Wrongful trading revisited
By Steven Wood, Practice Support Specialist (Insolvency)
1 June 2022
The temporary suspension of the wrongful trading provisions introduced by the Corporate Insolvency and Governance Act 2020 is now a distant memory and ICAS has recently seen an increase in queries about director responsibilities when a company is in danger of trading insolvently.
It is therefore an opportune moment to revisit the wrongful trading provisions, as a reminder of the action that directors should be taking (and advising parties should be recommending that they take) to be able to demonstrate a defence to accusations of wrongful trading.
Definition
In trading conditions where the company’s solvency is not in doubt, the directors are acting for the benefit of the company and its shareholders.
However, where it becomes apparent that the company is insolvent or at serious risk of insolvency, the focus of the directors’ duties switches and their overriding responsibility is to act in the best interests of the creditors of the company.
If a company is insolvent and its directors know (or ought reasonably to conclude) that it cannot avoid insolvent liquidation or administration, they are under a duty to take every step a reasonably diligent person would take to minimise potential loss to the company's creditors. Failing that, they risk personal liability for any worsening of the company’s financial position.
This is what is known as ‘wrongful trading’, as per sections 214 and 246ZB of the Insolvency Act 1986 (IA86). If a wrongful trading action is successful, the directors may be required to contribute to the company’s assets.
Fraudulent trading
Wrongful trading should not be confused with fraudulent trading – its more serious neighbour.
Fraudulent trading is a criminal, as opposed to civil, offence and requires intent on the part of the directors. As set out at sections 213 and 246ZA of IA86, the business of the company must have been carried on with the intent to defraud creditors of the company, or creditors of any other person, or for any fraudulent purpose.
Wrongful trading test
Wrongful trading cases remain relatively rare due to the high standard of proof required. Previous cases, such as Re Ralls Builders Ltd (in Liquidation) [2016] EWHC 1812(Ch) demonstrate that liability will not be imposed simply due to a company trading while in financial difficulties.
Potential for liability arises at the point that the directors know or ought to know that there is no reasonable prospect of avoiding insolvent liquidation or administration based on both the company’s current position and its realistic prospects. This should be judged without the application of hindsight. What the directors ought to have concluded is assessed by reference to the knowledge, skills and experience that a reasonably diligent person in that person’s position may reasonably be expected to have, and the actual knowledge, skills and experience that the defendant director did, in fact, have.
For example, a director who is a chartered accountant is expected to have greater skill and experience in relation to the finances of the company than a director who is a tradesman. That does not mean to say that the tradesman would not be able to be assessed on responsibility of financial decisions, just that the standard by which they may be judged may be at a lower level. There is no requirement for dishonesty by the director when it comes to assessment of wrongful trading. Further, there must have been a material increase in the company’s net deficiency as regards individual unsecured creditors as a result of continued trading.
Considerations for directors
Directors of struggling companies must attempt to strike a balance between two courses of action. If they conclude that an insolvency process is required, they must start that process early enough to both protect creditors so far as possible and to avoid the risk of personal liability.
However, they must allow time to explore the options for the company’s survival as exhaustively as possible. Directors’ responsiveness to events will be important in determining if liability arises, as will whether their assessment of the company’s prospects is ultimately considered credible. Directors should take care to gather all relevant information and continually re-evaluate their options considering professional advice and experience.
Some key considerations are:
- is the company 'insolvent', whether on:
- a cash flow basis – i.e. it cannot pay its debts as they fall due; or
- on a balance sheet basis – i.e. its liabilities exceed its assets.
- if the company is insolvent, is there a reasonable prospect of avoiding an insolvent liquidation or administration?
- is there funding available or arrangements that have a reasonable prospect of being agreed with stakeholders or other third parties which will prevent insolvency?
Practical steps
Some basic practical steps to consider:
- Take professional advice – from an insolvency practitioner if necessary. The advice that directors receive at the time will be of significance in assessing whether they could properly have taken the view that insolvent liquidation or administration could be averted.
- Ensure there is a paper trail evidencing all key business decisions which impact creditors. It is vitally important that all decision-making is fully documented.
- Back up with financial information and forecasts. Cashflow forecasts should focus on the medium to longer term backed up by separate short-term forecasts where the cashflow situation is more critical. Stress test the assumptions made within the financial forecasts to ensure that they are realistic to be achieved.
- Discuss with stakeholders where this is appropriate. There should be a clear understanding of attitudes of stakeholders and the impact that this might have on the business. It is particularly important to consider for instance the attitudes of banks and other finance providers, key suppliers as well as equity shareholders in the business.
- Regular board meetings should be held, and documented, to continually assess the viability of the business.