Compensation orders were introduced in 2015 and can lead to personal claims against directors who find themselves disqualified from acting. It is therefore vital to take expert legal advice to avoid mistakes. Otherwise you might give an undertaking to be disqualified only to find yourself on the receiving end of a significant claim for damages.
The Small Business Enterprise and Employment Act 2015 which was passed into law on 26 March 2015 made some very serious changes to the way in which directors could be can be made accountable for a company’s actions, particularly where it has been placed into insolvency.
- section 110 of the Small Business Enterprise and Employment Act 2015 inserted a new Section 15A into the Company Directors disqualification Act 1986;
- it states that a director subject to either a director disqualification order or a director disqualification undertaking may also be liable to a director disqualification compensation order being made against him or her, such compensation reflecting the loss he or she is alleged to have caused the Company.
Historically, it was not unusual for directors to be targeted for director disqualification proceedings by the Secretary of State, where any misconduct was found. The most common grounds for a finding of director disqualification misconduct can often be the simple accrual of large tax liabilities to HMRC.
- conventionally, a director subject to any such disqualification proceedings would have signed a disqualification undertaking to avoid being pursued for legal costs, with a view to continuing in a self-employed capacity, or as an employee or shareholder;
- however the new legislation means that directors in such circumstances may in future be liable for all losses that can be attributed to their personal behaviour or misconduct, regardless as to whether it was deliberate, negligent or accidental.
The protection of limited liability is therefore greatly reduced where the Company is placed into insolvency and this article attempts to address the risk to Directors being made
1. Which directors are covered by these changes?
An application for a compensation order may be brought against directors of companies that have been placed into insolvency proceedings and against whom director disqualification proceedings have been brought, or are proposed to be brought, by either the Secretary of State or the Official Receiver.
There is an ability for the criminal courts to make a director disqualification order against Directors in serious indictable criminal proceedings, particularly in relation to allegations of fraud.
It is also conceivable that in such circumstances directors could then be defending director disqualification compensation order proceedings where any such sentence has been passed and a director disqualification order made by a criminal court under Section 2 of the Company Directors disqualification Act 1986.
2. When did this new procedure start?
Under the Small Business, Enterprise and Employment Act 2015 (Commencement No. 2 and Transitional Provisions) Regulations 2015, the new regime commenced from 1st October 2015.
3. What limitation period applies to the bringing of compensation order application?
Under the legislation, a compensation order may be sought by the Secretary of State at any time before the end of 2 years beginning with the date on which a director disqualification order is made or a disqualification undertaking is accepted from the Director on behalf of the Secretary of State.
The commencement dates for the limitation period start on the date when the disqualification order or disqualification undertaking is executed, and not when the director disqualification commences (which is usually 21 days from the period of a disqualification order or director disqualification undertaking). This therefore leaves a distinctly long period of risk for directors of insolvent companies, as the legislation also extends the limitation period for director disqualification proceedings to 3 years from the date of insolvency.
Accordingly a director could face a scenario where just before the end of 3 years, disqualification proceedings are issued and, if defended, this could continue through the courts for a period of up to 2 years (or more).
- if at trial a director disqualification order is made, a further period of 2 years will apply from the date of that director disqualification order
- during this time a director disqualification compensation order application may be issued (with the consequential time spent dealing with the litigation proceedings thereafter, if defended).
Although we would expect a director disqualification compensation order application to be a more straightforward process, this could nevertheless take up to 1 year and accordingly (in the above scenario) a director of an insolvent company could be at risk for up to 8 years after the date of insolvency.
Conversely, other unusual circumstances exist where a director who is disqualified for a relatively short period (2-4 years) may find that they are released from the disqualification order (or disqualification undertaking) before a compensation order is made.
4. Why give a director disqualification undertaking?
Director disqualification compensation orders will be available to the Secretary of State regardless as to whether the original director disqualification proceedings were contested or not.
- in England and Wales most directors are disqualified by way of a voluntary undertaking;
- this is usually provided by directors so as to avoid the legal costs of the director disqualification proceedings, which can continue for 2-3 years and can incur quite significant legal costs without any certainty of success.
Since April 2013, civil litigation proceedings have not been possible for most types of claim or defence on a “no win no fee” basis, thus further restricting the legal options available to directors wishing to defend such proceedings.
5. What is the likely effect of a compensation order?
It appears to be a complete mistake for directors to now get rid of potential disqualification claims by signing a disqualification undertaking. If a director disqualification undertaking is signed and entered into, the director will continue for a further two years with the burden of knowing that for that period s/he could be at risk of compensation proceedings.
- if a director disqualification undertaking is signed in the mistaken belief that legal costs will be avoided, that director may then face the risk that s/he could have to pay substantially more as a result of losses to the company arising from his/her misconduct and thus the historic cost benefit has been removed as an incentive to sign a director disqualification undertaking.
- the most common type of director disqualification offence is trading to the detriment of HMRC and HMRC losses are being clawed back by the use of compensation orders.
- we are already seeing government attempting to recover such sums in proceedings for, for example, breaches of fiduciary duties or wrongful trading (which historically were taken by appointed liquidators).
6. Are there are alternatives to litigated director disqualification compensation order proceedings?
Yes there are. It is done by way of a negotiated compensation undertaking.
- a compensation undertaking will avoid any legal costs of the legal proceedings and accordingly minimise the expenditure by the director;
- however it remains arguable that the expenditure may be better spent on defending the original director disqualification proceedings, as such expenditure may well be considerably less and has the added advantage of being recoverable from the Secretary of State (which is very common in successfully defended director disqualification proceedings).
If director disqualification proceedings are not going to be defended, a disqualification compensation undertaking should be annexed or form part of negotiations as regards the provision of a disqualification undertaking by a director.
Otherwise a director remains at risk when signing a director disqualification undertaking, with a lot less bargaining power as a disqualification compensation order is almost guaranteed once the director has entered into a disqualification undertaking.
In the event you are offered a director disqualification undertaking we strongly recommend you seek legal advice from expert director disqualification solicitors before signing it in light of the recent director disqualification legislation changes and the financial risk to you going forward.
7. How much will I have to pay under a director disqualification compensation order or undertaking?
This is specified by Section 15B of the Company Directors disqualification Act 1986
- a compensation order or compensation undertaking will require a director to pay an amount to the Secretary of State which reflects the amount of loss caused by his/her action (or inaction – which means passive or even Non-Executive Directors face these same risks);
- this will take into account the nature of the conduct which formed the finding of unfitness in the director disqualification proceedings.
An example which would exacerbate the amount of compensation sought is where fraud or some sort of other serious conduct was subject to the original director disqualification proceedings.
The most likely situation however is where a Company has traded to the detriment of a creditor, usually HMRC and the tax loss suffered during that period of trading.
- quite often this can run to hundreds of thousands of pounds and this new legislation is undoubtedly a method by which the government seeks to reclaim such losses from directors (who it perceives often have great material personal wealth, regardless of the fact that most companies are small or medium-sized);
- the advantage for unsecured creditors is that where the company fails and has no assets, and there are no litigation claims against directors or third parties, this provides an additional source by which creditors collectively will be able to be paid a dividend out of the liquidation.
Although not preferable, bankruptcy will discharge such a debt under the legislative changes.
8. What are the options available?
Obviously, the first advice is to ensure such misconduct does not occur or that the Company does not enter into insolvency proceedings.
However, on the presumption this has occurred, a director has a statutory duty to assist the Secretary of State, the Official Receiver and any appointed liquidator or administrator in their investigations.
- if such investigations do lead to a finding of misconduct, the director needs to balance up the cost v benefit of deciding to take a disqualification undertaking;
- if disqualification in itself is not too disruptive, then the first point of call is to seek to negotiate a disqualification undertaking in parallel with a disqualification compensation undertaking.
However, if director disqualification is likely to cause too much damage, the above steps could also be taken but a director may also seek leave of the court to continue acting as a director of a specific company or companies (please see our page which describes making such applications under Section 17 Company Directors Disqualification Act 1986).
If this is not a viable option, either because the director disqualification in itself is not wanted or because the Secretary of State will not negotiate a satisfactory director disqualification compensation undertaking, then the only option is to defend the director disqualification claim.
9. What are the options once a director disqualification compensation undertaking is signed?
The Small Business Enterprise and Employment Act 2015 incorporates a new Section 15C into the Company Directors Disqualification Act 1986 which allows an application to court to vary the compensation payable under a compensation undertaking and even to seek revocation of any such director disqualification compensation undertaking.
This is similar to a provision under Section 8A of the Company Directors Disqualification Act 1986, which allows a director subject to a disqualification undertaking to seek a reduction of the director disqualification period.
- a reduction can only be sought for a compensation undertaking, as it is considered that a negotiated disqualification undertaking may not be as reliable as an order made in open court on the basis of detailed evidence;
- no reduction can be applied for in respect of a disqualification compensation order made by court, although there will of course be a right of appeal (which should be sought within 21 days of the order).
The Small Business Enterprise and Employment Act 2015 does not provide details as to what grounds must exist for such an application to reduce the sum of a director disqualification compensation undertaking and we would expect normally the Secretary of State to oppose any such application.
Obviously making such an application will incur legal costs in its own right which may not be recoverable (as well as potentially incurring legal costs payable to the Secretary of State) and thus it may be the case that a cost v benefit analysis will have to be conducted before issuing proceedings to see if it is worth it.
We would expect such applications only where the director disqualification compensation undertaking is for a large amount and a serious reduction is sought. Case law continues to develop to deal with this area.
10. What are the main issues to address when I receive a letter from the insolvency service?
We often find director disqualification undertakings are signed with little or no legal advice – which is never recommended.
It is only later when the implications of the director disqualification undertaking are felt is it necessary to take some sort of remedial action. Almost always by that point it is a case of damage limitation by reason of something a director or third party commits to paper which may later, on review, not necessarily be correct.
- often we face situations where a director has gone so far as to sign off an undertaking and later faces other types of proceedings which partially rely on his/her disqualification (and the impact it has on their credibility in any court proceedings);
- a very similar parallel is a claim made by a liquidator against a director, which will often only be made after that director has been disqualified and will rely on the director disqualification to discredit the director.
The same issues may arise in respect of compensation undertakings (although there will undoubtedly be more consideration paid by a director to signing such undertakings, which incur a personal debt). However, where a director disqualification undertaking has been signed it will be almost impossible to defend compensation claims (although not impossible, although the argument will undoubtedly be related to the amount payable, not the liability itself).
Once a director compensation undertaking is signed, the legislation does provide a right to seek a review of the amount agreed before the court. We would expect this to only be permissible where the director disqualification undertaking was signed under duress or there were unforeseen circumstances.
Although a still developing area of the law, an application for the variation or revocation of a director disqualification compensation undertaking may for most people be far preferable to going bankrupt or selling personal assets to discharge the amount payable under the director disqualification compensation undertaking.
Please contact one of our friendly expert director disqualification solicitors now for your initial consultation. At Francis Wilks & Jones, we have all director disqualification experience needed to deal with compensation orders an undertakings. We are the genuine experts in this field.