EOT’s : what happens when things don’t go to plan?

The Employee Ownership Trust (“EOT”) sector has grown significantly in the 10 years since the Finance Act 2014 introduced generous tax reliefs for business owners selling their shares to their employees rather than on the open market.

Many of those businesses will be at or near the point where they have repaid their founder loans. Others may be struggling to maintain payments concerning deferred consideration agreed at a time when the economy (and indeed the world) looked very different to today.

What must the directors consider?

The directors of an employee-owned business are under the same duties as the directors of any limited company. The key general duties are set out in the Companies Act 2006 and include the duty to act in the way they “consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole”.

If, however, the company’s financial position deteriorates to the point where it may be insolvent, the directors must also consider the interests of the company’s creditors and balance them against the interests of the shareholders where they may conflict. A sliding scale applies:

• Directors must place greater weight on creditor interests as the company’s finances worsen.
• Once an insolvent administration or liquidation is inevitable, the creditor’s interests are paramount.

The directors will place less emphasis on the interests of the employees and the employee benefits made available to the eligible employees via the EOT.

What are the consequences of getting it wrong?

If the company ultimately fails and is put into administration or liquidation, the directors’ conduct will come under scrutiny. If they have not taken the appropriate decisions at the right time, they may find themselves threatened with personal liability for the company’s debts.

Such a claim can arise in several ways, including:

• Wrongful trading: a director who allows a company to continue to trade when there is no reasonable prospect of it avoiding an insolvent liquidation/administration can be ordered to contribute to its assets.
• Misfeasance: a director who has breached their duties may be ordered to compensate the company for the loss it has suffered because of the breach.

Directors whose conduct has fallen below the acceptable standard can also be disqualified from acting as a director for a period of up to 15 years

What are the options?

In the case of deferred consideration, the likelihood is that the debt is owed to someone who not only has a longstanding attachment to the business but also has a financial interest in seeing it continue. For that reason, the first option will almost certainly be to explore with the founder whether the deferred consideration can be renegotiated, perhaps through a reduction in amount, interest payable, or an increase in the term over which the deferred consideration is paid.

If that fails, then a sale of the business may be considered, although the conditions of the EOT could be a barrier. A sale to a third party would likely result in a 20% tax charge to the Trust as well as triggering payment obligations to the founder and, if there are sufficient funds left over, to the eligible employees.

If the company’s solvency is in doubt, then the directors need the urgent advice of an Insolvency Practitioner and must take care to minimise any potential loss to creditors.

How can directors protect themselves?

In practice, it can be very difficult to accurately identify the point that a “reasonable prospect” of avoiding insolvent liquidation/administration disappears. Directors must keep the company’s financial position under close review and keep thorough records demonstrating that they have done so.

Practical steps that directors can take include:

• Ensuring that you understand your responsibilities as a director.
• Holding frequent board meetings to review the financial position.
• Explicitly considering the potential impact of any decisions on the company’s creditors.
• Keeping full and accurate board minutes and circulating them promptly after meetings.
• Keeping your own written record of discussions and meetings, particularly if a decision is reached that you disagree with.
• Taking professional advice, particularly concerning major decisions, and having that advice documented.

Directors should not let the company incur any new substantial liabilities unless it is clear how those liabilities will be paid.

What about trustee directors?

Directors of an EOT trustee company are also subject to directors’ duties and must ensure the employees’ interests as beneficiaries of the EOT are protected. Although the trustee directors should not be involved in the day-to-day management of the trading company, they should ensure, as part of their oversight and risk management role, that the trading company directors are fulfilling their duties and taking the appropriate action.

The trustee directors will have to consider when and how much information can be shared with the employees as part of the employee engagement process. There should be a constant dialogue between the EOT trustee board and the trading company (and the HR team) regarding communication with employees.

How can we help?

The earlier advice is taken, the more avenues are likely to be available to you. At Geldards we have specialists in both EOTs and insolvency who can advise and support you in relation to your duties, options and decision-making to achieve the best result possible.

If you are concerned about the financial position of an EOT business or your duties as a director, please do not hesitate to contact Ruth Thurland or Andrew Evans.