The Twilight Zone ends with the formal insolvency of the company or financial recovery (e.g. through obtaining further investment, getting a loan or sale of a loss making part of the business) and a return to normal trading conditions. It is hard when running a business to pinpoint when you enter the Twilight Zone. Some of the key practical indicators are:

• Are you failing to keep up with payments to your bank or funders



• Are you experiencing cash flow problems



• Are their rumours flying around about your financial status



• Are your creditors calling you all the time



• Have you lost your creditor insurance



• Is there pressure on the confidence of your managers and their capacity

In addition you need to consider whether you are legally insolvent. If you are unable to pay your debs as they fall due and/or if your current liabilities exceed your current assets then legally you are insolvent.

If the directors continue to trade after the time when they knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation, they may find themselves personally responsible for the increase in the liabilities which the company incurs from that point onwards, if the company does subsequently move into liquidation. These liabilities will include all new credit assumed and all trading losses, and a comparison will be made between the net deficiency of the company's assets at that point and the net deficiency of assets once in liquidation.

In assessing what the directors knew or ought to have known, a director will be judged against the higher of two standards:-

• The general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as were carried out by the director (the "objective" test).



• The general knowledge, skill and experience that that director has (the "subjective" test).

While a higher standard can be expected of a managing director than of a non-executive director, all directors will be expected to have knowledge of the company's financial affairs: it is no defence for a main board marketing director to say that he relied entirely on the finance director to draw matters to his attention relating to the finances.

Defence. There is only one defence available to a director facing a claim for wrongful trading; namely, to show that he took every step with a view to minimising the potential loss to the company's creditors. Provided a director can show that he has taken reasonable and objective business decisions based on accurate financial information and appropriate professional advice, he is likely to be able to rely on this defence even if his decisions turn out to have been commercially wrong.

Expert advice. While legal advice is very important for directors at this time, lawyers are generally unable to answer the key question asked by directors: is the company wrongfully trading, and should they carry on? This is a commercial rather than a legal question, and the lawyers must force the directors to examine the company's financial position and assess the likely outcomes themselves. If the position deteriorates, it is often sensible for the board to seek advice from an insolvency practitioner to ensure that any decisions taken can withstand objective and independent scrutiny, should the issue of wrongful trading subsequently arise.

Continuing to trade. Although it may appear counterintuitive, there can be particular circumstances in which it may be appropriate for directors to allow the company to continue to trade even after the conclusion has been formed that insolvent liquidation cannot be avoided, in order to avoid the potential for a wrongful trading claim.

For example, if the company owns valuable intellectual property rights which will achieve a much higher value when sold by the company on a going concern basis, and lose that value on insolvency, it may well lead to a better outcome for creditors if the company is traded for a further period to allow those rights to be marketed and sold. The difficulty will be judging how long to keep trading if a buyer cannot quickly be found.

In practice, claims for wrongful trading are rare and expensive to bring, and provided that the directors carefully monitor the financial position (which includes considering cashflow forecasts and compliance with financial covenants), hold and minute regular board meetings and take professional advice, they are unlikely to face a claim under this provision.

Where the directors have misapplied or retained, or become accountable for, any money or assets of the company; or where the directors have breached a fiduciary duty to the company then the charge of Misfeasance will be possible.

Once again, directors will need to pay due attention to both the "subjective" and "objective" tests (see "Wrongful trading" above). The court may grant relief to directors from liability if they acted honestly and reasonably, however, a director's incompetence is not sufficient to create a defence to a misfeasance claim.

Claims on the basis of fraudulent trading are less commonly seen. This is because to establish fraudulent trading, the liquidators must be able to prove that the directors carried on the business with the intent to defraud creditors or for some other fraudulent purpose.

It is not enough, to establish fraudulent trading, to show that the company continued to run up debts when the directors knew that it was insolvent. There must be "actual dishonesty, involving real moral blame". Thus most Liquidators concentrate on trying to show wrongful trading which has a similar civil liability penalty.

In addition to the civil liability to pay compensation, there is a criminal sanction for fraudulent trading which is applicable at any time (rather than just on insolvency).

INDEMNITIES AND INSURANCE

Among the most valuable protections for a director faced with claims against him will be an indemnity from his company and/or insurance.

Provisions purporting to exempt a director from his liabilities in respect of his company are void but exceptions to this general rule are that in certain circumstances, a company can indemnify its directors, and that a company can purchase directors' and officers' liability insurance (D&O insurance) for the benefit of its directors.

It is particularly important in the current climate that companies and their directors give careful thought to the issue of whether the company will indemnify its directors and, if so, on what terms, and whether D&O insurance will be bought by the company for the benefit of its directors.

Indemnities

A company may indemnify its directors in respect of proceedings brought by third parties, including legal costs and any judgment against the director, except for the legal costs of the unsuccessful defence of criminal proceedings, fines in criminal proceedings and penalties imposed by regulatory bodies. A company may also pay directors' defence costs as these are incurred (even in an action brought by the company itself, provided that the director will be liable to repay these costs to the company if the defence is unsuccessful).

Importantly, however, a company will only be able to provide its directors with an indemnity within the rules if:

• Its memorandum and articles of association permit this.



• The indemnity is evidenced in a written agreement between the director and his company.

D&O insurance

As a practical matter, any indemnity provided to the director by his company will only be as good as the covenant that the company is able to provide. As discussed, many claims against directors arise on insolvency, and the company will be in no position to protect its director by an indemnity in those circumstances. This is one area, therefore, where the availability of D&O insurance may be particularly important.

The D&O policy is, in a sense, an unusual form of insurance because, while it is bought by the company, the party who benefits from it is the director. Claims against directors are often very costly to defend and, if made out, frequently lead to sanctions other than damages, such as fines, disqualification and even loss of liberty. Given the nature of claims against directors, perhaps the greatest value of the D&O policy is therefore as a fighting fund.

Directors' duties: checklist

In order to encourage compliance with directors' duties, companies should consider:

• Whether board members are actively aware of their obligations under the Companies Act 2006, particularly their obligation to promote their company's success for the benefit of its shareholders.



• Whether board members are aware of the practical effects of these obligations for their day-to-day roles.



• Establishing or refining training for newly appointed directors.



• Establishing or refining refresher training for existing board members.

Directors should:

• Hold frequent board meetings convened specifically for the purpose of reviewing the company's position, and keep proper minutes of those meetings; in particular, any decisions made and the reasons for them.



• Keep accurate company financial records and ensure these are up to date.



• Undertake a thorough business review of the company's financial position and future cash flows and consider ways to reduce expenditure.



• Take professional advice aimed at reviewing whether insolvent liquidation is inevitable, or whether there is some way of resolving or mitigating the financial difficulties.



• Keep the company's position under constant review unless and until the financial difficulties are resolved, including both reviewing the financial position, and, if there is any change in that position, taking further professional advice in light of the change in circumstances.



• View resignation as a last resort. If it becomes unavoidable, always minute dissent with other directors at a full board meeting and set the reasons out again in a resignation letter to the whole board.

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