Liability for fraudulent trading existed long before liability for wrongful trading was introduced. However, the high standard of proof required to establish liability for fraudulent trading has meant that proceedings have rarely been brought. Following criticism of the ineffectiveness of s.213, the concept of wrongful trading was introduced. This is now the major risk run by the directors of a company trading on the brink of insolvency. It is of interest to know that successful wrongful trading actions are still relatively rare and those actions which are brought usually settle without going to trial. Nevertheless, directors invariably take the risk of incurring wrongful trading liability very seriously and it is an important part of a lawyer’s job to advise on the risk and how to mitigate it.
Purpose
The IA 1986 was amended by the SBEEA 2015 so as to give the right to administrators to bring wrongful trading actions (originally, it was only available to liquidators). In the statutory references given below, the first reference is to the one which applies to liquidators and the second, to administrators. Substantively, the provisions are the same.
The purpose of ss.214 and 246ZB is to ensure that when directors become aware (or ought to become aware) that an insolvent liquidation (or insolvent administration, as the case may be) is inevitable, they are under a duty to do everything possible to minimise the potential losses to the company’s creditors. If they fail to do this, the court can, under ss.214 and 246ZB, order the directors to contribute to the insolvent estate by way of compensation for the losses that the general body of creditors have suffered as a result of the directors’ conduct, and thereby, increase the funds available for distribution to unsecured creditors in the insolvency. Wrongful trading liability therefore imposes personal liability on directors and marks a very important exception to the principle of limited liability under which those who run a company cannot be liable for its unpaid debts.
Note that there is no requirement to show intent or dishonesty and so it is easier for a liquidator or administrator to prove wrongful trading than it is fraudulent trading.
Who may bring a claim?
Liquidators and administrators may bring a claim (ss.214(1) and 246ZB(1)). Administrators and liquidators can now (under the SBEEA 2015) assign wrongful trading claims to a third party as a way of raising funds for the insolvent estate and thereby, avoid the risk of litigation.
Against whom can the claim be made? – ss.214(1) and 246ZB(1)
Any person who was at the relevant time a director (and this includes shadow directors as defined in s.251 CA 2006, de facto and non-executive directors).
Contrast this with fraudulent trading where a claim can be brought against any person who has the intention to commit a fraud.
Requirements for liability under ss.214(2) and 246ZB(2)
For a director to be liable for wrongful trading, the court must be satisfied that:
- at some time before the commencement of the winding up or insolvent administration (for convenience, I will refer to that time as the ‘point of no return’)
- the director knew or ought to have concluded that
- there was no reasonable prospect that the company would avoid going into insolvent liquidation (or as the case may be, insolvent administration).
Note that a company goes into insolvent liquidation (or as the case may be, an insolvent administration) at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of winding up (s. 214(6)) or, as the case may be, the expenses of the administration (s.246ZB(6)). Insolvency for wrongful trading purposes is therefore judged solely on the “balance sheet test” and not on the “cash flow test” (see s.123).
If the company has not reached the point of no return, then wrongful trading liability cannot arise and there is no need to consider the ‘every step’ defence which we consider below.
The ‘every step’ defence (ss.214(3) and 246ZB(3))
Assuming the company has reached the point of no return, a director may be able to escape liability if he can satisfy the court that, after he first knew or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent administration or liquidation (i.e. from the ‘point of no return’ onwards), he or she took every step with a view to minimising the potential loss to the company’s creditors.
Examples of evidence that may be supportive of establishing the every step defence include:
- voicing concerns at regular board meetings;
- seeking independent financial and legal advice;
- ensuring adequate, up-to-date financial information is available;
- suggesting reductions in overheads/liabilities;
- not incurring further credit; and
- consulting a lawyer and/or an insolvency practitioner for advice on continued trading and the different insolvency procedures.
The reasonably diligent person test (ss.214(4) and 246ZB(4))
The court applies the ‘reasonably diligent person’ test in ss.214(4) and 246ZB(4) in order to determine whether (i) a liquidator or administrator has established that a director ought to have concluded that there was no reasonable prospect of avoiding an insolvent liquidation or administration (the s.214(2)/s.246ZB(2) liability) and (ii) whether the director then took every step to minimise the potential loss to the company’s creditors (the s.214(3)/s.246ZB(3) defence).
Under that test, the facts which a director ought to have known or ascertained, the conclusions which he ought to have reached and the steps which he ought to have taken, are those which would have been known or ascertained, or reached or taken, by a reasonably diligent person having both:
- the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by the director in question (an objective test); and
- the actual knowledge, skill and experience of that particular director (a subjective test).
The court then applies the higher of the two standards.
So, for example, although under the objective element to the test it might be reasonable to expect less of a director of a small company with less sophisticated financial systems than a much larger company, there is an objective minimum standard below which no director may fall. However, the court will also look at the subjective element to the test (i.e. the actual position of that director) and apply a higher standard if appropriate.
Directors should hold board meetings regularly and often to review the company’s financial position and consider whether in any particular case, it is appropriate to incur new credit and liabilities. They should write up minutes of each meeting so there is a written record on which the directors can later rely to justify why decisions were taken when they were. It is quite common for lawyers advising a company in financial difficulties to take an active role in helping directors to prepare minutes and to ensure that board meetings consider all the relevant issues.
Can a director avoid liability by resigning?
Sections 214(2)/246ZB(2) refer to a person who was a director at the relevant time. A director cannot therefore escape liability by simply resigning without previously taking every step with a view to minimising the potential loss to the
company’s creditors. In addition, a director who disagrees with how other directors are behaving should seek to persuade them to his point of view before resigning and only when he considers that he will not be able to do so may resignation be the most appropriate option.
Sanction
If a director is found to be liable for wrongful trading, the court can order that director to make such contribution to the assets of the company as the court thinks fit (ss.214(1)/246ZB(1)). The contribution will increase the assets of the company available for distribution to the general body of unsecured creditors.
The court has a wide discretion to determine the extent of the directors’ liability. Although ss.214 and 246ZB provide no guidance for calculating the amount of a director’s contribution, case law has clarified that the contribution will ordinarily be based on the additional depletion of the company’s assets caused by the directors’ conduct from the date that the directors ought to have concluded that the company could not have avoided an insolvent administration or liquidation (i.e. from the ‘point of no return’). An order by the court for a director to contribute to the company’s assets under ss.214 and 246ZB is compensatory and not penal in nature. An order to contribute may be made against the directors on a joint and several basis. However, the court has a discretion to apportion liability between directors based on their culpability by ordering the more culpable directors to pay more than the less culpable ones.
Under s.1157 CA 2006, the court may relieve a director from liability in proceedings for negligence, breach of duty or breach of trust, on such terms as it thinks fit, if satisfied that he/she acted honestly and reasonably, and having regard to all the circumstances of the case, the director ought fairly to be excused. However, that relief is not available in wrongful trading proceedings (Re Produce Marketing Consortium Ltd [1989] 1 WLR 745).
Where the court makes a contribution order against a director under ss.214/246ZB, the court also has a discretion to make a disqualification order against him/her under s.10 CDDA 1986.