Introduction
Company directors in England and Wales are subject to a range of duties, primarily codified in the Companies Act 2006 (CA 2006). The central duty is to act in a way that promotes the success of the company for the benefit of its members. However, this focus shifts significantly when a company encounters financial difficulties. At this point, the law expects directors to possess, or acquire, a specific awareness of the company’s financial state and to act accordingly. This essay will explain the knowledge expected of a director in these circumstances, focusing on the common law duty to consider creditors' interests and the statutory standard of knowledge required to avoid liability for wrongful trading under the Insolvency Act 1986 (IA 1986).
The Shift in Directors' Duties
The starting point for any director's duties is section 172 of the CA 2006, which requires a director to "act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole". This is a subjective duty, focused on the director's good faith judgment. However, the duty is not absolute. When a company approaches insolvency, the interests of its creditors become increasingly relevant. This common law principle, established in cases like West Mercia Safetywear Ltd v Dodd [1988] BCLC 250, is now acknowledged in section 172(3) CA 2006, which states that the duty to promote the company's success 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 means that as the prospect of insolvency becomes more real, directors are expected to have the knowledge that their duties are no longer solely focused on the shareholders. They must understand that their decisions could now directly impact the creditors' chances of being repaid. Continuing to trade in a way that benefits shareholders at the expense of diminishing the assets available to creditors can lead to a breach of this duty. Therefore, a director is expected to know when the company's financial position has become so precarious that the interests of creditors must be taken into account.
The Standard of Knowledge for Wrongful Trading
The most significant legal provision regarding a director’s required knowledge during financial difficulty is section 214 of the Insolvency Act 1986, which deals with wrongful trading. This section can make a director personally liable to contribute to the company's assets if they allowed the company to continue trading when they should not have. Liability arises if, at some time before the commencement of the winding up, the director "knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation".
The phrase "knew or ought to have concluded" is critical as it establishes an objective standard of knowledge. A director cannot simply claim ignorance of the company’s dire financial state. Section 214(4) IA 1986 sets out a two-part test for assessing what a director "ought to have known". The facts which a director ought to know or ascertain are those which would be known or ascertained by a reasonably diligent person having both:
a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director (the objective test); and b) the general knowledge, skill and experience that that director has (the subjective test).
This dual test means that every director is judged against a minimum objective standard. As held in Re Produce Marketing Consortium Ltd (No 2) [1989] BCLC 520, directors are expected to keep themselves informed about the company’s financial affairs. They have a duty to monitor the company’s performance and cannot avoid liability by being passive or failing to pay attention to warning signs like unpaid taxes or creditors threatening legal action. Furthermore, if a director has specialist expertise, such as being a qualified accountant, the subjective part of the test will hold them to a higher standard based on that expertise (Dignam and Lowry, 2022). Therefore, the law expects a director to actively seek out knowledge about the company’s financial position, review accounts, and if necessary, seek professional advice when they see signs of trouble.
Conclusion
In conclusion, a company director is expected to have a significant level of knowledge when their company is in financial distress. This begins with the understanding that their primary duty under section 172 of the CA 2006 shifts from promoting the success for members to considering the interests of creditors. More specifically, the wrongful trading provisions in section 214 of the IA 1986 impose a standard of knowledge that is both objective and subjective. A director is expected to know what a reasonably diligent person in their position would know about the company's financial health. This requires active monitoring and a realistic assessment of the company's prospects. Ignorance is no defence; the law expects directors to be informed, and a failure to meet this standard of knowledge can result in personal liability for the company's debts.
References
- Dignam, A. and Lowry, J. (2022) Company Law. 12th edn. Oxford University Press.
- Re Produce Marketing Consortium Ltd (No 2) [1989] BCLC 520.
- West Mercia Safetywear Ltd v Dodd [1988] BCLC 250.
- Companies Act 2006.
- Insolvency Act 1986.
