Director Duties in Financial Distress: Practical Steps to Manage Risk

When a business begins to experience financial pressure, the role of a director changes quickly. Decisions that may have been routine can carry personal risk, particularly if the company is or may become insolvent. For owner-managed businesses and SMEs, this is often a period of uncertainty. Directors are balancing cashflow, staff, creditors and their own personal exposure, frequently without a formal board or in-house finance team. This guide explains, in practical terms, how directors’ duties operate under UK law when a company is in financial difficulty and what steps should be taken to manage risk.

When should directors be concerned?

A company does not need to be formally insolvent for duties to change. The key question is whether the business is approaching insolvency.

Under section 123 of the Insolvency Act 1986, a company is insolvent if:

• it cannot pay its debts as they fall due (cashflow test), or
• its liabilities exceed its assets (balance sheet test)

In practice, warning signs often include:

• persistent cashflow pressure
• arrears with HMRC or key suppliers
• reliance on extended credit or director funding
• difficulty meeting payroll or loan repayments

If these issues arise, directors should assume that their duties are already shifting.

How directors’ duties change

Under the Companies Act 2006, directors owe duties to the company. However, when insolvency is likely, those duties shift towards protecting creditors rather than shareholders.

This is a critical change.

For SME directors, this means:

• decisions must prioritise preserving assets and minimising losses to creditors
• continuing to trade for the benefit of shareholders (for example, to recover value) can create personal liability
• informal decision-making without proper consideration becomes risky

The duty is not triggered only at the point of insolvency. It can arise earlier, when insolvency is probable or unavoidable.

Key risks for SME directors

In practice, a small number of issues account for most personal exposure. These should be the primary focus.

Wrongful trading

If directors continue trading when they knew, or ought to have known, there was no reasonable prospect of avoiding insolvency, they may be ordered to contribute personally to company losses.

The key issue is timing. Early action and evidence of responsible decision-making can significantly reduce risk.

Preference payments

A payment that puts one creditor in a better position than others may be challenged if:

• the company is insolvent at the time, and
• the director was influenced by a desire to prefer that creditor

Common examples include:

• repaying loans to connected parties
• reducing exposure under personal guarantees

Transactions at an undervalue

Selling assets for less than their true value can be set aside. This includes informal or urgent sales without proper valuation.

Taking on new credit

Continuing to incur liabilities when the business cannot realistically repay them is a high-risk area. This includes:

• taking deposits for future work
• ordering stock on credit
• entering new contracts

Dividends and drawings

Dividends can only be paid from distributable profits. If paid unlawfully, they may need to be repaid personally.

In distressed situations, even routine drawings should be considered carefully.

Personal guarantees

Many SME directors have given personal guarantees to lenders or suppliers.

Actions that reduce a director’s personal exposure at the expense of other creditors may be challenged as a preference.

What should directors do in practice?

Take advice early

Delaying advice is one of the most common and most serious mistakes.

Engaging solicitors and insolvency practitioners early can:

• identify viable restructuring options
• protect against personal liability
• demonstrate responsible conduct

Monitor cashflow closely

Directors should:

• maintain up-to-date cashflow forecasts
• regularly review the company’s ability to meet liabilities
• reassess the position frequently as circumstances change

Record decisions properly

For SMEs, this does not require a formal board structure, but it does require clear records.

Directors should:

• document key decisions and the reasons for them
• record financial information considered
• note any professional advice received

This can be critical if decisions are later scrutinised.

Avoid worsening creditor position

Once insolvency is likely:

• avoid taking new credit unless there is a clear and justifiable basis
• do not favour certain creditors over others
• ensure assets are preserved and properly valued

Consider restructuring options

Depending on the circumstances, options may include:

• informal arrangements with creditors
• a company voluntary arrangement (CVA)
• administration
• in some cases, an orderly winding down

Early advice is essential to assess these properly.

A practical example

A director of a small construction company begins to experience cashflow pressure due to delayed payments on a major project. The company starts to fall behind on VAT and supplier invoices.

To manage the situation, the director:

• continues taking deposits for new work
• repays a loan from a family member
• delays seeking professional advice

The company later enters liquidation.

In this scenario, the director may face scrutiny in relation to:

• taking deposits when the business could not fulfil obligations
• preferring a connected creditor
• continuing to trade without a realistic prospect of recovery

Earlier advice and more cautious decision-making could have reduced that risk significantly.

What about new compliance requirements?

Recent changes under the Economic Crime and Corporate Transparency Act introduce requirements such as identity verification for directors and increased scrutiny of company filings.

These are important from a compliance perspective. However, in a financial distress situation, the immediate legal risks arise from insolvency law and director conduct, rather than administrative requirements.

Directors should ensure compliance, but not lose focus on managing financial risk.

Key points for directors

• Duties shift towards creditors when insolvency is likely, not just when it occurs.
• The main risks arise from continuing to trade, preferring creditors and incurring new liabilities.
• Early advice and proper record-keeping are critical.
• Decisions should be cautious, informed and documented.

Conclusion

Financial distress is often gradual, and the point at which duties change is not always clear. For SME directors, the safest approach is to act early, take advice and proceed on the basis that creditor interests must be protected once financial difficulty becomes serious.

Clear, documented and commercially sensible decision-making is the best protection against personal liability.

This article provides general guidance on UK law. It does not constitute legal advice. Specific advice should be taken based on the circumstances of each case.