Bridge finance vs boardroom duties – what to do when survival and insolvency hang in the balance

In today’s K-shaped economy, many companies find themselves walking a fine line between survival and insolvency. While directors often have confidence in the company’s potential, optimism is not enough. The reality is that a company’s solvency can often turn on a handful of critical decisions. It is therefore imperative that directors ask themselves the hard question – should the company pursue another bridge financing round, or should they recognise that the business has reached the point of insolvency?

This is not only critical to the future of the company, but to the directors themselves. Directors are bound by various duties, and those duties may be breached if directors fail to recognise and respond to insolvency at the appropriate time. But pinpointing exactly when that ‘appropriate time’ comes is seldom clear cut.

It is important therefore to understand what duties directors are bound by generally, when the ‘creditor duty’ and wrongful trading may arise, and what practical steps directors should take when insolvency appears on the horizon.

What ‘duties’ apply to directors of UK companies?

Directors of companies owe various fiduciary duties to the company and are expected to use company assets which are in their hands or under their control only for proper purposes.

Directors of any UK company should already be aware that they are subject to a number of ‘general duties’ which have been codified under the UK’s Companies Act 2006 (the “Act”). These duties are:

• to act within powers (section 171);
• to promote the success of the company (section 172);
• to exercise independent judgment (section 173);
• to exercise reasonable care, skill and diligence (section 174);
• to avoid conflicts of interest (section 175);
• not to accept benefits from third parties (section 176); and
• to declare any interest in a proposed transaction or arrangement with the company (section 177).

These general duties arise on a director’s appointment as a director and end on the cessation of directorship. They apply to all directors, whether a member of the management team, an independent director or even a shadow director.

Who are these duties owed to?

These general duties are owed by the directors to the company. They are not owed to shareholders, creditors or to other directors. It is therefore the company itself which would need to enforce any actions that it wanted to take following a breach.

This said, directors should keep in mind that:

• the company’s shareholders may be able to bring a derivative claim for breach of duty against them on behalf of the company;
• the company may be sold to a third party or fall into the hands of its creditors;
• liquidators and creditors are able to apply to the court under the Insolvency Act 1986 (the “Insolvency Act”) to examine the conduct of directors and potentially order directors to make a repayment to the Company in light of a director’s breach of duty.

Therefore, while directors formally owe their duties to the company, they cannot disregard the interests of other stakeholders who can, and may choose to, challenge their actions.

Aside from these general duties, are there any other director duties that directors should be aware of?

While the general duties govern most of the day-to-day activities of a director, it is important to note that:

• there are numerous other duties owed by directors to their companies, whether documented in the Act or otherwise (including the ‘creditor duty’ – see below); and
• nothing in the Act or common law expressly precludes the existence of additional duties owed by the directors to third parties.

What is the ‘creditor duty’?

Section 172 of the Act concerns the duty of the directors to promote the success of the Company for the benefit of its members as a whole.  It does not expressly mention creditors. However, section 172(3) of the Act itself acknowledges that this rule is subject to any other law requiring directors to consider creditors. In other words, when certain circumstances arise, the law modifies s172 of the Act so that the ‘success of the company’ must include the interests of its creditors as a whole.

Sequana SA

Case law has unequivocally established that a ‘creditor duty’ exists, as confirmed in BTI 2014 LLC v Sequana SA and others [2022] (“Sequana SA”). Prior to Sequana SA, whilst it was clear that the duty to consider the position of creditors existed, it was not completely clear when that duty arose on any path towards insolvency or when directors should be addressing the position of creditors in priority to the position of the shareholders.

In Sequana SA, the Supreme Court provided some welcome clarity on these questions by confirming that the creditor duty will seldom be an obligation that is not present one day to emerge the next. Instead, the court’s view was that the priority between shareholders and creditors should be looked at on a sliding scale by reference to the likelihood of insolvency arising.  As was said in the judgment, when considering where a particular business falls on that scale, ‘[m]uch will depend on the brightness or otherwise of the light at the end of the tunnel; i.e. upon what the directors reasonably regard as the degree of likelihood that a proposed course of action will lead the company away from threatened insolvency, or back out of actual insolvency’.

Hunt v Singh

The Sequana SA framework was then tested the following year in relation to a claim against a director of a company which was deeply insolvent at the time. In Stephen John Hunt v Jagtar Singh [2023] EWHC 1784 (Ch) (“Hunt v Singh”), the High Court considered whether directors must have actual or constructive knowledge of insolvency in order for the creditor duty to arise or if the mere fact of insolvency alone is adequate to invoke this duty. The court concluded that ‘where a company was faced with a claim to current liability of such a size that its solvency depends on challenging that claim, then the creditor duty arises if the directors know or ought to know that there is at least a real prospect of the challenge failing.’

TL;DR – what do directors need to know about the creditor duty?

Essentially, the common law developments tell us the following:

• while statute does not specify that directors have a duty to consider the creditors of a company, case law does under specific circumstances;
• in Sequana SA, the courts established that the closer a company is to insolvency, the more weight should be given to the company’s creditors – directors are to balance the interests of shareholders and creditors accordingly; and
• in Hunt v Singh, the courts further clarified that the creditor duty may arise if the directors knew or ought to have known that there was a ‘real prospect’ that insolvency would occur (including where solvency depended on successfully defeating a large claim).

A ‘real prospect’ of insolvency is not just if insolvency is a possibility, but rather a probability, and if any options to pull back from that brink of insolvency are not more than fanciful.

Once insolvent liquidation or administration appears to be inevitable rather than just likely, creditors’ interests become paramount and directors are expected to prioritise creditors’ interests.

What’s the difference between a company that is struggling and a company that is insolvent?

This is a good question, particularly in relation to venture-backed startups who often operate at the edge of solvency, pouring money into growth with the expectation of future funding rounds or exits.

While insolvency can be assessed by various methods, it is generally accepted that a company is technically insolvent if it fails the below two tests:

• the balance sheet test – if a company’s total assets are insufficient to meet its total liabilities; and
• the cashflow test – if a company is unable to generate enough cashflow to meet its debts as they fall due.

While these tests may appear definitive, the key thing to note here is that on any given day, a snapshot of the company might fail the balance sheet and cashflow test. That does not immediately render it insolvent. Rather, these tests are to be applied prospectively as ongoing, commercially reasonable assessments of future viability.

So a venture company that is loss-making and burns cash to fuel rapid growth may not be considered insolvent if it has objective evidence of credible prospects of future funding. These could include active discussions with potential investors, imminent fundraising rounds or prospective third-party loans.

Think OpenAI, who are projected to achieve an ARR of c. $20 billion by the end of 2025 yet have publicly announced their commitment to spend c.$1.4 trillion on data centre infrastructure over the next decade. Financial analysts have even suggested that for every dollar OpenAI earns, it spends $2.25. Despite the clear imbalance between their current assets and projected liabilities, OpenAI is clearly not worried about insolvency. In fact, they have repeatedly asserted that the seemingly exponential demand for AI provides the company with strong, credible prospects of future funding and growth. As such, their expectation is that their revenue will double in 2026, climbing to over $125 billion by 2029. This illustrates why a director’s honest outlook on the company’s future is critical: their forward-looking analysis of a company’s future is what allows directors to continue operating, even if the business appears to satisfy the insolvency tests above. This is an especially common dynamic in fast-growing tech companies who are often willing to take substantial risks.

Nevertheless, all directors must remember that while the potential for future funding is relevant, they must still have regard to the creditor duty and the Sequana SA sliding scale. If directors wait until the company is bordering on insolvency, it is perhaps too late – the creditor duty may have been triggered already. For a startup, this might be the moment when its last funding round is almost exhausted and new investment is not materialising as expected, or when the company experiences a major product flop or market downturn but has a looming cash-out date. At that point, the writing is on the wall – it is highly probable that the company will be unable to pay its debts on time and so the creditor duty has been triggered.

What about wrongful trading?

The creditor duty is closely linked to wrongful trading. Essentially, if a director allows the company to continue trading when they knew (or should have known) that there was no reasonable prospect of avoiding insolvency, they could be found liable for wrongful trading as well as breaching the creditor duty.

But what is the difference between wrongful trading and breaching the creditor duty? It hinges on the state of the insolvent company. Wrongful trading (governed by sections 214 and 246ZB of the Insolvency Act 1986), is triggered if it can be shown that the directors knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. The creditor duty on the other hand can arise earlier in the insolvency journey, when the prospect of insolvency is apparent but not necessarily inevitable.

With a view, however, to that sliding scale point made above when considering Sequana SA, the liability for wrongful trading only arises if it can be shown if the relevant company was worse off for continuing to trade. The courts will not make an order for wrongful trading if the director in question had taken every step he could with a view to minimising losses for creditors.

What liability do directors incur if they get it wrong?

The consequences depend on which breach of duty or offence has been committed, whether it be breach of the general duties, the creditor duty, wrongful trading or fraudulent trading. 

• Breach of the general duties – the consequences of breaching a general duty depends on which duty (or duties) are breached. If the duty under section 174 of the Act, the duty of care, skill and diligence, is breached, the remedy is common law damages. The remedies for the remaining general duties are expressed to be the same as any other fiduciary duties owed by directors. These remedies would include: equitable compensation; recission; injunctions; an account of profits made by the director (provided those profits were generated within the scope of the conduct found to have been in breach of the duty); or any combination of those things.  While the actions of the directors can be retrospectively ratified by the shareholders, this only applies in certain circumstances and should not be treated as a fail-safe security net.
• Breach of the creditor duty – although the creditor duty is owed to the company and not to the creditors, there are still some circumstances where a director could pick up personal liability. The claimant would need to prove that there was a loss to the company that was attributable to a director’s breach of their creditor duty. If successful, the claimant would be entitled to one of the remedies set out in the list above. In practice however, as acknowledged in Sequana SA, a claim for breach of the creditor duty is most often dealt with during the liquidation process. Once again, a breach of the creditor duty cannot be ratified by the shareholders later on.
• Wrongful trading – if a director is accused of wrongful trading, a liquidator or administrator can look at whether that director knew or ought to have known that there was no realistic possibility of avoiding insolvency and seek a declaration from the court that the director in question makes a contribution to that company’s assets.
• Fraudulent trading – if, in the course of the winding up or administration of a company, it appears that any business of the company has been carried on with the intent to defraud creditors, or for any other fraudulent purpose, a liquidator or administrator can seek a court declaration that anyone who was knowingly party to the fraudulent business make a contribution to the company’s assets under the Insolvency Act 1986.  This is known as fraudulent trading and the offence is criminal. A director would likely be caught in this net.

So what should directors do to ensure they comply with the creditor duty and avoid wrongful trading?

As we know, the question of whether the creditor duty has arisen turns on the facts – it all depends on where the company currently sits on the Sequana SA sliding scale.

To avoid a scenario where directors have failed to recognise their creditor duty, or perhaps are now in danger of being accused of wrongful trading, we suggest that directors do the following:

1. Remain mindful of the creditor duty. If the company starts to fail either of the insolvency tests, directors should note that their current focus on shareholder interests may need to shift toward protecting creditors. This does not mean abandoning efforts to rescue the business – directors can and should continue pursuing options to avoid insolvency – but they must keep the creditor duty firmly in mind if and when the company’s financial position deteriorates.
2. As a first step, this also means educating the entire board on the creditor duty and perhaps their general duties if not already known.
3. Monitor the financials of the company. Although this may seem to be an obvious point, directors are often distracted by strategy and consequently overlook the financial realities. Given that the financial health of a company can shift quickly, it is imperative that directors keep a close and continuous eye on overall solvency and adjust their strategies accordingly.
4. Ensure that any and all decisions of the directors (or sole director if applicable) are properly minuted so as to keep a record of the commercial basis on which that sliding scale of priority was assessed at the relevant time.  Decisions should be arrived at by the directors independently by reference to the available financial and other relevant information.
5. Engage an insolvency practitioner as soon as possible. Notwithstanding all of the above, it is always advisable to engage (but perhaps not formally appointed unless necessary) an insolvency practitioner, to advise the directors well before the point in time at which it is clear that insolvency is highly likely.  By that point in time, the interests of the creditors may well need to be considered ahead of the shareholders. If there is no prospect of avoiding insolvent liquidation or administration, the directors should take steps to cause the company to cease trading immediately and minimise losses to creditors.

It should also be noted that resignation by a director in these circumstances is no “get-out-of-jail-free” card. Resignation will not, in itself, absolve a director of liability for decisions made (or not made) while they remained in office. The courts generally take an unfavourable view of directors who resign at the first sign of financial distress, and such conduct may be regarded as an abrogation of their responsibilities. That said, if a director has genuinely formed the view that there is no realistic prospect of avoiding insolvency and has, despite best efforts, been unable to persuade the board to take appropriate steps, this may weigh in their favour if they later seek to rely on statutory defences.

Directors should also appreciate that wrongful trading or a failure to consider the creditor duty may result in their disqualification. Governed by the Company Directors Disqualification Act 1986, a director may be disqualified if their conduct is deemed “unfit” to manage a company — for example, if they have allowed a company to trade wrongfully, failed to maintain financial records or have ignored clear indicators of insolvency. A director may be disqualified for a period of up to 15 years.

Final thoughts

When directors pursue one more bridge financing round as a last-ditch attempt to avoid insolvency, their rationale is clear – save the company before it is too late. However, it should now be evident that taking drastic steps to salvage the company without considering their legal duties or the likely consequences is reckless.

Understanding the general duties directors are subject to, when the creditor duty is triggered, and the risk of wrongful trading claims being brought against them is critical to striking the right balance between seeking rescue and acknowledging insolvency. Directors who document their decisions in detail, seek advice from insolvency practitioners early on, and maintain transparency regarding the company’s financial position are most likely to be able to demonstrate that they did what they could to minimise losses to the company and its creditors. Pre-emption, practicality and prudence are the best defences when survival and insolvency hang in the balance.

This article was written by Alina Merchant-Mohamed.  All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice and is not to be relied upon.  Much of the above will no doubt fall out of date and conflict with future law and practice one day.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law