Company insolvency, directors’ duties and the impact on a divorce financial settlement

When a business becomes insolvent and steps are taken to put it into voluntary liquidation, this will of course have significant implications for the shareholders, company directors, employees, suppliers and any creditors to that business. This financial uncertainty can be especially challenging when those involved are also going through a divorce, as it adds to the complication and stress of asset division, with ramifications on capital resources and income streams.

While a key advantage of establishing a limited company is the personal protection provided by limited liability for the business owners, directors are not always shielded from financial liability. In fact, in certain situations, directors may be held personally accountable, making them responsible for covering business debts or liabilities leading up to a company entering an insolvent process, for example a liquidation or administration. 

Role of a liquidator of a company

A liquidator, (the Official Receiver or an insolvency practitioner), is appointed to collect and realise the company’s assets and distribute the proceeds to the company’s creditors on a pari-passu basis (pro-rata).

As part of the liquidator’s enquiries, the liquidator will conduct investigations into the company’s demise and its directors, (including scrutinising a director’s conduct), to ascertain whether there are any claims to be made.

Such claims may be brought against a former director where the director has acted in contravention of their fiduciary duties, being a claim in misfeasance and/or relate to the unlawful payment of dividends, directors’ overdrawn loan accounts, preference payments, transactions at an undervalue, wrongful trading, fraudulent trading, or transactions defrauding creditors.

We discuss some of these claims by a liquidator/administrator as well as other claims by the Insolvency Service pursuing director disqualification and HMRC for repayment of taxes below.

When can a director be made personally liable for the debts of a company?

Where a company is insolvent or borderline insolvent, the directors’ duties will shift from acting in the best interests of the company to the best interests of the creditors as a whole.

1. Wrongful trading

A claim of wrongful trading can be brought by a liquidator or administrator after a company has entered into formal insolvency proceedings. Wrongful trading occursa when a  director allows a company to continue to trade when they knew (or ought to have known) that the company was insolvent. This can result in the director being held personally liable for company debts; a liquidator or administrator may pursue a former director personally to make a financial and personal contribution to the company’s assets for the benefit of creditors. 

Additionally, a director faces disqualification by the Insolvency Service under the Company Director Disqualification Act 1986. If the Insolvency Service is successful, a director of an insolvent company can be ordered to pay personal compensation to creditors.

2. Fraudulent trading

Fraudulent trading is a more severe offence than wrongful trading and a claim can be brought by a liquidator or administrator after the company has entered into formal insolvency proceedings. If a director deliberately deceives or misleads creditors by continuing to trade for a fraudulent purpose and/or with the intention of defrauding creditors, (for example, deliberately incurring debts and having no intention of repaying these debts to the company’s creditors), the director can be found guilty of fraudulent trading.

Whilst it carries criminal implications, this can also lead to personal liability and director disqualification claims by the Insolvency Service, when a director can be disqualified for up to 15 years. This means that the individual cannot be a director of any company registered in the UK or an overseas company which has connections with the UK. Fraudulent trading would likely fall into the upper bracket of time for disqualification.

3. Overdrawn director’s loan account

An overdrawn loan account is where a director takes money from the company in the form of a loan. Where the business becomes insolvent, the director may be required by the liquidator of the company to repay the amount personally.

4. Misuse of company funds

If a director improperly uses company funds for personal expenses or transfers assets below market value before insolvency, they could face claims for misfeasance or transactions at an undervalue. Courts may order the director to repay money, which could lead to bankruptcy if they cannot afford to do so.

5. Personal liability for unpaid taxes

HMRC can pursue directors personally for unpaid corporate taxes, particularly in cases involving tax fraud or deliberate avoidance. In some situations, HMRC may issue a Personal Liability Notice (PLN), making the director responsible for unpaid PAYE, VAT, or National Insurance contributions.

6. Personal guarantees

Many lenders and suppliers require directors to sign personal guarantees when granting credit. If the company fails to meet its obligations, the director becomes personally liable for the debt. 

Impact on divorce proceedings and financial settlements 

Negotiating a divorce or dissolution financial settlement can be financially and emotionally challenging. When company insolvency and/or personal bankruptcy are involved, the situation becomes even more complex.

The liquidation of a company or personal bankruptcy affects key aspects of a divorce financial settlement, including the valuation and division of assets, quantification of liabilities, income streams and so ability to fund maintenance payments. The timing of when it happens is also crucial.

Below, we explore some common issues and their potential impact on divorce proceedings.

Read more on divorce and bankruptcy.

1. Valuation and division of assets

Frequently, directors are also shareholders of a company. A shareholding in a business is a resource, meaning it can be subject to division during divorce. However, if the business is insolvent or struggling financially, its value may be uncertain or significantly reduced. This can create disputes over:

• whether the spouse should still receive a share of the business or its proceeds. See key issues for business owners in divorce settlements
• how to assess the true value of the business, especially if it has outstanding debts or liabilities
• whether insolvency was inevitable or whether the director played a role in the company’s downfall. 

In cases where the business holds no real value, the court may decide to attribute a low or nil value for the purposes of the financial settlement, but this can be contentious if the other spouse believes that there is a higher value or potential for the business, there are hidden assets or there has been financial mismanagement or misrepresentation of the figures.

2. Impact on maintenance payments

In divorce proceedings, maintenance payments (spousal and child maintenance) are assessed by considering each party’s income, earning capacity, ability to pay and the overall financial position. If a company director becomes bankrupt or if the director’s income is reduced or ceases due to company failure, it could affect their ability to meet these obligations.

Certain financial obligations like child maintenance are not automatically discharged in bankruptcy, meaning they must still be paid regardless of insolvency, although the quantum may need to be reassessed.

3. Complications arising from the timing of bankruptcy and divorce

If a company director is declared bankrupt before or during divorce proceedings, it can significantly impact financial settlements. Once a bankruptcy order is made, some key issues to note are:

• the director will be required to resign from all directorships
• control over the bankrupt director’s assets passes to the official receiver or trustee in bankruptcy, meaning they cannot freely dispose of or transfer assets
• creditors may have a legal claim over the director’s assets before a spouse can claim a share
• any divorce settlement involving lump-sum payments may be suspended or revised until the bankruptcy process is completed.

However, if bankruptcy is declared after a financial settlement is reached, the non-bankrupt spouse may still be able to enforce certain payments if they were structured correctly under family law provisions. Expert legal advice is required.

Conclusion

Company insolvency and personal bankruptcy add layers of complexity to divorce.

Company directors facing financial difficulties should seek early specialist legal advice to navigate these challenges with a view to minimising personal liability. It is important to ensure they comply with both insolvency related issues and any ongoing family law requirements. 

Likewise, spouses should be vigilant in ensuring financial transparency to prevent unfair settlements due to hidden or strategically managed bankruptcy or insolvency.