Fri 25 Jun 2021

What do I need to know about wrongful trading?

As a result of temporary provisions that have been in place since March 2020*, during the Covid period directors have been broadly protected from the risk of personal liability for wrongful trading.  Those temporary provisions are due to end on 30 June, 2021 and as a result, the law on wrongful trading again becomes highly relevant.

The wrongful trading sections of the Insolvency Act 1986 are sections 214 (liquidation) and 246ZB (administration).  What the sections do is to potentially expose directors (and shadow directors) of companies that go into liquidation or administration to a risk of personal liability in respect of the debts of the insolvent company.   That threat of personal liability of course cuts across the fundamental concept of limited liability in company law. Accordingly, the concept of wrongful trading is critically important for directors. 

The sections state that once the directors of a company know (or ought to know) that there is no reasonable prospect of a company avoiding insolvent liquidation (or administration) they should take every step that is practicable thereafter to minimise the loss to creditors in the ensuing insolvency.  If they do not take every such step, the directors may later be subject to an order from a court requiring them to contribute to the shortfall due to creditors. 

Wrongful trading is often colloquially referred to as "trading while insolvent" or "trading insolvently". Aggrieved parties often allege that a company is trading or has traded insolvently (and what they generally mean by this is that the company is balance sheet insolvent or has a cash flow difficulty and cannot meet its debts as they fall due), and that the directors should be called to account for any subsequent loss.   However, it should be noted that the Insolvency Act does not recognise the concept of "trading insolvently". It is only when the statutory test for wrongful trading has been met that directors can have an exposure to a possible personal liability under the sections. 

"No reasonable prospect of avoiding insolvency"

Wrongful trading liability becomes a concern once the directors have reached the point that they know (or ought to know) that the company has no reasonable prospect of avoiding insolvency.  What this means in practice is that the directors should always be taking a realistic and informed view of the prospects of the company and its ability to avoid insolvency.

In this context "ought to know" reflects the fact that the wrongful trading test is objective as well as subjective, and directors are deemed to have at least the ordinary knowledge and competence of a reasonable director. Directors are also under a duty to ensure that they have the necessary information to hand that will allow them to manage the company competently. A failure to have such information will not be a defence and directors will be assessed for wrongful trading as if they actually had the information that a reasonably competent director would have ensured was available.

The importance of evidence

It will not be enough for the directors to try to rely on overly optimistic projections to argue that the company had a reasonable prospect of avoiding insolvency.  In order to be properly placed to defend proceedings that may be brought against them in the future, directors must be able, whenever insolvency may be a possible outcome, to evidence their thought processes and the reasons for the decisions that they made at the time.  Ordinarily, that will involve at the very least cash flow projections being produced regularly and board minutes recording decisions and justifying those decisions. 

Taking every step to minimise loss

If directors do reach the stage where they consider that there is no reasonable prospect of avoiding insolvency, the next stage of the wrongful trading sections becomes relevant. Can the directors show that they then took every step to minimise the subsequent loss to creditors in the insolvency?  At this stage directors will require specialist legal advice to assist them in coming to the correct decision for them and for their creditors. For many companies, those steps may well be to cease trading and to place the company into a formal insolvency regime (i.e. stop trading to prevent the position getting any worse for creditors).   There will be other circumstances in which the best thing to do to minimise the loss to creditors may be to continue trading (perhaps on a reduced basis) for a period of time. This might be most likely to be appropriate where continued trading would allow the company to complete (and get paid for) contracts and thus improve the asset position in the short term. And there will be situations where a restructuring through an insolvency regime (such as CVA or administration) can be achieved to save the business. The earlier that professional advice is sought, the more options will be available to the business and the chances of optimising the outcome for stakeholders will be maximised.

All businesses have a degree of complexity and as a result the wrongful trading analysis for any individual business is also often quite complicated.  The courts will always appreciate that directors who are facing difficult economic conditions will face hard and complicated decisions on a daily basis.   And that is one reason why wrongful trading actions are relatively rare. Proving what the directors knew or ought to have known and what the prospects of avoiding insolvency at any given time were can be difficult for a liquidator or administrator.   However, the threat of wrongful trading liability is probably the main cause for directors to seek appropriate insolvency and restructuring advice and will often lead to them choosing to enter a formal insolvency process.

The lifting of the amnesty
Because of the temporary suspension of wrongful trading liability, it is possible that in the period since March 2020, many companies that would otherwise have gone into formal insolvency have not done so. Directors have not had to be concerned about the risk of personal liability during that period, and so one of the main reasons why directors would usually liquidate a company has not applied.  The protection will disappear from 1 July 2021 and directors will again have to focus on this risk, which will be particularly acute for those businesses that have had a heavy reliance upon the Government support measures to get through the pandemic. Directors must ensure that they have a realistic appreciation of the prospects and difficulties facing their company and must consider and act upon the options that are available to them. Failure to do so could expose the directors personally now that the spectre of wrongful trading liability has again become a real one.

Key points for directors

  • Ensure that they are fully briefed as to the current financial position and trading prospects (including the impact of the withdrawal of Government measures and a perhaps bumpy exit from Covid lockdown restrictions);
  • Hold regular board meetings and consider the developing financial and trading horizon and minute in detail the position and the decisions taken;
  • Ensure that action points to deal with trading or cash flow issues (e.g. cost control measures, supplier discussions, performance monitoring  etc) are monitored and progressed; and
  • Seek early advice if the facts and circumstances are showing corporate distress. If the directors can show they sought and followed appropriate advice during periods of distress that will assist in substantially mitigating any claims against them.

*The suspension of wrongful trading originally took effect from 1 March 2020 and expired on 30 September 2020. It was then resurrected with effect from 26 November 2020. There is therefore a "gap period" (1 October 2020 - 25 November 2020) when the suspension did not apply and in which the normal wrongful trading rules would apply.

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