This is my sixth article on legal issues in the gaming and tech sectors. This article focuses on insolvency proceedings and common mistakes directors make in these sectors.

Insolvency:

In the most basic terms, ‘insolvency’ is when a company is unable to pay its debts as they fall due.

There are three main forms of insolvency, and they are:

1. Liquidation

When trading is stopped entirely, the assets of the business are sold and any realisation is distributed to creditors (if any) of the company.

2. Administration

When certain contracts can still be executed, and potentially saved from insolvency.

3. Voluntary Arrangements

Similar to administration, in that there is scope for the company to be rescued, but the company agrees to a repayment structure with any listed creditors.

Consideration for Directors:

Directors owe statutory and fiduciary duties to the company when appointed as a director.

If, during the insolvency process, it becomes clear that the director of a company has breached his duties, certain transactions can be challenged by the insolvency practitioners, some of which are listed below.

Misfeasance is when directors use company funds for purposes that are not for the benefit of the Company/trading and/or breached their fiduciary duties to the Company, such as a director paying for their personal debts/expenditure (for instance using the company funds to pay for the director’s mortgage/rent directly). Payments which are found to be malfeasant can be sought from the directors personally. If the malfeasant act is a result of a fiduciary duty, then there no limitation period for the liquidator/administrator to make a claim (Burnden Holdings (UK) Limited v Fielding [2018] UKSC 14).

Transactions at an undervalue are self-explanatory. But for ease of reference, it is a breach of a fiduciary duty to transfer company property/assets to a third party for zero consideration (no financial benefit to the company), or significantly less than the asset’s true value, two years before onset of insolvency. Furthermore, the transaction must also take place when either the company is insolvent, or the company was unable to meet its debts at the time of the transaction. Any claim must be made within six years of the liquidated company entering liquidation/administration.

Preference payments relate to payments to a particular creditor over any others. The payment/transaction must put the creditor in receipt, in a better position than it would otherwise have been in upon the company’s insolvency. The company must also be influenced to prefer the creditor receiving the payment. If the creditor is a connected person, then intention is presumed. The company making the payment must either be insolvent at the time of the payment (or became insolvent as a result of the payment), or it was unable to meet its debts at the time of the transaction. Generally, payments made in the six months before onset of insolvency are investigated, or payments to connected persons two years before the onset of insolvency.

Wrongful trading is when you continue to trade, incur debts, while knowing you are insolvent (unable to pay debts as they fall due). This commonly occurs when directors try to trade their way out of debt, and usually take greater risks in the hopes of receiving a greater payoff – to repay the debt. This strategy almost always fails.

Fraudulent Trading is when a director defrauds creditors about the circumstances of the company. The difference between fraudulent trading and wrongful trading is the intent of the director(s). If found guilty, the director(s) can be imprisoned for up to 10 years. There is no time limit for claims pertaining to fraudulent trading and/or transactions. Any claims which contain an element of fraud, have the hurdle of proving the intent to defraud ‘beyond reasonable doubt’. Liquidators/administrators usually make claims for malfeasance, as a claim under section 212 of the Insolvency Act 1986 is more likely to succeed.

Consideration for Creditors:

A Creditor can petition the winding-up of a company if the debtor company owes £750.00 or more. The debt must be bona-fide, and for certainty, some creditors will serve a statutory demand (“SD”) in the first instance.

When petitioning a company to wind-up, the initial disbursement costs are:

1. The Official Receiver’s petition deposit is £2,600.00 (refundable, less £50.00 if withdrawn);
2. Filing a petition will incur a court fee of £302.00
3. If you intend to advertise the petition in the London Gazette, this will cost £79.40 plus VAT;
4. Any search at Companies House will cost £2.00 each; and
5. any petition will require a process server fee, varying between £75.00 and £200.00 plus VAT.

Once a petition has been sealed by the court, but before it is advertised in the Gazette, this is the perfect time to negotiate settlement of the debt. Once the petition has been advertised in the Gazette, other creditors may become aware of the petition. This means that if you negotiate settlement of the debt after advertising in the Gazette (but before the hearing), other creditors may take carriage of the proceedings, force the company into liquidation, and the liquidator may claw back the settlement as an unlawful preference payment. This is due to the “pari passu” principle. It means that all creditors are ranked equally and without a preference.

Video Games:

Many independent developers are founded by friends who share a passion for gaming. They are usually creative, technologically minded and very intelligent.

However, they rarely have experience in business, and as a consequence, are unaware of the commercial realities of running a business.

In instances where the companies are run by sole director shareholders who have invested significant personal savings into their company, there is a misconception that the company money is the sole director shareholder’s money (this misconception is not exclusive to the video games industry). This can lead to directors spending company money for their personal benefit, which can be investigated and clawed back, should the company enter liquidation within two years.

On the other hand, established developers are regularly snapped up by private equity/venture capital investors. However, issues have regularly arisen where the new shareholders raise debt against expected earnings of an upcoming game release.

In the current economy, consumers are cutting back on non-essentials, of which gaming and other entertainment costs are usually the first to be cut. As a consequence, when the aforementioned release underperforms, the developer is left with debt that cannot be serviced by their income, despite the game itself being profitable.

This is why there has been a large increase in successful studios and developers entering liquidation, or dissolving, despite having a catalogue of successful game franchises.

There has also been a continued year on year reduction in investment rounds which peaked in 2021. This is likely due to higher interest rates (predominantly) and other economic factors. On top of this, the industry has suffered an onslaught of redundancies, and those struggling to regain employment in the industry are looking at setting up their own companies, all competing for the reduced finance available. Investors will be much more wary of how their money is spent, and how it is secured, as a consequence.

E-Sports:

Many E-Sports teams have been given masses of funding when there was a gold-rush between 2010 and 2020 where several teams saw major investments and partnerships. However, the teams and management did not correctly utilize the funds which were invested, and many teams failed and had to liquidate as a consequence of poor financial planning. This has recently accelerated liquidation of teams that were scraping by, due to the contraction in advertising spending in 2023 and higher interest rates internationally, which meant that sponsors had less funds available for marketing and partnerships were less viable.

The rise of the Saudi E-Sports Federation has given some hope to the wider E-Sports industry/community, as they have shown that there is a viable investment strategy to allow E-Sports teams to grow more sustainably and return a profit (eventually). It would appear teams need to be given room to grow and find their feet before investment is pulled.

Technology:

The technology sector is filled with start-up fairy tales of hustling founders who scrape by on limited funds, carefully controlled by venture capital funds, before hitting the jackpot and becoming a “unicorn” (a privately owned company valued at one billion dollars [USD]).

During the covid pandemic, there was an injection of capital into the tech sector, attempting to capitalize on the growth the industry was seeing. During this period, time was of the essence, and as a result, due diligence was (it would appear) expedited. Since the boom, there has been an almighty crash, and many tech companies have entered liquidation. The highest profile tech companies that are now insolvent include WeWork and Silicon Valley Bank (“SVB”).

Since the pandemic, however, there has been a contraction in investments. When VCs invest in a tech company, they usually secure it over some equity of the company and the intellectual property (“IP”) which the company is attempting to grow and exploit.

With the recent boom in AI, there has been significant investment into AI companies. However, there is speculation that the AI large language models (“LLMs”) are not as powerful or game changing as advertised. Companies raising investment on these LLMs also require significant data harvesting from third parties to train their programs. But this has not yet been tested in the courts. Getty Images v StabilityAI will determine the legal viability for a large portion of these AI companies and their LLMs where third party IP is conditional on its success. Directors who misrepresent the feasibility of their LLMs in order to raise investment, or to prevent debtors presenting winding-up petitions, may give rise to misfeasance or to fraudulent trading claims in the future.

Advice:

Directors should consider seeking the advice of professional advisers (from incorporation of their company), including but not limited to: lawyers, accountants, and potentially consultants.

If your company is struggling financially, it is generally recommended that you liaise with an insolvency practitioner/lawyer sooner rather than later, so that they can determine if your company is still a viable asset. This is the most sensible option under the circumstances, as the Official Receiver, or appointed liquidator(s), may pursue you personally for various company debts as directors.

Griffin Law has experience acting for creditors of distressed and liquidated companies, as well as liquidators and directors of liquidated companies.

Griffin Law is a dispute resolution firm comprising innovative, proactive, tenacious and commercially-minded lawyers. We pride ourselves on our close client relationships, which are uniquely enhanced by our transparent fee guarantee and a commitment to share the risks of litigation.  For more details of our services please email justice@griffin.law or call 01732 52 59 23.