Risks for Transactions and Directors in Financially Distressed Businesses (Jersey)

When a company is in financial distress and enters into insolvency proceedings, there are a variety of legal and practical issues to consider.

Before the distressed company goes into insolvency proceedings, the directors may need advice on what they need to do to fulfil their duties to the company, its creditors, and shareholders, and will need to consider the status of any ongoing transactions the company may be engaged in. Once the company has gone into insolvency proceedings, the pre-insolvency actions of the directors will be scrutinised by insolvency officials attempting to achieve the greatest return for the company’s creditors.

This Note considers the legal and practical issues involved in the law of Jersey and addresses:

• The duties that directors owe to their company, its shareholders and its creditors, and how these may change according to the company’s financial situation
•  The investigation of the pre-insolvency actions of the directors by insolvency officials
• The powers of the insolvency officials to unwind any ongoing transactions and general powers of recovery in their aim to achieve the greatest possible return for the company’s creditors and other applicable aims
• The potential for any claims against the company’s directors, and whether the directors can be personally pursued because of certain conduct even if ordinarily they would not be liable for the insolvent company’s debts

Directors’ Duties

The starting point when considering the main duties owed by directors of a Jersey company is Article 74(1) of the Companies (Jersey) Law 1991 (Companies Law), which states:

“A director, in exercising the director’s powers and discharging the director’s duties, shall:

(a)  act honestly and in good faith with a view to the best interests of the company; and

(b)  exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.”

Common law largely reflects the provisions of Article 74(1). In particular, the directors of a Jersey company have the following duties:

• Duty to act in good faith: When exercising powers and discharging duties, directors must act honestly and in good faith with a view to the best interests of the company as a whole
• Duty to exercise powers for a proper purpose: Even if directors are acting in good faith and in the interests of the company and its members as a whole, they must use their powers for the purposes for which they were conferred
• Conflict of duty and interest: Directors must avoid actual or potential conflicts of interest between their duties to the company and their personal interests or duties as a director of another company. The Companies Law qualifies the common law position concerning transactions with a company involving the interests of a director in several ways and now largely overtakes the common law by specific statutory provisions, particularly Article 75 of the Companies Law (see below)
• Duty to account for profits: The fiduciary position of directors precludes them from making a personal profit from any opportunities arising from their directorship, even if they are acting honestly and for the good of the company. Directors must always pay any profit which results from opportunities arising from their directorship to the company

The Duty to Disclose: Article 75 of the Companies Law

Article 75 of the Companies Law imposes a statutory duty on directors to disclose conflicts of interest. Directors must inform the company of the nature and extent of any interest they have, whether direct or indirect, in any transaction the company enters into or proposes to enter into which, to a material extent, conflicts with the interests of the company. Directors must make this disclosure as soon as practicable after the director becomes aware of the circumstances that give rise to the duty to disclose.

Under Article 76(1) of the Companies Law, if a director fails to disclose an interest, the company or a shareholder can apply to the Royal Court for an order setting aside the transaction concerned and directing that the director account to the company for any profit or gain realised.

Duties of Care, Diligence and Skill

The level of care, diligence, and skill expected of a director is that of a reasonably prudent person.

Directors are not required to be experts in the type of business which the company promotes unless they are appointed because of their specialist qualifications in that business. Boards are often comprised partly of these experts, with the remainder of directors being specialists in business administration or in certain general aspects of business management such as legal, financial, accounting, banking, or expert trade practice.

A director is entitled to rely on the advice of their fellow directors, particularly in matters in which they are, or should be, experts.

Ratification of a Breach of Duty

When a director breaches a statutory duty, the breach can be absolved if all the shareholders authorise or ratify the relevant act or omission, if the company is able to discharge its liabilities as they fall due immediately following the relevant breach (Article 74(2), Companies Law). Shareholder authorisation or ratification is not, therefore, effective when the company is (or will be) cashflow insolvent immediately following the breach.

Bordering on Insolvency

Where a company is insolvent, or bordering on insolvency but is not faced with an inevitable commencement of formal insolvency proceedings, the directors should consider the interests of creditors, balancing them against the interests of shareholders where they may conflict. The greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors.

How Directors’ Duties Change in the Pre-Insolvency Period

Directors’ duties shift to prioritising creditors over shareholders when they know or should know that there is no reasonable prospect of avoiding an insolvency process.

In BTI 2014 LLC (Appellant) v Sequana SA and others (Respondents), the UK Supreme Court confirmed that where a company is insolvent or nearing insolvency, the directors’ duty to act in the best interests of the company includes acting in the interests of the company’s creditors as a whole (the Creditor Duty). This is a sliding scale, as the greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors. However, the Supreme Court did not deem a “real risk” of insolvency to be sufficient to trigger the Creditor Duty. Rather, the Creditor Duty is triggered at the point that the directors know, or should know, that the company is insolvent or bordering on insolvency, or that an insolvent liquidation is probable.

Where an insolvent liquidation is inevitable, the creditors’ interests become paramount as the shareholders stop having any valuable interest in the company. The directors must consider the interests of creditors as a whole rather than those of individual creditors.

The Supreme Court’s handed down its judgment in the Sequana case in October 2022 and, while it is not directly binding in Jersey, it would likely be persuasive in similar circumstances before the Royal Court of Jersey.

Examination of Directors’ Pre-Insolvency Actions During Insolvency Proceedings

An integral part of an insolvency office holder’s role is to:

• Investigate the circumstances that led to the insolvency
• Identify realisable assets
• Identify claims against wrongdoers to make recoveries and increase distributions to stakeholders

The Viscount’s Department is the executive arm of the Jersey courts, and serves as a national insolvency service for the island. When the Viscount’s Department is involved, it:

• Protects and realises the debtor’s property
• Investigates the debtor’s affairs
• Performs other duties similar to a liquidator in a creditors’ winding up

Potential Claims Against Former Directors

Breach of Duty

The effect of a breach of a director’s duties under Jersey customary law or the Companies Law is, depending on the duty which has been breached, that:

• The relevant transaction may be set aside
• The director will be liable to:
  –  compensate the company for any loss it suffered as a result of the breach; and
  –  account to the company for any profit or gain the director made.

If proceedings are instituted against a director alleging that the director breached their duties to the company, the director can apply to the court to be relieved from liability on certain grounds (see below). The court is empowered by Article 212 of the Companies Law to relieve the director, in whole or part, from liability for negligence, default, or breach of duty or trust on such terms as the court thinks fit.

A court application to relieve a director’s liability does not rectify a breach of duty but does allow the court, having regard to all the circumstances of the case, to absolve the director from liability if it is satisfied that both the director:

•   Has acted honestly

•   Should fairly be excused

If a director breaches their statutory duties, the court can absolve the breach if all the shareholders authorise or ratify the relevant act or omission. Shareholders can only approve this if the company will be able to discharge its liabilities as they fall due immediately following the relevant breach (Article 74(2), Companies Law). Shareholder authorisation or ratification is not, therefore, effective if the company is (or will be) cashflow insolvent immediately following the breach.

Article 77 of the Companies Law generally prohibits a company from providing an indemnity to directors, although there are certain exceptions, including:

•   An indemnity for liabilities incurred by a director in successfully defending civil or criminal proceedings

•   Funding and maintaining directors’ and officers’ liability insurance

Wrongful Trading

A director has a duty not to allow the company to trade if the director knows (or is reckless about whether) the company will be unable to avoid insolvency. The provisions relating to wrongful trading are contained in:

• Article 177 of the Companies (Jersey) Law 1991 (www.jerseylaw.je)
• Article 44 of the Bankruptcy (Désastre) (Jersey) Law 1990 (Désastre Law) which mirrors Article 177 of the Companies Law but is applicable when a company is placed en désastre. Under Article 177 of the Companies (Jersey) Law 1991, courts can hold directors and former directors personally liable, without any limitation of liability, for debts or other liabilities of the company arising after the date of commencement of the formal insolvency process (that is, a creditors’ winding up under the Companies Law). Courts can hold directors personally liable under Article 177 if they:“(a) knew that there was no reasonable prospect that the company would avoid a creditors’ winding up or the making of a declaration under the Désastre Law; or
  (b)  on the facts known to him or her was reckless as to whether the company would avoid such a winding-up or the making of such a declaration.”

However, Article 44(3) of the Companies Law provides that the court will not make an order if it is satisfied that, “the person took reasonable steps with a view to minimising the potential loss to the company’s creditors”.

These provisions therefore create liability where there is no fraud, but where the conduct of the director is unreasonable and has caused loss. This mirrors the emerging common law duty of directors towards creditors where the company is insolvent, whereby a director will be excused from personal liability if, following the time when its insolvency should be apparent to them, they take reasonable steps to minimise the potential loss to creditors.

Accordingly, as soon as a director becomes aware that the company is insolvent, or cannot avoid insolvency, they must take all reasonable steps to protect the creditors’ position. Otherwise, if the company trades wrongfully, the court can hold the director personally liable and require them to contribute to the assets of the company, as the court thinks proper.

Fraudulent Trading

A court can also hold a director (or any other person) liable for fraudulent trading, as set out in Article 178 of the Companies Law:

“(1) If, in the course of a creditors’ winding up, it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of another person, or for a fraudulent purpose, the court may, on the application of the liquidator, order that persons who were knowingly parties to the carrying on of the business in that manner are to be liable to make such contributions to the company’s assets as the court thinks proper.

(2) On the hearing of the application the liquidator may himself or herself give evidence or call witnesses.

(3)  Where the court makes an order under this Article [178] or Article 177, it may give such further directions as it thinks proper for giving effect to the order.

(4)  Where the court makes an order under this Article or Article 177 in relation to a person who is a creditor of the company, it may direct that the whole or part of a debt owed by the company to that person and any interest thereon shall rank in priority after all other debts owed by the company and after any interest on those debts.

(5)  This Article and Article 177 have effect notwithstanding that the person concerned may be criminally liable in respect of matters on the ground of which the order under paragraph (1) is to be made.”

A director (or former director) guilty of fraudulent trading can be held personally liable for the debts of the company incurred while fraudulently trading (Article 178, Companies Law). There is also potential criminal implications arising out of the crime of fraud under Jersey customary law. While it is generally difficult to prove intent to defraud another person, once wrongdoing is established, liability is unlimited and the court has complete discretion to make any order regarding liability as it sees fit.

Company Transactions That Can Be Challenged and Unwound If the Company Becomes Insolvent

If a company enters a creditors’ winding up under the Companies Law, or its assets are declared en désastre under the Désastre Law, transactions that it entered into in the lead up to the commencement of formal insolvency may be challenged as a:

• Preference (see Preferences)
• Transaction at an undervalue (see Transaction at an Undervalue)
• Extortionate credit transaction (see Extortionate Credit Transaction)

Preferences

Under Article 176A of the Companies Law and Article 17A of the Désastre Law. If a debtor enters into a transaction with a creditor, surety, or guarantor, the transaction may be challenged as a preference if all of the following circumstances exist:

• The transaction puts the other party in a better position, in the event of a declaration of désastre (under the Désastre Law) or winding up of a company, than if the transaction had not occurred
• There was a desire on the part of the debtor to prefer (that is, to put the other party in a better position)
• The transaction occurred within 12 months of the declaration of désastre or winding up of the company
• The company was insolvent or became insolvent as a result of the transaction

Regarding connected parties, there is a presumption that there was a desire to prefer, that is, that the debtor preferred and intended to put that particular creditor in a better position. Further, where the recipient of a preference is connected with or an associate of the company, the insolvency of the company is effectively presumed.

To avoid a setting aside order, it is therefore necessary to prove that the company was not insolvent when it gave the preference and that it did not become insolvent as a result of giving the preference.

Transaction at an Undervalue

Under Article 176 of the Companies Law and Article 17 of the Désastre Law, a transaction can be challenged as a transaction at an undervalue if either:

• The company debtor received no consideration under the transaction (that is, a gift was made to a creditor)
• The value of the consideration that the company received was significantly less than the value of the consideration that the company provided

In relation to transactions with unconnected parties, transactions can be challenged if both:

• The parties entered into the transactions within the five years preceding the winding up or désastre
• The company was insolvent at the time or became insolvent (under the cash flow test) as a result of the transaction

In the case of parties connected to the debtor, the burden of proof for insolvency shifts, and the transaction can be challenged, unless the connected party can prove that the company was solvent, or did not become insolvent (in each case under the cash flow test), as a result of the transaction.

In the case of both connected and unconnected transactions, these provisions do not apply if the company entered the transaction in good faith for the purposes of its business, and there were reasonable grounds for believing the transaction would benefit the debtor.

Extortionate Credit Transaction

An arrangement with a company can be challenged as an extortionate credit transaction if both:

• The parties entered into the transaction within the three years preceding the creditors’ winding up or désastre of the company
• Having regard to the risk accepted by the provider of the credit, the terms of the transaction either:

–  required grossly exorbitant payments to be made concerning the provision of the credit; or

–  otherwise grossly contravened ordinary principles of fair dealing.

If the Viscount or liquidator made an application, the onus is on the provider of the credit to prove that the transaction was not an extortionate credit transaction.

Where the court finds an arrangement to be an extortionate credit transaction, it can (among other things) make an order to:

• Set aside the whole or part of any obligation created by the transaction
• Vary the terms of the transaction
• Require a person who was a party to the transaction to repay amounts paid to them

Duties of Insolvency Officials and Other Authorities to Investigate Pre-Insolvency Transactions and Director Conduct

When a company enters a formal insolvency process, the primary objective of the Viscount (on a désastre) or a liquidator (on a creditors’ winding up) is to protect and realise the debtor’s property and maximise the return to the company’s creditors.

As part of this, the liquidator or Viscount (whichever is applicable) must investigate the debtor’s affairs and the matters leading up to the onset of formal insolvency. Similarly, liquidators and the Viscount must report possible criminal offences relating to the company.

Powers of Insolvency Officials and Office Holders to Require the Production of Information, Documents, or Assets When Investigating

Article 183 of the Companies Law empowers the liquidator of a company to require any current or former director or secretary of the company, employee, or person who was an employee in the 12 months before the start of the winding up of the company to, both:

• Provide the liquidator with any information about the company and its business, dealings, affairs, or assets that the liquidator reasonably requires
• Meet with the liquidator at any reasonable time, when given reasonable notice

The liquidator can also apply to the Royal Court of Jersey for an order requiring any person who has possession or control of any asset or record, to which the company appears to be entitled, to pay, deliver, surrender, or transfer the asset or record to the liquidator (Article 180, Companies Law).

Similarly, Article 174 of the Companies Law provides that during a creditors’ winding up, a lien or other right to retain possession of a company record is unenforceable to the extent that enforcing it would deny possession of the record to the liquidator.

The Viscount has several comparable specific statutory powers under the Désastre Law. These include, under Article 20 of the Désastre Law, the power to summon any person who is in possession of, or suspected to be in possession of, information relating to the debtor’s activities and to require production of any book, paper, document, or record relating to the property of the debtor. The Viscount can also seek an order to question these persons under oath and under the Désastre Law, the debtor must co-operate.

Reproduced from Practical Law with the permission of the publishers. For further information, visit www.practicallaw.com