(1) provides that a director must seek to "promote the success of the company for the benefit of its members as a whole" (emphasis added).  However, when a company is facing difficult times, creditors' interests intrude.  Not only is section 172(1) subject to the common law rule that, when the company is approaching insolvency, directors must take creditors' interests into account in their decision-making process, but the wrongful trading provision of the Insolvency Act 1986 imposes a positive obligation on directors who know that their company is failing to do all they can to minimise the loss to the company's creditors.

Why might a director benefit from understanding the importance of the regime's creditor protection mechanisms?  As far as the publicity requirements are concerned, a director who understands why the rules exist is in a better position to comply with them than one who regards them merely as inconvenient hoops through which to jump.  The trading disclosures rules, for example, can be difficult to comply with in practice, and a director who understands that they were devised not on a whim, but in order to ensure that people dealing with companies know precisely with whom they are doing business, may be more willing to do what it takes to ensure full compliance.  As far as the obligations to consider creditors' interests are concerned, the simple fact is that a director who is not aware of the obligations may, if the company fails, find that, as a result of an inadvertent breach, he has exposed himself to personal liability.

Shareholders should certainly be at the forefront of directors' minds in most situations.  However, in order to carry out his duties effectively, a director must appreciate that creditors, too, are at the heart of the company law regime.

Nigel Banerjee can be contacted at nigel.banerjee@kcl.ac.uk.
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