Updated: 4th February 2021
When a limited company becomes insolvent, directors are typically protected by the ‘veil of incorporation’ and don’t face the same risk of personal liability as sole traders, whose business debts must be paid from personal funds. This is because a limited company is classed as a separate legal entity from that of its directors and shareholders; the business operations and financial position of a sole trader, however, are indistinguishable from their personal position.
There are instances where directors aren’t protected, however, and if the interests of creditors aren’t placed first, whether deliberately or not, directors are susceptible to accusations of wrongful trading or misconduct.
So let’s look at what happens to directors when their company becomes insolvent. The first change occurs when an administrator or liquidator is appointed.
Control of the company passes to the administrator or liquidator as soon as they’re appointed. Directors must take a step back, but are expected to co-operate fully and provide any information requested by the office-holder.
As we mentioned earlier, the limited company structure means the business is legally separate from its owners, but in insolvency, certain circumstances can change this default position.
If a director owes money to the company, for example by way of an overdrawn directors' loan account, the office-holder will require repayment as the money belongs to the company and can be used to repay creditors. Similarly, if a director has provided a personal guarantee in order to obtain bank lending, the lender will demand payment of the outstanding amount as the company is no longer able to meet the terms of the loan.
In both of these cases, directors face legal action if they can’t afford to pay, with the potential for bankruptcy and loss of their home.
When a company enters insolvency, the actions of directors are investigated by the insolvency practitioner (IP) to establish the cause of the company’s decline. If any incidences of director misconduct or wrongful trading are found, directors face serious sanctions and fines.
Essentially, the investigator will want to know that directors prioritised the interests of creditors – in other words, that they did not engage in activity which could have worsened the position of outstanding creditors as soon as it was known the company was insolvent.
They will also look for instances where creditor interests were overlooked or ignored, such as if a loan with a personal guarantee attached to it was repaid in preference to other creditors.
Penalties for misconduct or wrongful trading include disqualification as a director for 2-15 years, financial penalties, personal liability for the company’s debts, and in cases of fraud, potentially a prison sentence.
A director of an insolvent company can become director of another company as long as they haven’t been disqualified or found guilty of any offence.
Directors who worked under a contract of employment at their company as well as being director, may be able to claim redundancy pay and other statutory entitlements, including unpaid wages and holiday pay. Eligibility criteria include working for a minimum of 16 hours per week in the business, and being paid via PAYE.
If your company is insolvent, or you are worried it is heading that way, it’s a worrying situation for you as a director. Begbies Traynor can help you deal with the insolvency, offering options for business rescue where appropriate. Please contact one of our expert team for more information – we operate a broad network of offices around the country, and can offer you a free same-day consultation.