Director disputes: mistakes that can lead to personal liability

One of the most common misconceptions among directors is that the limited liability enjoyed by a company automatically protects them from personal consequences.

In reality, directors can face personal liability in a wide variety of circumstances, particularly where they have failed to comply with their legal duties.

There are many areas whereby personal liability exposure can occur, but there are many ways in which you can minimise your risk.

Personal guarantees: a signature that can have serious consequences

Many lenders require directors to provide personal guarantees as a condition of lending to a company. Whilst this can be an effective way of securing finance, directors often agree to such arrangements without fully appreciating the potential personal exposure involved.

A personal guarantee creates a direct contractual obligation between the director and the lender. If the company subsequently defaults, the lender may be entitled to pursue the director personally for the outstanding debt.

In practice, pursuing an individual under a personal guarantee can often be simpler and more cost-effective than enforcing security against a company. As a result, where financial difficulties arise, lenders may look to directors’ personal assets as a route to recovery.

Before signing a personal guarantee, directors should carefully consider the level of risk they are assuming and where possible, seek to:

• Negotiate lending arrangements that do not require personal guarantees
• Limit the amount or duration of the guarantee
• Cap liability to a fixed sum
• Ensure liability is shared between fellow directors rather than borne by one individual
• Obtain independent legal advice on the terms and implications of the guarantee

A personal guarantee may appear to be a routine document, but it can effectively bypass the protection of limited liability and place a director’s personal assets at risk. Careful consideration at the outset can avoid significant financial consequences later.

Continuing to trade when insolvency is on the horizon

One of the most serious risks for directors arises when a company is experiencing financial difficulties.

When a company approaches insolvency, directors must become increasingly mindful of creditor interests. Continuing to incur liabilities that the company cannot realistically repay can expose directors to allegations of wrongful trading or misfeasance.

Warning signs may include:

• Persistent cashflow problems
• Inability to pay suppliers or HMRC
• Reliance on emergency borrowing
• Missed payroll obligations
• Creditor pressure and statutory demands

Seeking professional advice at an early stage is often considerably less expensive than dealing with an insolvency claim later.

Misfeasance

This is a claim brought against a director or officer for the misuse of company assets or money. It is often when a company has been liquidated and the actions of the directors leading up to the insolvency are being investigated as they have caused harm or loss.

Examples are:

• Failing to act in the company’s best interests by using company funds for personal purposes, diverting business opportunities, or entering into transactions that favour personal interests over those of the company. Directors should identify, declare and appropriately manage any conflicts of interest
• Concealing or removing assets so that they are out of reach of creditors
• Taking a high salary which the company cannot afford, unauthorised loans to directors or the improper payment of dividends
• Preferential payment – for example, paying a family member over another creditor

Communication and record keeping

Many disputes arise not because of financial misconduct, but because communications break down. Examples include:

• Removing access to financial information
• Making decisions without consultation
• Refusing to hold board meetings
• Excluding shareholders from management
• Diverting business opportunities

Whilst directors understandably become frustrated during disputes, actions taken in the heat of the moment can often become key evidence in any subsequent claim.

When reviewing a director’s conduct, courts and advisers will frequently ask: Where are the board minutes? Why was this decision taken? Was any conflict of interest properly declared and managed?

In many cases, it is not the decision itself that creates difficulty, but the absence of a clear record explaining how and why it was reached.

Early communication, proper governance and accurate record-keeping can therefore play a crucial role in minimising allegations that a director has failed to comply with their duties.

Director duties

The Companies Act 2006 imposes several key duties on directors, including duties to:

• Act within their powers
• Promote the success of the company
• Exercise independent judgment
• Exercise reasonable care, skill and diligence
• Avoid conflicts of interest
• Not accept benefits from third parties
• Declare interests in proposed transactions

These duties apply to de facto directors and shadow directors too.

Many directors are surprised to learn that liability can arise even where there has been no dishonesty or deliberate wrongdoing.

A failure to properly consider relevant information, manage conflicts appropriately, or keep adequate records of decision-making can give rise to allegations that directors have fallen short of the standards expected of them.

Prevention is far cheaper than cure

In our experience, most director disputes do not arise because individuals set out to do the wrong thing. More often, they develop gradually through informality, poor communication, unmanaged conflicts and a lack of understanding of directors’ duties.

The consequences, however, can be significant. Directors may face personal claims, regulatory scrutiny, reputational damage and substantial legal costs.

Taking advice early, maintaining proper governance procedures and seeking to resolve disagreements before positions become entrenched can substantially reduce both legal and commercial risk.

The most expensive director disputes are rarely caused by one catastrophic decision. They are usually the result of numerous small decisions that seemed perfectly reasonable at the time.

How Morr & Co can help?

If you have any questions in regards to director disputes, personal liability or you would like any additional information on the content of this article, please do not hesitate to contact our Dispute Resolution team on 0333 038 9100 or email info@morrlaw.com.

Disclaimer
Although correct at the time of publication, the contents of this newsletter/blog are intended for general information purposes only and shall not be deemed to be, or constitute, legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article. Please contact us for the latest legal position.