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University directors and trustees reminded of fiduciary duties to creditors

Out-Law Analysis | 29 Apr 2016 | 3:55 pm | 2 min. read

FOCUS: A recent High Court case should be a reminder to university boards and trustees of the duties they owe to creditors should the institution find itself in financial difficulties.

As well as being a recent, rare example of a wrongful trading case making it to court, the Re Ralls Builders case is also significant as it sets out guidance for directors and trustees on what they should be doing when, for example, a company or institution is in financial difficulty.

Directors of educational institutions, or trustees if the institution is a charity, owe fiduciary duties both to the institution and its creditors. These duties become particularly important where the institution is in financial difficulty and in the so-called 'twilight zone' where potential insolvency becomes a real possibility, as directors who act in breach of their fiduciary duties to creditors run the risk of being held personally liable for the offence of wrongful trading.

In Re Ralls Builders, the High Court held the directors of a construction company liable for wrongful trading under section 214 of the 1986 Insolvency Act. This was because they continued to trade, and incurred further debts, after the date when they should have known that the company could not avoid insolvent liquidation and there was no reasonable prospect of securing significant outside investment.

However, the judge also found that the directors were not personally liable to make financial contributions to account for the new trading losses of the company incurred during the 'twilight zone', making the judgment in some respects helpful for directors and trustees. In addition, the judge gave a detailed overview of what would and would not be relevant to a defence to wrongful trading.

What should directors be doing?

Under UK law, there are two grounds on which a party can be considered insolvent:

  • cash flow insolvency, meaning it is unable to pay its debts as they fall due;
  • balance sheet insolvency, meaning it is unable to pay its debts on the basis that its assets are less than its liabilities, including contingent and prospective liabilities.

When an institution becomes insolvent - or, potentially, is merely of doubtful solvency - the primary focus of its directors' and trustees' duties shift from the shareholders to the creditors. To minimise the risk of liability for wrongful trading and vulnerable transactions, directors should take steps to avoid losses to creditors from an early stage.

Practically, for an institution in financial difficulty, this will mean:

  • carefully and frequently evaluating the financial position of the institution;
  • holding regular board meetings and taking detailed minutes;
  • taking documented professional advice and acting upon it;
  • complying with Higher Education Funding Council for England (HEFCE) reporting requirements;
  • being wary of entering into significant transactions, obtaining independent valuations where necessary.

The 2006 Companies Act sets out the broad duties of directors. Significantly for institutions, there is no distinction between the duties of executive and non-executive directors.

What defences are available?

Directors can defend themselves against claims of wrongful trading by showing that they took every step that they ought to have taken with a view to minimising the potential loss to the creditors; and that they took informed advice on their position and acted accordingly.

The decision in the Re Ralls Builders case gave detailed consideration and analysis of the circumstances in which directors can be liable for wrongful trading, and considered in detail the extent of that liability in monetary terms. It will be a useful decision for those assessing their potential exposure if they continue to trade in stretched financial circumstances.

Amy Flavell is an insolvency law expert at Pinsent Masons, the law firm behind Out-Law.com.