Directors personally liable for invalid solvency statement and breach of duty

Out-Law Legal Update | 21 May 2018 | 10:26 am | 3 min. read

LEGAL UPDATE: A solvency statement was found to be invalid, a reduction in capital and distribution unlawful and three directors in breach of their duties after a corporate reorganisation left a company unable to meet its liabilities, the High Court has ruled.

The High Court has ruled that a director's solvency statement made in respect of a corporate reorganisation was invalid because the reorganisation left the company unable to pay its debts, despite the company being balance sheet solvent. The directors were personally liable for the invalid statement, the unlawful capital reduction and distribution and had breached their duty to promote the success of the company.

In 2009 as part of a reorganisation LRH Services Ltd (LRH) reduced its share capital to £1 and made a distribution to its shareholder of around £21.3 million. While LRH was a non-trading company, it was the tenant of a number of commercial properties, some of which were occupied by its trading subsidiaries. When an occupier failed to pay its rent, LRH was unable to keep up with its lease payments, and eventually a landlord commenced winding-up proceedings against it. The company entered liquidation in 2010.

LRH's liquidators brought claims against its former directors, Raymond Trew, Derek O'Neill and Jason Brewer. The basis of the claims was that the reduction in share capital and payment of the £21.3 million dividend was a breach of the directors' duties under the Companies Act 2006 (CA06) to act in good faith in promoting the success of the company and exercise reasonable care and skill.

Under section 643 of CA06 a company can reduce its share capital if each company director makes a solvency statement. The solvency statement declares that each director has formed the opinion that, if the capital reduction takes place, there is no ground on which the company would then be unable to pay its debts over the 12 month period following the statement. Without reasonable grounds for holding such an opinion, a director can be criminally liable.

A solvency statement is not automatically invalid if the directors lack reasonable grounds, if their opinion was honestly and genuinely formed, as was made clear in a 2014 High Court case between BAT Industries and Sequana. However, if a solvency statement is found to be invalid, all actions resulting from it would also be invalid and those carrying out those actions could be potentially personally liable.

Trew was a director at the time that the solvency statement was made, Brewer became finance director after the statement was made, but before the dividend was paid, and O'Neill had been the finance director prior to the statement being made and he had been instrumental in the planning of the reorganisation, although he resigned hours before the solvency statement was signed.

The judge clarified that while courts will not scrutinise the reasonableness of the director's opinion in determining validity, the court will consider whether the directors have:-

  • considered the contingent and prospective liabilities of the company, and
  • considered what assets are properly available to the company in order to meet its debts, and, if necessary, set aside specific assets or put in place arrangements to produce income or assets sufficient to discharge the company's liabilities as they fall due, for the next 12 months.

The court reasoned that Trew had failed to make any enquiries into or give any thought for the company's actual liabilities. Liability under the leases was not in doubt at any point, and therefore a commercial assessment should have been undertaken, and provisions made accordingly. Trew wrongly assumed that, if necessary, the company would be able to meet its liabilities through the support of its parent company, even though there was no guarantee in place.

The court also found O'Neill responsible even though he resigned before the solvency statement and the distribution that relied on it were made, saying that "the reality is that they were the implementation of the plans that he had put in place while acting as a director. As I held above, he intended this result and realistically knew that there was no genuine prospect that it would not eventuate after his resignation…O'Neill therefore knew the essence of the basis on which the solvency statement was being improperly made and must be regarded as responsible for the fact it was so made."

Brewer was also found responsible as he took part in the resolutions to implement the capital reduction and dividend without making any enquiry at all about the propriety of these measures or what if any steps had been taken to justify them. The court considered that "he was, in the true sense, reckless as to whether they were proper, and is responsible for the consequences of the fact they were not."

The judge ruled that:-

  • each director had breached his duties to act in the best interests in the company, by taking actions that meant insolvency was inevitable, and
  • the solvency statement was invalidly made, the capital reduction and distribution unlawful, and each director was personally liable for the full amount of the assets unlawful paid away, potentially the entire £21.3 million dividend paid out.

This judgment demonstrates that directors must be extremely diligent, and demonstrate this diligence, when reviewing a company's financial information prior to signing a solvency statement. This could include producing a detailed record of assets and liabilities and not relying on any intra-group assistance without a formal agreement in place.

Matt Ford is a restructuring expert at Pinsent Masons, the law firm behind Out-Law.com