Directors’ Obligations When Insolvency Looms
New EU regulations mean directors of financially stressed companies must have regard to the interests of creditors, writes Ian Barrett, Managing Director in KPMG’s Restructuring Team
Recently, there has been much commentary on the prospect of a large increase in company insolvencies arising from the Covid-19 pandemic, along with an increasingly turbulent macroeconomic environment. The level of insolvencies since the onset of the pandemic in March 2020 has been widely described as artificially low. A high volume of corporate insolvencies has been avoided due to various government supports, tax warehousing and creditor forbearance.
Since supports have ended, businesses across a number of different sectors are also facing complex challenges such as inflation, interest rate rises, supply chain or output disruption and falling demand, ultimately leading to cash flow shortages and financial difficulties.
Boards of directors must understand their duties and obligations if their business is in financial trouble or at risk of insolvency, and what immediate actions need to be taken. Directors should be cognisant of the warning signs of financial distress, such as falling sales, continuous trading losses, cash flow shortages, loss of significant customers or clients, increased pressure from creditors, and bank overdraft facility constantly at its limit.
STATUTORY DUTIES AND OBLIGATIONS
Normally a director’s fiduciary and statutory duties are owed to the company and its shareholders. However, when a company is insolvent, directors’ fiduciary duties are extended, requiring directors to have regard for the interests of the company’s creditors. In addition, the European Union (Preventive Restructuring) Regulations 2022 introduced in July 2022 for the first time places a statutory obligation on directors to have regard to the interests of the company’s creditors “where the directors become aware of the company’s insolvency”.
PRACTICAL STEPS
Directors need to analyse whether the business is viable and can survive and, if not, explore the various restructuring options available. In addition, directors should ensure that financial information is accurate and up to date and hold regular board meetings to monitor trading performance and financial position closely.
Furthermore, detailed financial projections should be prepared for the next 12 months, which are stress tested for various adverse scenarios. These must also be regularly reviewed by the board, allowing directors to take appropriate steps to address any issues quickly. Finally, evidencing strong governance about the monitoring of the business and decision-making is very important, such as keeping detailed board minutes and paper trail documenting critical decisions.
CORPORATE RESCUE MECHANISMS
Examinership and the Small Company Administrative Rescue Process (SCARP) are formal insolvency processes that allow a company to restructure its debts and continue to trade. The processes allow a restructuring of debts by way of a compromise arrangement with its creditors, where a proportion of debts are usually written off, and the company agrees to pay back a lower proportion of the remaining debt.
SCARP was introduced as a more affordable process for small and micro companies, given that these companies make up around 98% of all companies incorporated in Ireland. Both processes are feasible options for potentially insolvent but viable businesses to continue trading and should be explored by directors.
EARLY INTERVENTION IS CRITICAL
Directors concerned about a company’s financial position should take professional advice regarding their legal obligations and potential solutions to deal with the financial position. Delaying decisions on seeking professional advice and/or taking steps to try to resolve a company’s financial difficulties may lower the prospect of recovery while the financial position of the business continues to deteriorate.
Company directors must recognise their duties and obligations when in financial difficulty and the potential consequences if the right actions are not taken.
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