When a company gets into financial difficulties but is not yet technically insolvent, a period often referred to as the ‘zone of insolvency’, the directors must consider the interests of creditors alongside their duty towards the shareholders of the company when making any decisions.
The directors’ actions or lack of action can lead to a claim being brought against the directors if the company goes into insolvent liquidation or administration. One of the most common claims against a director that can arise in these circumstances is known as wrongful trading and is a statutory offence under the Insolvency Act 1986.
In this article, our Insolvency solicitors discuss how wrongful trading claims are made, the evidence required and the remedies if a claim is successful.
Jump to:
- What is wrongful trading?
- What is an example of wrongful trading?
- What does it mean for a director who is found guilty of wrongful trading?
- Who can bring a claim for wrongful trading?
- How to make a wrongful trading claim?
- Is there a time limit to making a wrongful trading claim?
- How can wrongful trading be proved?
- How can directors limit the likelihood of being accused of wrongful trading?
- What are the most common defences available to directors accused of wrongful trading?
- What is the remedy for wrongful trading if a claim is successful?
- Summary
What is wrongful trading?
Wrongful trading occurs when at some point before a formal insolvency procedure, the director knew or ought to have known that there is no reasonable prospect of the company avoiding insolvency and they do not take steps to minimise losses to creditors but continue to trade in the hope of turning the company’s fortunes around.
What is an example of wrongful trading?
Examples of wrongful trading include:
- accepting deliveries or credit from suppliers which won’t be repaid
- continuing to pay excessive salaries or bonuses to directors
- repaying a director’s loan ahead of other creditors
- accepting payments or deposits from customers for new orders which cannot be met
- getting into arrears with salaries, national insurance and tax payments
- signing up to hire purchase or credit agreements which cannot be paid
- building up any other type of debt in the company
- failing to file accounts at Companies House.
What does it mean for a director who is found guilty of wrongful trading?
Wrongful trading claims can be very damaging for directors both personally and professionally.
On a personal level, directors can be ordered to personally contribute to any company losses in order to compensate creditors and may also incur substantial legal costs defending the claim. Although not a criminal offence, if directors are being investigated for wrongful trading there is a risk they may be found guilty of fraudulent trading which is a criminal offence and could result in time in prison.
On a professional level, a wrongful trading claim can seriously damage a director’s reputation as their integrity and competence will have been brought into question. A director may also face disqualification for a period of up to 15 years.
Who can bring a claim for wrongful trading?
Wrongful trading claims can only be brought by a liquidator or administrator after the company has entered into formal insolvency proceedings. Sometimes a liquidator or administrator may choose to assign a claim to a third party, such as a creditor where they do not wish to pursue the claim or do not have the resources to pursue it.
How to make a wrongful trading claim?
Wrongful trading claims will be pursued by the liquidator or administrator for the benefit of the creditors - any amounts successfully recovered from the directors will be added to the creditors’ pot for distribution.
A claim can only be taken against a company director. The claim not only covers directors registered at Companies House, but also de facto directors (those who act as directors), as well as shadow directors (those with a significant controlling interest in the decision making of the company). It also includes non-executive directors as well as executive directors. It is important to note that resigning as a director will not get you off the hook.
Is there a time limit to making a wrongful trading claim?
Yes – there is a six year limitation period which runs from the date the company goes into administration or liquidation.
How can wrongful trading be proved?
The liquidator or administrator bringing the claim needs to pinpoint a date of knowledge of insolvency. This will be when the directors knew, or should have known, that the company was or was likely (in the sense of probable) to become insolvent. Retrospectively trying to establish a specific date for this is not an easy task for an insolvency practitioner and will depend each time on the circumstances of the case.
An example may be when a company that has asked for the forbearance of creditors for a short while to secure extra funding, realises that the funding is not going to be forthcoming but carries on trading anyway.
In assessing the required standard of knowledge, the courts will apply an objective and subjective test and will look at the facts the director ought to have known or ascertained, the conclusions that the director ought to have reached and the steps that the director ought to have taken against that of 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 that director in relation to the company (the objective test), and the general knowledge, skill and experience which that director has (the subjective test).
In proving that the creditors suffered further loss, a court will take the point at which it believes the company should have ceased trading but didn’t, and then look at the increase in the loss to the creditors as a whole from that date until the date that the company actually ceased trading.
How can directors limit the likelihood of being accused of wrongful trading?
Some of the ways in which directors can reduce their risk of being liable for wrongful trading include:
- continuously monitoring the financial position of the company and having an accurate view of the company’s finances at all times - cash flow forecasts can help show that you have considered the effect of continuing to trade on the creditors’ position.
- holding regular board meetings to discuss the financial viability of the company and what actions should be taken and making sure that these are recorded in detail should they be required later on to evidence the reasoning behind decisions. Directors also need to show that they have made their decisions independently based on the financial information known to them.
- not taking on any more credit during this time unless you can be sure it will be repaid.
- not removing assets from the company and ensuring the sale of any company assets is at market value, having obtained an independent valuation.
- not repaying director loans, or any loans that may personally benefit the directors – for example, repaying an overdraft which has been personally guaranteed by a director - this can all be clawed back.
- ensuring Companies House filings are made on time and salaries and taxes are paid correctly and on time.
- not paying yourself an unreasonably high salary or bonus as this could be seen as depriving creditors of cash owed to them.
- taking legal and financial advice as early as possible – contacting specialist insolvency solicitors and/or director disqualification solicitors, if there is any doubt at all.
What are the most common defences available to directors accused of wrongful trading?
The most common defence to wrongful trading claims is the statutory defence of taking every step with a view to minimising the potential losses to creditors. This will be very dependent on the facts of the case and is likely to include steps such as not incurring further debt, preserving the assets of the company and taking professional advice.
In the recent BHS case where wrongful trading claims were brought successfully against the directors, the judge confirmed that not taking professional advice will make it more difficult for the directors to show that they had taken every step to minimise the potential losses to creditors but the court will also look at the quality and extent of the advice and whether it was ultimately followed by the directors.
It is crucial that directors keep detailed records of their board meetings and any decision making process and any advice on which they have relied in making these decisions in the event that they need to defend a wrongful trading claim.
What is the remedy for wrongful trading if a claim is successful?
The court’s discretion is very wide but usually the court will order the director or directors to contribute personally to the assets of the insolvent company in proportion to the value of the increase in loss to creditors during any period of wrongful trading. Any money ordered to be paid by the director will go back to the company for the benefit of all creditors, not just the creditor that brought the claim.
If there is more than one director, the court can decide how much each director should pay, or order that the amount is to be paid on a joint and several basis.
Summary
A wrongful trading claim can result in serious personal and professional consequences for a director, as we have seen above. These claims can be difficult for a liquidator or an administrator to bring as they require a great amount of time and expense to establish. Nevertheless, as a director, you don’t want the threat of these claims hanging over you at a time of great stress for you and the business. Recent cases have highlighted the importance of obtaining legal advice both as a board and independently. Our team here at Harper James have many years of experience advising directors in similar situations so if you do have any concerns or need advice, please contact us today.
