Directors and Officers: Fiduciary duties in hard times

A Knight’s Fiduciary Tale

A medieval landholder, in contemplation of his death before his son turned 21, made arrangements to leave his land to his eldest son. As such, a feudal lord would provide wardship to the deceased landholder’s estate and arrange the son’s marriage. This wardship would allow the feudal lord to retain a significant amount of the landlord’s estate in doing so. As a form of tax, the king and the feudal lords strongly profited from this which could lead to mismanagement of the estate and a lack of concern for the landlord’s children.  

However, to evade this, a trust was formed for the benefit of the landholder’s children which was to be managed by the trustees until the children turned 21. Naturally, principles and rules formed to ensure that the trust was managed in the best interests of the children or beneficiaries which includes fiduciary duties such as duty of loyalty and duty care. A trustee had a duty to reasonably manage the estate so the beneficiaries would be in as good, if not better, a financial position.

Over the ages, these duties and rules have expanded significantly. Similarly, directors and officers act as “trustees” of a corporation and shareholders, therefore, they owe a duty of loyalty, care, and other duties such as the financial health of a company.

Overseeing Financial Health

Directors and officers should be overseeing the cash flow and liquidity of the company. In fact, in BTI 2014 LLC (Appellant) v Sequana SA and others (Respondents) [2022] UKSC 25, the UK court held that when a company is in the “zone of insolvency,” a director also owes a duty to the company’s creditors, not just shareholders and the company. The UK Supreme Court stated:

Where the company is insolvent, or bordering on insolvency, but is not faced with an inevitable insolvent liquidation or administration, the directors should consider the interests of creditors, balancing them against the interests of shareholders where they may conflict. The greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors.

Here, the Supreme Court has strengthened this duty to creditors which creates a complex balancing act. It is also important that the non-executive directors or independent directors are involved in overseeing the cash flow and liquidity updates related to the Company. An independent director will have to be able to tell the executives on the team that they should not proceed in borrowing further funds.

D&O Mentality Makes a Difference

While different jurisdictions will have different tests and requirements related to insolvency, here are questions that directors should always have in the back of their minds when a company is on a downwards trajectory.

1. In the near future, does it look unlikely that we can timely pay our debts?

2. Can we pass the cash flow and balance accounting tests?

3. Is restructuring a possibility in the short, medium, and long-term to improve the company’s position?

4. Have there been any shareholder complaints about the way in which the company is being managed or should be managed?

5. How is your industry doing in general? What about your competitors?

6. What is the advice of your accountants, finance team, and counsel? Is it worth engaging more specialised professionals in this area to mitigate the risk of insolvency?

In addition to his or her fiduciary duties owed to the company and shareholders, directors should also be aware that they may be charged with or held liable for the following in relation to insolvency (this will differ depending on the jurisdiction):

1. Wrongful trading

2. Fraudulent Trading

3. Transactions at an Undervalue

4. Preferences

5. Disqualification

6. Material Omissions of a Company’s Affairs

7. Prospectus Misstatements

Courts will often look to see that directors and officers of an insolvent company acted honestly, reasonably, and responsibly in the time period preceding insolvency. As such, directors and officers should be proactive in ensuring that they are not only taking the right steps in preventing insolvency but also documenting these steps, as well.

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