Five Tips for Investor Directors in the Zone of Insolvency

There are distinct advantages to investors sitting on the boards of their portfolio companies, not least their ability to look after their investment and work toward maximising their return. The human capital provided by investor directors can be invaluable in driving efficiencies and creating growth opportunities. The interests of investors, investor directors, and the company will generally be aligned in seeking the success of the business.

However, when nearing or in the “zone of insolvency” the interests of the investors and the company can diverge. Investors will want to limit losses. Some may want to write off the investment completely and withdraw support regardless of whether that will precipitate insolvency. Others may be willing to provide further investment to salvage the business but often on more stringent terms. Investor directors must be vigilant for these dynamics, and remember that although they may be appointed to look after the interests of the investor, they are also directors and subject to director’s duties. The law does not excuse a director from their duties because they clash with the interests of the director’s appointer.

Balancing the role of director with the interest of their appointer, who can at times also be the employer of the investor director, can be challenging. These investors need to manage the perception of being an advocate for the investor, recognise their duties, and consider the interests of the company and creditors. The Silentnight Group case is a reminder that investors should not unnecessarily seek to take advantage of companies during financial distress or unnecessarily create burning platforms.

Below are our top five tips for investor appointed directors to help them navigate the complexities that arise when companies are in financial difficulties.

1. Record keeping

Proper record keeping is imperative, particularly comprehensive board minutes of regularly held board meetings. These minutes will help evidence the directors, including the investor directors, complying with their duties and taking well-considered decisions, including the decision to continue trading (see more below).

Directors may disagree with decisions being taken, and those disagreements should be minuted. Where a director is not supportive of boards’ collective decisions they may consider resigning, however, resigning will not absolve the resigning director from liability so long as they have the power to influence the company making the right decisions. Investor directors, in particular, should clearly distinguish their own contributions to board business from input they have been asked to provide on behalf of the investor.

Failure to keep proper records can make answering breach of duty and/or wrongful trading claims much more difficult.

2. Conflicts

Conflicts or interests in transactions often arise with investor directors when any interaction with the investor entity is considered and should always be declared and recorded. It is not uncommon during financial difficulties for investors to consider further investment to save the company, and the investor director will often play a vital role in liaising between the board and investor.

While the company’s articles might allow for interested directors to be present and vote at meetings, the interested director should carefully consider whether recusing and re-joining meetings at the appropriate time might be more prudent, as it allows the other directors the opportunity to have a more open discussion and reach a conclusion without any undue influence. Where directors do recuse themselves, they should remember to re-join the meeting for the reminder of the board’s business.

Investor directors also need to be mindful that they may receive confidential or non-public information during board meetings, which they may not be able to share with the investor.

3. Liquidity

Liquidity should be discussed at every board meeting. Board members should be fully aware of the company’s financial challenges, its cash position, and possible upcoming liquidity pinches. This allows directors to determine how long they can keep the company going and when they could be in wrongful trading territory. For investor directors, liquidity updates may inform the investor’s decision on whether to make further funding available or not.

Directors will need to carefully consider whether additional financing should be taken and on what terms. Would the additional credit allow the company to navigate financial difficulties, or would the expenses incurred on reliance of the new funding contribute to its balance sheet insolvency? When considering investment from existing investors, directors will need to consider if such funding is on competitive terms given the company’s situation, what alternatives are available, and whether the terms of the funding would force the company to favour a particular creditor (such as the investor) or require extortionate repayments.

Where additional funding is unlikely to help steer the company away from its financial difficulties, directors should consider seeking insolvency protection rather than increase the company’s liabilities. For the company to incur new credit when the decision-makers know or are reckless as to whether the debt can be paid when due, will take those decision-makers into fraudulent trading territory. Great caution should be exercised, and appropriate advice should be sought.

4. Reasonable Prospect Test

Wrongful trading liability arises once a director or directors conclude (or should have concluded) that there is no reasonable prospect of the company avoiding an insolvent liquidation or administration, and they did not take every step that a reasonably diligent person would take to minimise potential loss to the company’s creditors.

To rebut wrongful trading claims and properly discharge their duties, it is useful for the directors to clearly to set out the basis on which they believe it is reasonable to continue trading and avoid insolvency at every board meeting. Any steps taken to increase income and reduce expenditures, which may include finding redundancies and terminating service agreements, should be highlighted. Reliance, placed on the continued support of the investor, should be genuine and not fanciful backing.

If the directors conclude there’s no reasonable prospect of avoiding insolvency, their decision as to what to do to minimise potential loss to creditors also needs to be carefully minuted to protect themselves against subsequent criticism.

5. Indemnity

The investor director should consider whether they need an indemnity from their appointer (i.e., the investor entity) to indemnify the director for any liability incurred in their role as director when acting on the instructions, or in the interest of, the investor.* Investors may resist indemnities and offer insurance instead, but directors are reminded that insurance is unlikely to be available for wrongful trading liability, although it may cover the costs of defending themselves.

* As the appointer may want to limit the indemnity to these circumstances, the director would say, “I need an indemnity to cover my role as a director, which is what you had me sign up for.”