Insolvency procedures: What Directors must and must not do. Part 1

As we will see over the next few weeks there are various ways in which a directors can be held to account both for the way they respond to the insolvency of a company, and what they actually do before the company becomes insolvent.

Directors have two things in particular they must consider. The first is whether the company is going to go or is likely to go into insolvent liquidation. The second is what steps are necessary to minimise any losses to creditors. These are not necessarily easy things to identify. A sound business may go through a rocky period but still be a sound business. The directors have to monitor things and keep them under constant review. Reasonable grounds for thinking that the business might turn around one thing. Wishful thinking is something entirely different.

One thing that always has to be borne in mind is that minimising loss is not the same as stopping trading. Of course, hindsight is a wonderful thing and it is very easy after the event to take a different view as to what should have been done. Stopping trading might increase the loss to creditors. At times it can be a very difficult judgment call for the directors, because on the one hand if they stop trading they can be criticised for having done so, but on the other hand if they carry on trading and contrary to their expectations it increases the losses they can be criticised for that as well.

A recent example as to how this might operate in practice has come with a liquidator's analysis into the insolvency of the Lehman Brothers investment bank in the United States. (Therefore the legal position that will be different as will the insolvency terminology: in this country bankruptcy as such only applies to people not companies). Bryan Marsal, co-chief executive of Alvarez & Marsal stated in his report that Lehman filing for bankruptcy after the US government had refused to bail out the bank wasted between $50 billion and $75 billion of value for creditors due to its consequent collapse. On the liquidator's analysis the biggest loss of value arose because the effect of a bankruptcy filing meant that the bank was in default on various trading contracts. The effect was to cancel 900,000 separate derivatives contracts including ones where otherwise the bank would have received money. An orderly disposal could according to the liquidator had saved $50 billion. Moreover sale of bank assets ended up occurring in a market which was in a state of shock as a result of the Lehman bank collapse. As against that, we do not yet know what the response is on behalf of those alleged to have made the wrong decisions, and no doubt part of it will be to suggest that once the government would not offer support it was simply impractical to carry on. Whoever is right, it illustrates the potentially widely diverging consequences of deciding to carry on trading or deciding not to. Although they might not reach the right decision, what the directors have to do is consider the effect of that which they do.

One thing which directors will often consider is taking professional advice from an insolvency practitioner or an accountant or some other professional service to get an independent view. Whether that view is right or wrong, it is at least the view from someone outside the company and therefore can be regarded as more independent.