A changing commercial and legal environment means directors are faced with increased risk of litigation if a company goes bankrupt. As the credit crunch increases Simon Goldring, partner and Charlotte Lilley of City law firm Reynolds Porter Chamberlain LLP look at what has changed and what steps directors should take to manage these risks.

The current economic conditions suggest the number of corporate insolvencies will increase substantially relative to the past sixteen years. It is stating the obvious that insolvency will be financially distressing for the company's stakeholders such as its suppliers, creditors and employees. However, we believe insolvencies will increasingly be financially ruinous for the company directors because of the increased threat of civil claims and director disqualification.

The risk of claims and disqualifications

The majority of civil claims against directors in the UK arise out of their company's insolvency. The company's liquidators are under a duty to maximise the assets of the company for the benefit of the creditors and so they will have to examine whether they should bring a claim against the directors, either under the insolvency legislation or for general breach of duty and mismanagement.

One potential claim under the insolvency legislation is a claim for 'wrongful trading'. Wrongful trading occurs when the company continues to trade even though the directors knew, or - importantly - ought to have known, that the company was insolvent and had no real prospect of avoiding insolvency. If found liable, the director may be personally liable and ordered to contribute to the company's assets usually to the extent of how much the company's financial position deteriorates from when the director knew or ought to have known there was no real prospect of avoiding insolvency.

Alternatively, the liquidator can bring a claim against the directors for breach of duty owed to the company itself. A common claim is for the repayment of dividends declared at a time when there were insufficient distributable reserves, and the director can be ordered to repay the dividends even if they have not themselves received any benefit.

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In addition, the liquidator is under a duty to compile a report on the directors' conduct which in turn could lead to their disqualification for a period of up to 15 years, affecting their ability to take part, directly or indirectly, in the promotion, formation or management of any company.

How are these risks different compared to the last recession?

The first significant change since the last recession relates to the funding of claims. Previously, high legal costs have deterred liquidators from pursuing claims against directors since by definition, there will be limited monies available to finance such claims. The availability of litigation funding has changed since the last recession in two respects, and we believe these changes could lead to an increase in claims against directors following a corporate insolvency. Conditional fees were introduced in the mid-1990s. These are 'no win no fee' agreements, so liquidators do not pay their lawyers if the claim is unsuccessful, thereby removing a large element of risk when deciding whether to pursue a claim. In addition, the law has recently changed to allow specialist investment vehicles such as hedge funds to fund litigation in return for a proportion of the damages. The combination of conditional fees and specialist litigation funders results in liquidators potentially having no risk in pursuing claims, and this will probably result in their increased appetite to do so in the future.

The second significant change since the last recession is the Companies Act 2006. There are three relevant aspects that could result in an increase in claims against directors. First, the Companies Act [1] codified the traditional directors' duties - these are now stated for the first time in one place. Secondly, it introduced a new duty so that directors must now act in the way they consider, in good faith, would be most likely to promote the success of the company, bearing in mind the interests of all of its stakeholders such as employees, creditors, the community and the wider environment. The interests of these stakeholders might conflict with each other, meaning the directors should consider key decisions carefully. The third relevant factor is the ability of the company's auditors to limit or cap their liability to the companies, for the first time. The result is that the liquidator may not be able to recover all losses from the auditors and so may have to target the directors for any shortfall. All commentators believe these three changes, all recently implemented, will increase the frequency and severity of claims against directors.

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Finally, the legislation concerning directors disqualifications was implemented in the mid-1990s as a reaction to the last recession, so this is clearly a new risk for directors.

Managing the risks

The above discussion begs the question of what steps directors should take to manage these risks.

First, there are certain actions a director can take if they see their company approaching insolvency. As soon as a director knows or suspects there is no reasonable prospect of avoiding insolvency the first action is to hold a board meeting with a view to seeking specialist insolvency advice and initiating insolvency proceedings. Where these points cannot be agreed a director should seek independent advice. In order to assess this position, it is crucial that the directors have access to the company's full and up-to-date financial information and projections.

Secondly, the directors should review their company indemnification agreements and D&O insurances. Company indemnification will be useless where the company is insolvent or otherwise financially unable to pay the indemnification and so in this context the D&O insurance is the best way for directors to manage their risk. A D&O policy is usually taken out by a company on behalf of its directors and officers to cover liabilities arising from their activities as directors or officers of the company, and these will typically cover the directors for any claims brought by liquidators and pay defence costs in company disqualification proceedings. In the present 'soft market' D&O insurance is relatively inexpensive, although commentators are expecting the rates and terms of these policies to harden in the next two years.