It’s generally accepted, as a result of Canadian case law, that corporate directors have a duty to ensure their company does not carry on business after it becomes insolvent.
The Supreme Court of Canada has found, notably in Peoples and BCE, that directors owe a duty of care to all stakeholders in their company. That duty is very likely breached if business continues once the company is unable to meet its financial obligations as they come due, thereby making directors liable to claims of trading while insolvent and oppression.
Oppression
Oppression is the unfair disregard for the interests of a stakeholder, such as a creditor, shareholder, employee or supplier, and where oppression is proven, the court has the power to impose any remedy it sees fit in order to redress the situation.
To head off trouble, directors should know the generally accepted signs that a company is struggling.
1. Cash flow problems, especially a trend toward late payment of supplier invoices, is often the first sign that a company is in serious trouble. This may also show up in the form of suppliers demanding cash on delivery.
2. Sales that fall consistently below forecast are a sign that the sales department is providing overly optimistic projections and that revenues may soon decline below expenses.
3. Slow stock turnover or an accumulation of dated stock indicates an impending revenue problem and the possibility the balance sheet could turn negative as the value of these old assets declines below liabilities.
4. If the company’s bank overdraft or lines of credit have been maxed out and principals are being asked for personal guarantees in order to secure additional funding, this is a big warning sign that the company is becoming illiquid.
Dual test
At this point, directors should insist on a dual test for insolvency: 1.) a balance sheet test examines whether liabilities are greater than assets, and 2.) a cash flow test determines whether the company can meet its financial obligations as they come due. A closely related question is whether the company is capable of meeting anticipated new obligations, such as the cost of a bridge loan to see it through its liquidity crisis.
If the company fails either or both of these tests, it is approaching insolvency and directors must consider whether it’s time to call in an accountant or an insolvency professional. If the problem is confined to cash flow, it may be caused by management issues, such as allowing creditors too much credit or too much time to pay. In this case, new credit policies and better credit monitoring systems may be sufficient to right the ship, depending on an accountant’s advice.
If there’s no such obvious fix, it’s likely time for the company to enter into insolvency proceedings for restructuring or liquidation and for each director to call his or her own insolvency counsellor.