COVID-19. The country faces total lockdown, whilst the world’s health care services desperately try to reduce the tragic effects of the coronavirus pandemic in December 2019.
By now, there are ample free resources and materials being made available to help businesses of all sizes trying to legally manoeuvre around the devastating landscape being carved out by the novel coronavirus known as COVID-19. We have also provided this here.
This will, undoubtedly, end at some point. But it has already caused significant disruption and even with various Government incentives, not all businesses will survive extensive periods of financial difficulty; for some businesses, it will be the cause of their insolvency.
If your business is unable to weather this particularly savage storm and you are forced to place your company into insolvent liquidation or administration, then you may be understandably concerned about any potential, personal, claims against you as a director.
To touch briefly upon directors’ duties to their companies, the Companies Act 2006 sets out 7 general duties, see below (this is not an exhaustive list):
- To act within powers.
- To promote the success of the company.
- To exercise independent judgment.
- To exercise reasonable care, skill and diligence.
- To avoid conflicts of interest.
- Not to accept benefits from third parties.
- To declare an interest in a proposed transaction or arrangement.
We have previously considered the extent of Liquidator’s powers here, which explains the Liquidator’s duties to the creditors and various powers to try and recover as much as possible for the benefit of those creditors against directors who have not, amongst other things, complied with their duties; one of these grounds of claim being “Wrongful Trading”.
Directors can be ordered to make a contribution towards the assets of the company if found to have been wrongfully trading.
Recently, the UK Government has announced that, amongst other measures, it will suspend the wrongful trading law in order to try to protect company directors during the pandemic if the company is unable to keep afloat and is placed into insolvency.
But what is wrongful trading, and why could directors have been at risk?
Insolvent
Fundamentally, wrongful trading applies to insolvent companies. There is no formal, legal definition of “insolvent.” Rather, there are two tests to evidence insolvency:
- “Cashflow insolvency”; where a company is unable to pay its debts as and when they fall due (an unpaid statutory demand will usually satisfy this);
- “Balance sheet insolvency”; where the value of the company’s assets are less than its liabilities (bearing in mind contingent and prospective liabilities).
Wrongful Trading
A wrongful trading claim can only arise once the company has been placed into insolvent liquidation or administration and it is for the office holder (by this, we mean the liquidator or administrator) to establish:
- The “insolvency date” that is the date on which the directors knew, or ought to have known, there was no reasonable prospect of the company avoiding insolvency.
- That, from the “insolvency date”, the directors failed to take every step to minimise future losses to the Company’s assets/creditors (this must be to the creditors as a whole, not just a certain creditor).
- That the loss caused to the company/its creditors was as a result of the wrongful trading.
It is a common misunderstanding that the wrongdoing is “trading whilst insolvent”. There is no requirement to show that the company traded. Moreover, the liability for wrongful trading only arises if after the Insolvency Date, the directors failed to take every step with a view to minimising the losses and, further, will then only bite if the company in fact goes into insolvent liquidation or administration.
Potential Defence(s)
Following the above, therefore, there are some avenues for a director to challenge/defend the claim.
The first stems from (1) above; the director’s knowledge. If the director can satisfy the Court that they did not know or could not have known there was no reasonable prospect of avoiding insolvency at the relevant time, this may defeat a claim.
When considering this element, the Court will consider the steps a reasonably diligent director would have taken, having regard to:
- The general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions (including functions not carried out by the director which had been entrusted to them), as are carried out by the director, and
- The general knowledge, skill and experience of the director in question.
This test has two strands to it. The first is an objective test and concerns “the reasonable director”, the second is subjective, and concerns the actual director before them.
One obvious example is that of a start-up company. Technically, a start-up company with nominal income and which has taken a large loan will be insolvent, but it has just started up so the directors are not going to have any inclination of it becoming insolvent.
The second key defence stems from (2). If the directors can show that they have taken “every step” to minimise future losses to the creditors as a whole, then this may act as a defence. However, this is a very high hurdle to overcome.
Finally, the next possible challenge comes from (3). English law is predicated on the notion that the wrong doer should compensate for the losses incurred as a result of the wrongdoing. Our civil legal system, save where specifically prescribed, is generally speaking, not a punitive based system; rather, it is to put the injured party back into the position they would have been if not for the wrongful act or omission.
Therefore, if there is no actual loss that has occurred as a result of the wrongful trading, then the Court will not make an order for a contribution from the directors.
It is for the office-holder to satisfy that the wrongful trading has caused an “increased net deficiency”.
Whilst the wrongful trading rules are being relaxed, temporarily, directors will nonetheless need to remain mindful of their duties and continue to act in the interests of the company and its creditors as a whole. This suspension will not apply to other insolvency offences, and Liquidators/Administrators may still be able to pursue claims for misfeasance and antecedent transactions, such as preferences, in the event a company is placed into insolvency.
This is not legal advice; it is intended to provide information of general interest about current legal issues.