As businesses grapple with such economic headwinds as rising interest rates, inflation and cost of energy crises, directors should be aware of their statutory obligations if their company is in financial difficulty or even insolvent. Many will be seeking professional advice from their accountant on their responsibilities and options.
Normally a director’s fiduciary and statutory duties are owed to the company and its shareholders. However, the European Union (Preventive Restructuring) Regulations 2022 transposed into Irish law in July 2022 now place a statutory obligation on directors to have regard to the interests of the company’s creditors ‘where the directors become aware of the company’s insolvency’.
As a result, for the first time there is a statutory obligation on directors to give genuine attention and thought to the interests of the company’s creditors, the need to take steps to avoid insolvency, and to avoid deliberate or grossly negligent conduct that threatens the viability of the company’s business.
When directors have reason to believe that a company is, or is likely to be, unable to pay its debts, then the duties under sections 224A and 228 of the Companies Act 2014 apply. Therefore, it is important for directors to be alert to the warning signs of financial distress. Below are some examples, with some usually occurring before others.
Company insolvency test
Two tests that determine whether a company is insolvent are the cashflow test and the balance sheet test.
For the cashflow test, the question is whether a company can pay its debts as they fall due. This criterion shows the importance of a board preparing regular and detailed cashflow projections with a focus on the immediate/short-term cashflow requirements for the business.
The balance sheet test is applied to show whether the company has sufficient assets to discharge its liabilities. It also focuses on whether it can meet its longer-term liabilities over time based on its asset position.
Directors must analyse whether the business is viable. If it is not, they must explore the various restructuring options available by obtaining professional advice. Directors should ensure financial information is accurate and up to date and hold regular board meetings to closely monitor trading performance and financial position. Financial projections should be prepared for the coming 12 months, stress-tested for various adverse scenarios and adjusted on the basis of any favourable or unfavourable events that have arisen since the projections were originally prepared.
Strong governance in relation to the monitoring of the business and decision-making is very important. It includes keeping detailed board minutes and documenting key decisions.
Examinership and the small company administrative rescue process (Scarp) are formal insolvency processes that allow viable but insolvent companies to restructure their debts and continue to trade. They allow the restructuring of a company’s debts by way of a scheme of arrangement or rescue plan agreed with its creditors, where a proportion of debts are written off, allowing the company to continue to trade.
Scarp was introduced as a more affordable process for small and micro companies in Ireland given that they make up around 98% of all companies incorporated in Ireland. Both examinership and Scarp are feasible options for small and micro companies to continue trading, and they should be explored by directors.
Directors concerned about a company’s financial position should take professional advice on potential solutions. They should be aware that delays in taking professional advice or taking steps to try to resolve a company’s financial difficulties may lower the prospect of survival and potentially worsen the financial position. It is important that company directors recognise their duties and obligations when in financial difficulty, and the potential consequences if the right actions are not taken.