The Liability of the Directors When a Company Cannot Pay Its Trade Creditors - Paper Example

Published: 2021-08-16
1939 words
8 pages
17 min to read
Wesleyan University
Type of paper: 
Case study
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In most cases, if a company has been responsibly managed and it reaches insolvency, its trading debts remain with the company. This is the case because once a company is registered, it becomes a separate legal entity. Being a separate legal entity means that the company has its own rights that are separate from its owners, managers, employees, and agents. A company can, therefore, enter into contracts, own and dispose property and other assets, and sue or be sued (Altman and Hotchkiss 2010). This provision of the law applies even in insolvency. Note that for the company has to responsibly managed. However, there are some particular instances when the directors of the company can be held responsible to meet its trade debts. Such cases are discussed below.

Debts Incurred When the Company becomes Insolvent

Jacob Roberts has discovered that Law Training Tomorrow Limited (LTT) cannot pay its suppliers to the extent that the creditors have served the company with statutory demands for payments. This is an indication that the company is insolvent. As it stands, Jacob and other directors are not liable for LTT debts. However, as the directors of the firm, they may decide to take up more loans and debts in order to save the company from completely shutting down its operations. In case they decide to take this action, they will be personally liable for the debts they incur when LTT fails to pay back the debts. One of the fundamental duties of the directors at LTT is to ensure that the company does not trade while it is insolvent. Additionally, trading while bankrupt can be considered illegal and punishable by the law (Von Eije and Megginson 2008). It is for this reason that they would be personally responsible for the companys debts.

Company Losses Caused by Neglect of Directors Duties

As mentioned earlier, for a company to be liable for its debts even during insolvency, it must have been responsibly managed before it went bankrupt. If a director breaches or neglects his duties and as a result causes the company to suffer some loss, that particular director can be held responsible for the debts (Hill and Painter 2009). In the case of LTT, Peter Myddelton is the cause of the companys insolvency. Even though health issues cause him to neglect his duties, he should be liable for the losses as the situation could have been avoided. In case a director is sick and cannot fulfill his obligations, he is supposed to delegate his responsibilities to other directors or give up the position of a director in the company. Peter fails to do any of the two causing LTT severe issues with its suppliers. It is important to note that as a director, the obligations to the creditors may continue even after the company ceases to trade or is deregistered. The law does not apply to the members of the company or the shareholders. For shareholders, the only obligation is to pay the company any unpaid amounts on their shares on when called upon to do so.

Other consequences for a director failing to perform their duties include being guilty of criminal offense punishable by the law either attracting a penalty of $200,000 or imprisonment for up to five years or both, being prohibited from managing any other company and attracting a civil penalty provision.

Guarantor or Security of Personal Assets

It is a common commercial practice that a bank, trader credit or anyone else providing financial assistance to a company asks for a personal guarantor of the companies liabilities, some form of security over a directors own assets. Such practice acts as security by the company to meet its obligations. If the company fails to meet these requirements, any of the people who acted as personal guarantors are liable (Altman and Hotchkiss 2010). In most cases, the directors act as guarantors for their company. If any of the directors at LTT has personally guaranteed for the company, they will be personally liable for the firm.

Question 1 (b).

The Effect of Peters Position as a Director at LTT to the Company if He is Declared Bankrupt

It is possible for companies directors to go bankrupt. In the case a director is declared bankrupt, he or she should resign the position in accordance with Company Directors Disqualification Act. One is allowed to resign any time before you apply. However, the resignation must be done no later than the date of a bankruptcy order being made against you. It is possible for the bankrupt directors to continue working for the company as employees earning a monthly salary with applicable deductibles including taxes and national insurance. However, such employees should not be involved, either directly or indirectly, in the promotion of the business, formation, and management of the company (Hill and Painter 2009).

A company and its directors are separate legal entities. In the same sense that a director is not liable for the companys obligations in case of insolvency (unless in the cases mentioned earlier including personal guarantee), the company is also not responsible for the financial obligations of any of its directors declared bankrupt. Therefore, a directors bankruptcy should not affect the companys finances including its bank account, cash balances, and cash equivalents or any other assets owned by the firm. This is the same as that would happen to LTT if Peter were declared bankrupt.

There are some instances where a directors bankruptcy may affect the business, especially in smaller owner-director companies. For such firms, if the directors personal bank account is with the same bank as the businesss account, the bank is made aware of the directors bankruptcy. This raises concern about the viability of the company itself. As a result, such an organization may see its credit facilities including bank overdrafts or credit cards reduced or withdrawn altogether. Again, if Peter is declared bankrupt and he holds a bank account with the same bank as LTT, the company may suffer this fate.

Question 2 (a)

Can LTT Purchase Peters Share if He Chooses to Leave?

In most countries, it is possible for a company to buy back its shares from the shareholders. In the United States, before the Companies Act in 2006, a company was prohibited from buying back its own shares. Shareholders wishing to sell their shares were forced to look for a third party to purchase the shares. Currently, the companies can buy back their shares under very restrictive provisions of the Act. It is, therefore, possible for LTT to repurchase Peters shares as no other party is interested in buying them.

What will Happen to LTT if they Buy Back the Shares?

When LTT decides to but backs Peters shares, the directors should know that the company will receive nothing of financial value in return. The shares will instantly be worthless after the repurchase hence will have to treat them as canceled. If LTT was a public company, canceling the shares after a buyback would have reduced the number of shares in issue. The overall effect is that profits per share will have increased (Von Eije and Megginson 2008).

How can LTT Finance the Buyback?

The Companies Act of 2006 goes ahead to give provisions of how such repurchases should be financed. The first method is through the use of distributable profits. Section 830 of the Act defines distributable profits as the accumulated or realized profits less its losses. The Act requires that the repurchase of the shares be paid immediately. In case buying back uses all the distributable profits, a company has the option of using some its existing capital to finance the repurchase. This is known as buyback out of capital (Altman and Hotchkiss 2010).

One issue with buying back out of capital is that it increases the companys risk to insolvency. The reduction in capital means that the company owns less than its original investment as repurchases do not have any financial value to the firm. Consequently, the amount of capital available to pay the creditors reduces. In this regard, it is likely that the creditors will receive less money after the buyback. It is for this reason that the creditors must be notified if the company wishes to finance the repurchase the shares out of capital as it will be mentioned later. If the company is declared insolvent after evidently buying back its shares out of capital, the directors may be liable for the companys financial obligations. In some instances, they may even face criminal charges. As LTT is currently facing the possibility of insolvency, it is advisable that it repurchases the shares from Peter using its distributable profits.

Question 2 (b)

Procedure of Stock Repurchase

As mentioned earlier, before the Companies Act of 2006, it was not legal for a company to repurchase its shares. When the Act was passed, it did not only allow the companies to buy back the shares but also laid out the particular procedure for the firms wishing to repurchase their stock from the shareholders. This procedure must always be followed by all the companies. If the directors at LTT Ltd decide to buy back shares from Peter, the process should also be adhered to.

The first step in buying back the shares involves checking the companys Articles of Association to see if it contains a provision authorizing buying back of own shares. If the Articles does not include such a provision, it is altered by passing a special resolution in the general meeting. The firm can then proceed to convene a Board Meeting after giving notice to all the directors. The directors should propose a statement during the meeting. The Directors statement specifies the amount of capital to be used in repurchasing the shares. The statement should also stipulate that the firm fully examined its affairs and prospects and the directors are sure that after the repurchase, there will be no basis for saying it is unable to pay its debts and that there are enough resources to continue with business operations as usual. For these reasons, an auditors report must be attached to the statement (Hill and Painter 2009).

The auditors report must indicate that auditors have investigated the companys financial position and agree that the amount of capital to be used to repurchase the shares as specified in the Directors statement has been accurately determined. The report should also support the directors opinion that buying back the shares will not affect the companys financial resources. The next step is the shareholders approval of the contract between the company and the director wishing to sell back their shares. This can be done by the passing of an ordinary resolution. The buyback contract should then be availed for inspection by the shareholders at the firms office at least 15 days before passing the ordinary resolution. The director selling back the shares loses voting rights.

Approval by Special Resolution

In most cases, the company buying back its shares uses its capital. In such instances, the shareholders of the business must pass a special resolution that authorizes the payment to be made out of its capital. The earlier mentioned directors statement should be signed the same day of passing the special resolution or within the week. In addition to availing the directors statement to the shareholders before the vote, the auditors report should also be provided. If the voting takes place in a meeting, the documents can be shown to them. If otherwise, the two documents should be sent to the shareholders. If they vote to give the company the go-ahead to repurchase the shares, the business undertakes the next step.

Publishing Notices

The company publishes notices saying that the shares will be repurchased using its capital. The announcements are meant to give the credi...

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