One hand in the cookie jar: Fraud and directors’ duties in insolvency

…there is nothing to say that directors who genuinely believe that the clouds will roll away and the sunshine of prosperity will shine upon them again and disperse the fog of their depression are not entitled to incur credit to help them to get over the bad time”

The words of Buckley J, Re White & Osmond (Parkstone) Ltd (unreported)

As the global pandemic continues to effect businesses’ survival and future solvency, we are reminded of the words of Buckley J (as he then was) above in the 1960s case of Re White & Osmond (Parkstone) Ltd (unreported) which ring eerily true in the present day. Although White & Osmond concerned a claim for fraudulent trading under the Companies Act 1948, the words also apply to directors continuing to trade through the pandemic. It is a reminder to keep in mind their general duties to the company, and in the bad days (the “cloudy fog of depression”) their duties towards creditors.

It is now trite law that directors must have regard to their general duties in sections 171-177 of the Companies Act 2006 (the “CA06”) when performing their role. These duties include: to act within their powers, to promote the success of the company, to exercise independent judgment, to exercise reasonable care, skill and diligence, to avoid conflicts of interests, not to accept benefits from third parties and a duty to declare interests in transactions.

These are, importantly, duties owed to the company itself; not; generally speaking, to third parties such as shareholders or creditors. But what happens when a director commits fraud by misappropriating company assets?  Or what of the director who continues trading knowing that the company has no realistic prospect of paying its debts as and when they fall due? To whom does a director owe duties at that point and what recourse is there against that director? This article explores these questions.

Rogue One

Although a rogue director reaching into the proverbial cookie jar and diverting company funds/assets for their own gain (or others connected to them) would undoubtedly be in breach of their duties and/or guilty of misfeasance, any cause of action for that breach vests in the company itself. If the director is the one running the show, the company is very unlikely to investigate and bring such a claim, unless the shareholders themselves are able to take action, for example, through a derivative claim. This assumes, of course, the fraud has even been uncovered whilst the director is still in office. A rogue director may have gone to great lengths to cover their tracks such that the fraud is only uncovered months or years down the line when they have left office or the company is insolvent. In this scenario, is the director off the hook for breach of their duties?

In short, no.

Promotion of success

Firstly, section 172 CA06 (duty to promote the success of the company) imposes a statutory duty on the director to act for the benefit of its members as a whole, taking into account such matters as the likely consequences of any decision in the long term and the need to foster the company's business relationships with suppliers, customers and others. However, under section 172(3), that duty is subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company. This obligation to have regard to the needs of creditors applies generally when the company is in “financial difficulties”. In other words, the duty to take into account creditors can kick in where the creditors’ money is at risk; the company does not even have to be technically insolvent on a balance sheet or cash flow basis. The precise “tipping point” when the duties to creditors start to take priority will always be fact specific and directors in any doubt would be wise to seek urgent advice from both solicitors and insolvency practitioners.

Survival of duties

Secondly, the case of Re Systems Building Services Group Ltd (in Liquidation) [2020] EWHC 54 (Ch) has also made clear that even once a company has entered administration or liquidation, a director’s general duties under sections 171-177 continue. In that case, the sole director of Systems Building Services Group Ltd, Mr Mitchie, purchased from the company (acting by its original liquidator, a Mrs Sharma) a property for himself, which he knew to be at a substantial undervalue, days after the company went into administration. The transaction was challenged years later in 2016 when Mr Stephen Hunt had taken over Mrs Sharma’s appointments and began investigating her historic dealings. He applied to set aside various transactions but, particularly, to set aside the property transaction on the basis that Mr Mitchie had acted in breach of his duties to creditors arising under section 172(3). Mr Mitchie contended his director’s duties ended once the company went into insolvency. The court did not agree and confirmed that whilst the powers of a director cease upon a company entering into administration or liquidation, the duties continue.

Office holders’ powers

Thirdly, as insolvency practitioners will know, once an office holder is appointed they take over the management of the company and have the power to do anything necessary to manage the affairs, business or property of the company. In addition to investigatory powers of interview (which we wrote about in our first newsletter here and here) office holders have the power to bring legal proceedings on the company’s behalf. This includes the power to pursue directors for damages for breach of their duties to the company (or duties to creditors) and to bring claims under the relevant provisions of the Insolvency Act 1986 (the “Act”).

In circumstances where funds/assets have been misappropriated or fraud has taken place, in addition to a general breach of a director's duties under CA06, this might include the following possible claims against directors under the Act:

• Section 212 (misfeasance claims) Office holders can apply for an order from the court that both current and former officers of the company be compelled to repay, restore or account for money or property or any part of it (with interest) and/or contribute to the company’s assets by way of compensation for misfeasance or breach of duty. This power can also be wielded by creditors and shareholders with sums recovered paid into the insolvent estate;
• Sections 213 (liquidations) and 246ZA (administrations) (fraudulent trading claims) where any business of the company has been carried out with an intent to defraud creditors the court may declare any person who was knowingly party to such fraud liable to contribute to the company’s assets. This includes both current and former officers of the company;
• Section 214 (wrongful trading claim) which we have already written in depth about here;
• Section 238 (Transactions at an Undervalue) (“TUV”) where a director has caused the company to gift assets of the company at no consideration or at a value which is significantly less than the value provided by the company within certain time periods, the court can restore the position to what it would have been had the TUV never occurred;
• Section 239 (Preferences) where a director allows the company to do anything which had the effect of putting one of its creditors in a better position than it would otherwise have been in had the company gone into insolvency, the court will restore the position.  

Disqualification

Fourthly, it is also noteworthy that a failure to have regard to creditors’ interests when the duty under section 172(3) comes to the fore can also lead to disqualification proceedings being successfully brought under the Company Directors Disqualification Act 1986 (“CDDA”). Office holders are obliged to make reports on former directors if certain conditions under the CDDA have been met. Officer holders should also be aware of their reporting duties under section 218 of the Act. If its appears to the liquidator in a winding up that any past or present officer or shareholder might be guilty of an offence in relation to the company for which they are criminally liable (i.e. fraud) the office holder must report the matter to the Secretary of State and furnish such information as required to enable an investigation.

Limitation

The usual rules of limitation will apply to these types of claim unless otherwise specified in the Act. For example, the usual 6 year time period will apply for section 212 (misfeasance) claims beginning on the date the misfeasance or breach of duty complained of first arose. Section 238 or 239 claims have their own time limits by reference to the “relevant date” of insolvency; being a maximum look back period of 2 years for connected parties or, otherwise, 6 months.

However, just because a possible cause of action under one provision of the Act might be time barred, the law is clear that this does not time bar all alternative claims. In  Re Palmier plc (in liquidation) [2009] EWHC 983 (Ch), a section 212 Act claim was allowed even though an alternative claim under section 239 as a preference was time barred.

Notwithstanding the above, it is not all bad news for directors (the honest and reasonable director at least). Section 1157 of CA06 allows a director to plead as a defence to any claims against them for negligence, breach of duty, default or breach of trust that they acted honestly and reasonably and that it would be just to relieve them of liability in whole or in part. Section 1157 clearly rules out cases of fraud where the director’s dishonesty is at the heart of the allegations of breach of duty.

For those directors thinking of dipping their hand into the cookie jar during the current pandemic and hoping the world is too busy or distracted to notice, beware.  You might yet find a claim being brought against you.