Jonathan Masucci advises on measures directors can take to protect themselves in the context of the Insolvency Act and COVID-19.
What is wrongful trading?
The statutory offence for wrongful trading is set out under the Insolvency Act 1986 (IA 1986). An offence is committed where a person who is or was a director of the company concludes, or ought to have concluded, that there is no reasonable prospect of the company avoiding an insolvent liquidation or, in relation to business conducted on or after 1st October 2015, insolvent administration but, nevertheless, the company continued to trade and losses to the company’s creditors were not minimised.
How does it differ from fraudulent trading?
In contrast with the broader offence of fraudulent trading, which is committed where it appears that any business of a company has been carried on with the intent to defraud creditors of the company, or any other fraudulent purposes, wrongful trading actions can only be brought by a liquidator against directors of the insolvent company. The IA 1986 also defines “Director” broadly to include any person occupying the position of director, by whatever name they are called. As a result, it is possible for de facto and shadow directors to fall under the definition of “Director” and be convicted of wrongful trading.
What are the rules?
Both subjective and objective tests are applied in order to determine what that particular director knew and what a reasonable director would have known in the circumstances, with regards to whether or not the company could avoid insolvency. Such tests will take into account matters such as the size of the business and the director’s function. For instance, where a director is the finance director for the company, it would be reasonable to expect them to have a greater degree of knowledge, competence and understanding on accountancy matters than other directors.
That said, in practice, a liquidator will seek overwhelming evidence of insolvency that any director should have known about. Actions such as:
- creditor pressure, late filing of accounts
- the company being insolvent on a balance sheet basis
- qualification on the accounts by the auditors
- the company only paying creditors after such creditors have issued proceedings or statutory demands
- judgments against the company,
are all examples of evidence that could be used to establish the offence of wrongful trading against any director, regardless of their specific position and day to day duties within a company.
A defence to wrongful trading is available, where it can be demonstrated that the director took every step with the intention of minimising potential loss to the company’s creditors, after becoming aware that the company had no prospects of avoiding insolvency. This would include the following:
- taking professional legal and accountancy advice
- minimising the purchase of further goods on credit
- rigorously pursuing the collection of debts and frequently reviewing management accounts to obtain an up to date understanding of the financial position of the company.
The defence does not usually require the director to resign from their position as director of the company.
How can you be sure to avoid issues?
In order to avoid accusations of wrongful trading, directors should consider taking various measures to protect themselves. These include:
- keeping accurate records of their own activities
- ensuring sufficient financial records are kept
- seeking professional advice at the earliest opportunity if there are signs the company is in financial difficulty
- when financial concerns start to become evident, these should be raised with the Board.
What are the potential consequences if you fall afoul of wrongful trading laws?
Generally speaking, directors are not personally liable for the debts of a company. This is due to the fact a company has a separate legal personality. That said, there are some exceptions, which include wrongful trading. If an offence of wrongful trading is established, then the court can order a director to make a personal contribution to the company’s assets, for the loss that their actions have caused.
In addition to the above, a court can make an order to disqualify a person, if they are found liable for wrongful trading, for a maximum period of up to 15 years.
In 2018, the government ran an Insolvency and Corporate Governance consultation on ways to reform these respective frameworks. The government’s response was published on 26th August 2018 and in relation to the current insolvency framework, this sought to strengthen it in cases of major corporate failure by:
- taking forward measures to ensure greater accountability of directors in group companies when selling subsidiaries in distress
- legislating to enhance existing recovery powers of insolvency practitioners in relation to value extraction schemes
- legislating to give the Insolvency Service the necessary powers to investigate directors of dissolved companies when they are suspected of having acted in breach of their legal obligations.
In relation to wrongful trading in particular, it seems clear that once legislation is enacted, not only can directors expect to face an increased level of scrutiny over the decisions they made prior to a company being dissolved, it will be much more difficult to rely on the defence set out in the IA1986. This will no doubt increase the importance of receiving timely legal and accountancy advice at the outset, should directors have concerns about the financial health of the company.
On 28th March 2020, in the wake of the COVID-19 pandemic, the government announced that it would suspend the operation of rules relating to wrongful trading for three months, effective from 1st March 2020, with the possibility that such period of suspension may be extended.
Since then, draft legislative provisions have been published in the Corporate Governance and Insolvency Bill (CGIB). These would operate by requiring a court to work on the basis that a director is not responsible for any worsening of the financial position of the company, or its creditors, that occurs from 1st March 2020 until 30th June 2020 or one month after the CGIB is enacted and comes into force, whichever is later. Whilst this may offer some reassurance to directors in the current economic climate, in reality, it remains to be seen whether acts of wrongful trading might instead be brought under other liabilities, such as misfeasance for breach of duties.
For further advice on this and other Commercial Law issues, please contact Jonathan Masucci.