Directors in the twilight zone

Directors in the twilight zone Neil Cooper Partner, Kroll Corporate Advisory & Restructuring Past President, INSOL International

The “Twilight Zone” • The period when the future of the company is uncertain - • Is it solvent or insolvent? • Is it profitable or loss-making? • In essence, will it survive or fail?

Introduction • considerable advances in corporate governance generally • insufficient consideration of liability in the twilight zone • two publications by INSOL International • In essence, it is the time when directors’ responsibilities change from protecting shareholders to protecting creditors

Main issues • On what does “twilight zone” depend • Actions giving rise to liability • Who may be liable • Orders available to the court • Impact on counterparties • Enforcement • Remedies • Duty to cooperate

On what does the “twilight zone” depend? • whether formal proceedings commenced? • actual or assumed knowledge of insolvency? • nature of transaction? • whether other party connected or associated? • any other factors?

Actions giving rise to liability • Breach of general & common law liabilities • Insolvency specific liabilities

Actions giving rise to liability – early stage • falsification of company's books • transactions defrauding creditors • extortionate credit transactions • fraud in anticipation of winding-up • false representations to company's creditors

Actions giving rise to liability -later stage • fraudulent (or dishonest) trading • wrongful (or negligent) trading • preferences • transactions at undervalue • incurring further credit during the twilight period

What defences are permitted? • lack of actual knowledge of insolvency • reasonable belief of solvency of company at time of/after transaction • benefit to company or group of related companies from transaction • other (e.g. technical defence no intention to prefer)

Who may be liable? • Directors • Shadow directors • De facto directors • Former directors • Lenders/financiers • Third parties dealing with directors with or without knowledge of insolvency

Orders available to the court • pay compensation to company • liability to creditors • disqualified from acting as director • imprisonment or fine • setting aside "tainted" transaction • postponing any debt owed by company to director

Duty to co-operate • who is subject to a duty to co-operate with the office holder • defence of privilege against self-incrimination? • court sanction to enforce duty by fine and/or imprisonment • statutory presumptions reversing burden of proof where connected parties concerned

Sundry issues • Time limits for actions • Appeal periods • Foreign application as well as domestic? • D & O insurance • Ability to incur further credit in twilight period

Pros and cons Pros • Stop recklessness before too late • Encourages responsible management • Incentive to hire professionals Cons • Accelerates collapse • Inhibits workouts • Weakens enterprise initiative • Increases risk to lenders & introduces uncertainty

In practice • Most directors start out honest • Poor results encourage little lies • which leads to bigger deception • and need to falsify • coupled with self-justification • and eventually little left to lose • And they can’t work out how it ended that way

International best practice • Need for positive encouragement for improved corporate governance • Financing consequences • Increased penalties for abuse • Wrongful trading test is most workable • Improved rescue laws provide viable alternatives to directors

Directors in the twilight zone