The ongoing recession is likely to result in increased instances of directors allowing companies to continue trading whilst insolvent. In these circumstances, they need to be aware of the concept of wrongful trading first introduced in the Insolvency Act 1986 (IA86) to discourage directors from doing so by making them personally responsible.

 

This article considers the wrongful trading charge in comparison with the charge of fraudulent trading, the parties most likely to be affected, the basis underlying a review of the directors’ knowledge and the steps they should have taken, the primary “tests” underlying successful Court actions and the primary lines of defence available to those accused of wrongful trading.

 

What is wrongful trading?

 

In order to have been wrongfully trading, it must emerge in the course of a winding up of a company that a director, at some time prior to the commencement of the winding up, knew or ought to have concluded that there was no reasonable prospect that the company could avoid going into insolvent liquidation. In these circumstances, relevant aspects relating to directors being potentially liable to make up any losses incurred after that time include the following:

 

(a) wrongful trading can only apply following an insolvent liquidation so that an Administrator or the Supervisor of a Voluntary Arrangement or a Receiver has no power to bring an action against directors;

 

(b) wrongful trading is a civil offence under the IA86 so that the standard of proof for a successful action is that based on “the balance of probabilities” as opposed to that based on “beyond reasonable doubt”; and

 

(c) the Court can make an order requiring one or more of a company’s directors to make a financial contribution to the liquidator for the benefit of the company’s creditors and directors may be disqualified from being concerned in the management of a company.

 

The charge of wrongful trading was introduced in the IA86 as a “lesser” offence relative to that of fraudulent trading because bringing an action in

relation to the latter necessitated showing that the business of the company must have been carried on with intent to defraud its creditors or creditors of any other person or for any fraudulent purpose. Moreover, as a successful action resulted in a criminal conviction, the standard of proof in relation to fraudulent trading had to be “beyond reasonable doubt”. The introduction of wrongful trading therefore resulted in the ability to take action through a lower standard of proof whilst continuing to ensure that directors were responsible for their actions after a company failed.

 

Who are directors in relation to wrongful trading?

 

References to “directors” are deemed to include both “de facto” and “shadow” directors.

 

A “de facto” director is one who acts as a director, whether formally appointed or not. A “shadow director” is a person on whose instruction the directors of the company are accustomed to act. In this context, it is important to note that the following may be regarded as directors in relation to the offence of wrongful trading:

 

(a) non-executive directors on the basis that they sit on the board of directors;

 

(b) a parent company on the basis of it giving directions to a subsidiary which goes into insolvent liquidation; and

 

(c) practising accountants, lawyers and other advisors or those acting in interim financial or legal posts on the basis that there is potential for their actions to render them shadow directors.

 

Judging the directors’ knowledge and the steps they should have taken

 

In determining the knowledge of the directors and the steps which they ought to have taken, there is a mixed objective and subjective test.

 

It is important to consider the general knowledge, skill and experience that may reasonably be expected of someone in the position of the director.

 

It is also important to consider the general knowledge, skill and experience that the director actually has. On this basis, the following examples illustrate the aspects which could be taken into account given that different standards could apply to different people depending on their level of skill and experience:

 

(a) although a sales director would be judged against the standard of the “reasonable” director as applicable to all directors and shadow directors, the onus on such a director may not be considered to be as great as upon the managing director, who would be seen to have a greater level of general skill and responsibility, or the finance director, who would be assumed to have a higher level of specialist skill and experience;

 

(b) the standards expected of a director of a small company would be lower than those in relation to a large company; and

 

(c) the standards expected of a non-executive director would be lower than those of an executive director.

 

Aspects underlying successful actions against directors

 

Successful actions against directors accused of wrongful trading are likely to be supported by indicators that the company concerned was in financial difficulty including the following:

 

(a) the late filing of financial statements;

 

(b) insolvency on a balance sheet basis, i.e. the company’s assets were insufficient for the payment of its debts and other liabilities;

 

(c) increasing pressure from creditors, e.g. creditors were withholding supplies; and

 

(d) payments to creditors being made only when legal action was commenced and the company was unable to pay its debts as they fell due.

 

Primary lines of defence

 

Directors who contend that they were not involved in wrongful trading may be able to cite the following aspects of their involvement in relation to their defence:

 

(a) the board of directors relied upon updated financial information including profit and cash flow forecasts;

 

(b) there was regular consultation with other directors and discussions

were minuted accurately;

 

(c) appropriate external legal and financial advice (including possibly that from a Licensed Insolvency Practitioner) was sought as soon as there was an awareness that the company had serious problems;

 

(d) accurate assessments were made in relation to the solvency of the company with particular regard being taken of contingent liabilities and, if the company was considered to be insolvent on a balance sheet basis, consideration was given to its ability to be profitable in the foreseeable future; and

 

(e) steps were taken to try to minimise the potential loss to the company’s creditors including serious consideration having been given towards consulting with the major creditors so that they knew the risks of supporting the company.

 

It is important to note that resignation does not absolve directors of responsibility where it should have been apparent before resignation that insolvent liquidation would follow.

 

Conclusion

 

In the current economic climate, it is important for directors to be acutely aware of their companies’ trading performance and financial position and to ensure that they are undertaking their responsibilities with due care so that they are not left open in future to potential actions relating to wrongful trading.

 

Rakesh Kapila is a member of the Expert Witness Institute and the Academy of Experts. He is a partner at Sim Kapila, Chartered Accountants, a firm based in London W1 which specialises in forensic and investigative accountancy. E-mail: rkapila@simkapila.co.uk

 

The author has copyright over this article and its reproduction, in whole or in part, is not permitted without his prior written consent.