What founders should know about insolvency risk

Directors’ duties change as a company approaches insolvency, and the change is not announced. What founders and boards should watch for, and when.

Insolvency law is written for the moment after a company fails, but its most important effects are felt in the months before. As a company approaches the zone of insolvency, the duties of its directors shift — from acting in the interests of shareholders to acting in the interests of creditors — and nothing external announces the change.

The shift in duty

Once creditors’ interests engage, decisions that were previously ordinary commercial judgment become exposed. Continuing to trade while incurring credit the company is unlikely to repay, paying one creditor ahead of others, or transferring assets to a related entity can all be revisited by an insolvency practitioner with the benefit of hindsight.

• Trading on while there is no reasonable prospect of avoiding insolvency
• Preferential payments to connected creditors within the look-back period
• Transactions at an undervalue, including intra-group asset transfers
• Granting security for existing unsecured debt as pressure mounts

Document the reasoning, not just the decision

The defence to most of these claims is that the board acted reasonably on the information available at the time. That defence depends entirely on contemporaneous records. Board minutes that record the forecasts considered, the advice taken and the basis for continuing are worth considerably more than a recollection offered two years later.

The question is never whether the board was optimistic. It is whether the optimism was reasonable, and whether anyone wrote down why.

Restructuring is an option, not a last resort

Companies that engage early have options: standstill arrangements, consensual rescheduling, a formal arrangement with creditors, or a sale of the business as a going concern. Companies that engage late have one option, and it is usually the worst one. The cost of taking advice at the point of concern is a fraction of the cost of taking it at the point of demand.