Personal Liability of Directors: Director Duties When Trading in the Insolvency Zone

Directors of Hong Kong companies under cashflow pressure or financial distress should be aware that as their companies approach insolvency, their duties are increasingly owed to the creditors of their companies rather than to the shareholders of their companies. Pressure from suppliers and other creditors to make payments can place directors in a difficult position of incurring personal liability. In this article, we explore director duties in times of possible corporate bankruptcy and some risk areas from a liability perspective.

Where companies experience financial difficulties, their directors may be called upon to make decisions as to which creditors to pay and how much. How a director chooses to make these decisions may affect the probability that, should the company be wound up on an insolvent basis, the liquidator, on behalf of the company, will pursue the director for compensation or refer the director to the Official Receiver for potential criminal prosecution or director disqualification.

Directors' Duties

In general, a director owes both a statutory duty of care under the Companies Ordinance to exercise reasonable care, skill and diligence in carrying out his functions as a director as well as a fiduciary duty to act bona fide (i.e. in good faith) in the best interest of the company.

General Duty to Shareholders Outside of Insolvency Context

These duties are owed to the company itself but at law, in the normal course, the will of the shareholders is the will of the company, meaning that should a director breach his duties to a company, the shareholders will normally be able to ratify the breach so as to absolve a director of any liability for such breach.

Fiduciary Duties to Creditors in Insolvency Context

However, when a company enters the insolvency zone, though the duties of a director are still owed to the company alone, the interests of the shareholders are no longer paramount in determining whether a director has satisfied his fiduciary duties. Instead, in satisfying these duties, a director must first take into account the interests of the creditors as a whole and then the interests of the shareholders. This is because where a company is wound up on an insolvent basis, the creditors are entitled to look first to the assets of the company to satisfy their claims in priority to those of the shareholders.

Triggering the Duty to Creditors: Meaning of Insolvency Zone

A threshold issue for a director is whether his company has entered the “insolvency zone”, thereby triggering the duty to take into account the interest of creditors. Naturally, a company has entered the insolvency zone if it is in fact insolvent. In this regard, a company is insolvent if:

• Cash Flow Test – the company is unable to pay its debts as they fall due; or

• Balance Sheet Test – the company’s liabilities exceed its realizable assets.

However, there is some uncertainty under Hong Kong law as to when a company may enter the “insolvency zone” before actual insolvency.

• Imminent Insolvency – There is no real possibility that the company can avoid the insolvency, meaning that although the company is not yet insolvent, it will become insolvent as a matter of course in a short period of time. 

• Likely Insolvency – It is probable that a company will become insolvent. There remains a real possibility that the insolvency can be avoided but the possibility is unlikely to materialize.

• Real Risk of Insolvency – An insolvency is not necessarily probable but there is a realistic probability that the insolvency may arise.

In practice, when a director knows or should know that the company is or is likely to become insolvent, he should take into account the interests of creditors in making decisions.

This means at the least that he should be free to act with regard only to the interests of shareholders where insolvency is only one of many possible but realistic outcomes but he must act with regard to the interests of creditors where the insolvency is inevitable.

Requirements and Standard of Duty

As a company enters the insolvency zone, a director has a duty to preserve the assets of the company to make them available for distribution to creditors as a whole. In so doing, he must act bona fide in what he honestly believes is in the best interests of the company.

Thus, a director who acts under an honest belief that he is acting in the best interests of the company will bear no liability simply because his actions appear to be unreasonable or because his actions happen, in the event, to cause injury to the company.

However, while the court seeks to identify what is in the mind of a director, a director should bear in mind that where it is clear that an act or omission results in substantial detriment to the company, he will have a harder task persuading the court that he honestly believed it to be in the company’s interest.

Thus, for example, where a director has a personal interest in making a payment to a creditor which puts that creditor in a better position to the detriment of other creditors, it is likely that a court would have difficulty believing a director’s assertion that he believed the payment was in the best interests of the company.

Accordingly, in these circumstances, the court may compel the director to personally restore the company back to its pre-payment position.

Interests of Creditors "as a Whole"

A company may have different classes of creditors, such as secured creditors whose claims are secured over assets of the company, preferential creditors such as employees, and unsecured creditors such as typical trade creditors who provide goods and services to the company but hold no security interest.

As a company enters the insolvency zone, directors should have regard to the interests of the creditors as a whole rather than to a particular class of creditors.

In light of the foregoing, a director might be in breach of duty if he acts to advance the interest of a particular class of creditors and such act is inconsistent with the interest of all creditors in general. On the other hand, a director may act to advance the interests of the creditors as a whole even though such act may be inconsistent with the interest of a particular creditor class.

Thus, for example, a director who honestly and reasonably believes that a company would be able to trade to generate money to repay liabilities owed to creditors in general need not wind up the company even though a winding-up would benefit preferential creditors as these preferential creditors would then be entitled to payouts ahead of all unsecured creditors.

Unfair Preference

Complementing these fiduciary requirements, the Companies (Winding-up and Miscellaneous Provisions) Ordinance enables a court to:

• reverse any payment or other disposition of property made to a creditor where the payment or disposition constitutes an “unfair preference” given with the desire to prefer that creditor; or

• compel a director who wrongfully made such payment to restore the money to the company.

In this regard, a company will be regarded as giving an unfair preference to a creditor if, within a prescribed period before the commencement of a winding-up, the company does anything which has the effect of putting a creditor in a better position in the event that the company goes into liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the winding-up.

What Constitutes a Desire to Prefer Creditors

Whether the company was influenced by a desire to put that creditor in a better position will normally depend upon the state of mind of the directors.

However, where a company gives an unfair preference to a director or other person connected with the company (except by reason only of that person being an employee), unless otherwise proven, the law presumes that the preference was given with a desire to prefer that person.

Director's Loan to Company Secured by Floating Charge

Whether a director may be personally liable for an unfair preference will depend not only upon his role in giving the unfair preference but also his state of mind in so doing.

In one case, a director advanced funds to the company at a time when the company was in financial distress and caused the company to grant a floating charge to himself to secure the advance. The funds so advanced were used to reduce indebtedness owed to a bank.

The court accepted that the director’s advances to the company were made to enable the company to continue trading and that the company’s decision to grant him that security for his advances was influenced by the need to raise money from a source other than the bank (which had an upper limit on the overdraft) in order to keep on trading. The court thus held there was no unfair preference.

Repayment of Loan Guaranteed by Director

However, a director of an insolvent company might be liable if he causes the company to make selective payments to a particular creditor to repay a loan which the director himself has personally guaranteed (thereby reducing his own liability on the guarantee).

Fraudulent Trading

If, upon the winding-up of the company, it is found that the director has knowingly engaged in “fraudulent trading”, the director may not only be personally liable without limitation for any and all liabilities of the company but may also bear criminal liability. This is so even if the transaction is voided as a disposition of property with intent to defraud creditors.

In this regard, under CWUMPO, fraudulent trading takes place where any business of a company has been carried on with the intent to defraud creditors or for any fraudulent purpose.

Element of Dishonesty

In determining whether fraudulent trading has occurred, the courts will look at whether a person carrying on the business has been dishonest. This will depend on an assessment of all the facts.

By way of example, the courts will have little difficulty in finding that a director has been dishonest if, at a time when the company could not pay its debts:

• he has ordered goods greatly in excess of the company's normal requirements so that they would be subject to a creditor’s floating charge and reduce the amount for which the director himself would be personally liable on his guarantee of the company's indebtedness;

• he has obtained credit on behalf of the company from a creditor by deceiving the creditor into believing that it would be paid when the sums fell due when, in fact, the director knew perfectly that there was no hope of that coming about; or

• he has caused an insolvent company to continue to trade to obtain goods and services from a creditor by making misrepresentations about the company’s financial position whilst knowing that the company would never be able to make any payment to the creditor and the creditor would never be able to recover anything when the company went into liquidation.

This does not mean that the courts will necessarily find intent to defraud creditors merely because there is little prospect of the creditors getting paid. Where a director honestly believes that there is a reasonable prospect for the company to trade out of its financial difficulties and to repay debts incurred, a court is unlikely to find that the director had engaged in fraudulent trading even though objectively speaking the company may have had a low likelihood of survival.

Managing Personal Liability Risk of a Director

The position of a director is one of increasing personal risk as a company approaches the insolvency zone. On the verge of corporate bankruptcy, directors must be careful to balance the interests of the creditors as a whole against the interests of shareholders and must ensure that they act honestly and without bias, lest a liquidator if appointed, finds fault with them.

The law in this respect is complex and directors should consider seeking legal advice if they face pressure from competing creditors. Directors may also consider company or debt restructuring options to relieve cashflow pressure and avoid corporate bankruptcy.