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Why the directors of firms in financial mess shouldn’t quit

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Instead of resigning, directors can take other steps to minimise the risk of personal liability. PHOTO | POOL

When a company is facing financial headwinds, one of the instinctive actions often taken by directors is to resign from their positions.

They do this in a bid to distance themselves from failures of the firm due to reputational damage and personal liability, which may ensue.

Their concern is not unfounded as the law sets out quite a high standard on directors’ duty of care.

Where a director allows a company to continue trading or to incur liabilities at a time when he knows, or ought to have known by virtue of his position, that there is no reasonable prospect of the company avoiding insolvency, such director could incur personal liability for the losses sustained by the company's creditors.

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Similarly, a director may be held liable for fraudulent trading if it is proved that any business of the company has been carried on with the intention to defraud creditors or for any fraudulent purpose.

To compound matters, directors who are found guilty of any misconduct in relation to a company may also be disqualified by the court from acting as directors or from being involved in the promotion, formation or management of any company for a period of up to 15 years.

Strictly speaking, however, running away from directorship when a company is on the brink of insolvency does not automatically absolve a director from personal liability.

On the contrary, it may leave the director worse off if by the act of resigning, the director is deemed to have abdicated his duty to act in the best interests of the company and its creditors.

Instead of resigning, directors can take other steps to minimise the risk of personal liability.

These include holding frequent board meetings to review the company's financial position until the company stabilizes and properly documenting minutes of meetings held, noting any resolutions passed and the basis for the resolutions.

Directors can also seek professional advice when it comes to the significant decisions to be taken by the company.

Importantly, the directors should not let the company incur any new substantial liabilities unless it is clear how such liabilities will be settled.

It would, for instance, be inappropriate for a company on the verge of insolvency to declare and pay dividends to shareholders.

Equally, payments to connected creditors ahead of other creditors within 2 years leading to insolvency or other actions taken that would disadvantage some creditors, can be set aside by the court on application by an insolvency officeholder.

As an exception to the rule, however, a company in financial distress may be allowed to incur liabilities if the board considers that such liabilities are essential and in the best interests of the company and its creditors, particularly if the new monies will help turn around the company.

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Directors’ resignation is therefore not always the only option or even the best option.

A delicate balance should be maintained between the directors’ interests and those of the company and its creditors.

Where resignation is inevitable, the resigning director should clearly articulate his reasons for resigning in his resignation letter to the board, ensuring that the resignation is the least disruptive it can be in the circumstances so as not to further escalate the company’s precarious standing.

Nyabira is the partner and head of the Projects, Energy & Restructuring Practice At DLA Piper Africa (IKM Advocates). Murangi is a senior associate in the same practice.