When a dot.com Collapses

November 1, 2001

The Internet start-up business sector has thrown up both winners and losers. Whereas some dot.coms go from strength to strength producing healthy returns for investors, others fail to do so. In this article, I am focusing on the dot.com losers. In fact, I am looking at the dot.com companies that fall into insolvency and leave little or no return for creditors and investors.

Most pure.com businesses are financed largely by equity capital. No security is taken and if the company fails, the investors are the last in the queue to be paid back. In most cases there is no prospect of investors getting any money back. Increasingly, investors and lenders are looking at ways of trying to take security. If there is some security, then at least there is a chance that on insolvency the asset(s) charged can be sold and realise a return for the lender. But what can be charged and does it have a value?

Lenders typically like to lend against land, buildings and book debts as security. However these assets are rarely available in a dot.com business. The best bet for lenders to dot.coms is to look at taking a fixed charge over the whole package of rights that go to make up the businesses Web site. This is not the place for a detailed analysis of this issue. However, to give an effective charge, the lender will need to analyse what it is that the dot.com has to offer in terms of hardware, software, domain names, copyright, patents and registered design rights.

Lenders need to be aware, however, that recent experience is proving that these intellectual property assets are achieving low values on insolvency sales. Systems that may have cost millions of pounds to develop are realising less than 10% of those costs.

Are the Directors Personally Liable for the Losses?

In the current climate, when things go wrong, we often assume that there must be someone to blame. In terms of business failures, perhaps the failure was simply down to bad luck – for example, a change in the market, the withdrawal of a lucrative contract or the collapse of a key supplier. However, what if those managing the business were just not up to the job? Is there a risk that directors could be held personally liable to creditors and investors for some of these losses?

More often than not, even if directors are at fault, they have insufficient personal wealth to justify creditors or investors throwing ‘good money after bad’. Nevertheless ‘directors and officers’ insurance (see below) may be in place to cover the exposure. Directors need to be aware of the risks of personal liability and disqualification.

English law has had a long tradition of indulgence towards directors of companies. Historically, provided that a director observed obligations of honesty and good faith including the subordination of his own interests to those of the company, a director was unlikely to incur personal liability. The general level of care and skill expected of the director in the conduct of the company’s business has generally been low and, even where the collapse of the company was down to the negligence or incompetence of a director, directors were rarely held to account. The Insolvency Act 1986 was passed to tackle some of these problems, including new provisions governing disqualification and wrongful trading.

The recent rise and fall in the fortunes of dot.coms has put the activities of some of the inexperienced young entrepreneurial directors into the spotlight. So far as I am aware, there are no reported cases as yet of directors of dot.coms being held personally liable for the debts of the insolvent dot.coms. However, in some cases, the high ‘cash burn’ and the speed of the rise and fall suggest that some of the ingredients are present that could put directors at risk from creditor action.

One of the most dramatic stories from the business world in recent times was the rise and fall of Boo.com. In 1999, Boo was seen as one of the rising stars of the European Internet scene. It was on the way to becoming the leading e-tailer of fashionable sportswear. The founders had no track record in retail – Kajsa Leander was a former model and Ernst Malmsten was a poetry critic. Within 16 months of inception, Boo called in KPMG to liquidate the business. Liquidation was the only option once investors refused to pump more money into the business. Investors had already lost US$135 million and Boo was burning an average of £1million per week.

Boo was launched at a time when the start up dot.coms had little difficulty finding venture capital. Venture capitalists were eager to share in the expected extraordinary profitability of start-ups such as Boo, and finance was not hard to find in this optimistic climate. During these heady days, marketing was the priority and outspending your rivals was part of the core strategy. The size of the spend was seen as inevitable in view of the profits to be made. In the words of one investor:

“If you looked at Boo in concept as potentially a global company, then spending £100 million building it is not necessarily a lot of money. We are hoping to build a company worth £1 billion”.

Spending at Boo was lavish. One systems analyst employed by Boo said:

“For the first nine months of its existence, the company was run on the economic rule of the three C’s: champagne, caviar and Concorde. It was crass stupidity. Bad financial control at the top of the company and a lack of management experience doomed this place. They have spent, spent, spent until there is nothing left”.

On liquidation there was little left. The liquidator sold Boo’s technology for £170,000 and the name was sold for a similar price.

Although the Boo story is the most dramatic of the European dot.com collapses, similar patterns can be found with a number of other rapid rise and fall dot.com stories. In this article, I am not intending to examine the particular conduct of the Boo directors. Rather, I want to look at some of the issues for directors that inevitably arise when expectations and spending are high but insolvency results.

Distinction between the Position of Investors and Creditors

Venture capitalists are in the risk business. In the Boo-type scenario, management typically have the full backing of the investors from beginning to end. Investors and management know the stakes. If the project is a success, the profits and returns for investors can be expected to be high. If the project fails, the investment is lost. Investors can have no complaints.

However, the position of trade creditors is a little different. Trade creditors in the main are not in the risk business. Particularly in view of the speed of the rise and fall and the extent of the cash burn, directors can expect a receiver, administrator or a liquidator (ie ‘an office holder’) to look closely at the conduct of directors to see if the directors have in any way fallen short of their legal duties. If so, directors may find that they incur a personal liability and possible disqualification.

Directors Duties

A company is a person from a legal point of view, albeit an artificial one. A company is recognised by the law as being a separate legal person from both its directors and shareholders. In general terms, directors owe duties to the company and not to creditors or shareholders. Directors have three primary duties:

  • a fiduciary duty to the company to act honestly and in good faith and in the best interests of the company as a whole
  • a duty to exercise such a degree of skill and care as might reasonably be expected from someone of their ability and experience
  • a duty to carry out the statutory obligations imposed by the Companies Act and other legislation.
  • Must act in best interests of the company

Directors have a duty of loyalty to act in the best interests of the company. The best interests of the company are generally accepted as being ascertained by reference to the interests of shareholders (both present and future) and balancing the short-term and long-term interests of the company. However, if the company is insolvent or nearing insolvency, the interests of the creditors prevail. Under the insolvency laws, creditors get paid before shareholders and, when heading towards insolvency, directors need to do what they can to preserve assets for creditors.

Lavish expenditure on the good life for directors without any real consideration of whether the expenditure is in the best interests of the company could constitute a breach of this duty.

Duty of care, skill and diligence

There are no minimum paper qualifications required to be a director. There are no exams to sit. Some argue that this needs to be changed. However at present directors will be judged against a common-law test. A director must satisfy the higher of a subjective and objective test. The director must take such actions as would be taken by ‘a reasonably diligent person’, having both:

(a) the general knowledge, skill and experience that may reasonably be expected of the person carrying out the same functions as are carried out by that director in relation to the company;

(b) the general knowledge, skill and experience that that director has.

A person should not accept a directorship if he fears that he may be out of his depth.

What are the consequences of breach of duty?

Whilst times are good, it is unlikely that the company (by its shareholders) will sue directors for a breach of duty. However, when insolvency strikes, the position changes. In the event of insolvency, an office holder will pursue every course open to him to recover funds for the company and creditors. If a director of a company, now insolvent, has been in breach of duty resulting in loss to the company, the director in question may find that he is a defendant in an action commenced by the company.

Can creditors sue directors? No. Loss suffered by individual creditors is represented by the loss caused to the company and the consequent diminishing assets available for distribution.

What if a director’s breach of duty is approved or ratified by shareholders? Does that exonerate directors from liability? It does if the breach occurs when the company is solvent and likely to remain so. If however the breach is likely to cause loss to creditors because the company is insolvent at the time or in consequence of the breach, the ratification will be ineffective. This must be right. Why should shareholders alone be able to ‘pardon’ a breach when the detriment will be felt by the creditors? When heading towards insolvency, the law recognizes that, in a sense, ownership of the company’s assets lies with the creditors of the company and not the shareholders.

Personal Liability for Wrongful Trading

In the high ‘cash burn’ type of scenario, directors have to be particularly careful not to fall foul of the wrongful trading provision contained in s214 of the Insolvency Act 1986. Where a company ends up in insolvent liquidation, a court may order a director to make a personal contribution to the company’s assets if the director knew or ought to have concluded that an insolvent liquidation was unavoidable and failed to take every step to minimise the loss to creditors.

The minimum standard used to assess when the director should have concluded that insolvent liquidation was inevitable, and also the adequacy of the steps he took to minimise losses to creditors, is that of the general knowledge, skill and experience that may reasonably be expected of the person carrying out the same functions as the director concerned. However, the actual standard by which the director is judged may be higher if in fact his general knowledge, skill and experience is greater than might reasonably be expected.

The provisions relating to wrongful trading are compensatory rather than penal. The amount the director will be liable to contribute will be measured by reference to the amount by which the assets of the company have been depleted by the conduct of the director.

Resignation will not assist a director if wrongful trading took place in the period before the resignation.

In a ‘cash burn’ situation, directors need continually to evaluate whether on the resources available to the company, or which they reasonably believe will become available in the future, the company can avoid insolvent liquidation. If the answer is ‘No’, then the company must eliminate or minimise the risk to creditors and stop trading.

Directors of a dot.com that is being funded by equity and loan funds are unlikely to fall foul of the wrongful trading provision provided that the company ceases to trade when funds run dry and before incurring trade credit that cannot be repaid.

What if an investor has invested £2m, the company has already burned through £1m, the downward spiral to collapse is inevitable and the investor wants to cut his losses and take out his remaining £1m? If the company is going nowhere and the investor (whether as a shareholder or creditor) wants his money back, the directors may be in breach of their fiduciary duty to the company in allowing trading losses to continue. The directors must consider whether it is in the bests interests of the creditors to stop trading.


An office holder is bound to report to the Department of Trade and Industry if he considers that a director’s conduct makes him unfit to manage a business.

Courts can now make disqualification orders against directors. During the period of disqualification, a director cannot be concerned in the management of a company for a specified period without permission of the court. The minimum period of disqualification is 2 years; the maximum is 15. The primary purpose of disqualification is not to punish the individual but to protect the public. Whenever courts find against a director for wrongful trading, they must consider whether a disqualification order should also be made.


Directors can insure against most forms of civil action that can be taken against them. This is becoming increasingly common in practice. It is now possible for the company to take out and pay for directors and officers liability insurance indemnifying its directors against liability arising from negligence, negligent misstatement and wrongful trading committed by the directors while performing their duties as directors. As a rule, policies will exclude liability arising from dishonesty, fraud and claims based on a director gaining a profit or advantage to which he was not legally entitled.


Investors may consider that they have been duped into investing funds into a business and that, but for the misrepresentation, they never would have injected cash into the business. The misrepresentation may be oral or in writing, fraudulent or negligent. This may expose directors to direct action by investors. However, the legal threshold that an investor has to satisfy to succeed with this type of claim is high. Successful claims are few and far between.


There are of course a range of Internet businesses. Some are simply part of existing established businesses. The cash flow of the non-Internet sectors of such businesses often support the Internet start-up costs. It is the ‘pure’ Internet businesses that have attracted greatest publicity. The success or failure of the latter typically depend upon cash flow generated through the Web site.

There is no separate set of legal rules that relate to Internet businesses. A company director in this sector needs to consider the same set of statutory and common-law duties that apply to all directors. The wrongful trading and disqualification provisions that we have looked at are there primarily to protect the position of trade creditors. Investors are expected to have gone into a venture with their ‘eyes open’. They participated in the risk. Provided that the company has traded in accordance with the business plan and/or prospectus, investors can have few complaints.

This month sees the publication of ‘Boohoo.com’, the inside story of Boo written by Leander and Malmsten. Serialisation rights have of course already been sold and a movie deal is expected to follow shortly. Cameron Diaz has been tipped to play Leander. Leander and Malmsten can be expected to cash in on the publicity but there will be no such financial joy for the Boo investors or creditors.

David Leibowitz is a partner in the corporate recovery department at Berwin Leighton Paisner.