Wrongful trading

Wrongful trading is a principle of UK insolvency law. It was introduced to enable contributions to be obtained for the benefit of creditors from those responsible for mismanagement of the insolvent company.

The Insolvency Act 1986

The principle of wrongful trading was introduced in the Insolvency Act 1986, to complement the concept of fraudulent trading. Unlike fraudulent trading, wrongful trading needs no finding of 'intent to defraud' (which requires a high burden of proof). Wrongful trading is therefore a less serious, and more common offence than fraudulent trading.

Under UK insolvency law [ s214 Insolvency Act 1986 ] , wrongful trading occurs when the directors of a company have continued to trade a company past the point when they:

*"knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation"; and
*they did not take "every step with a view to minimising the potential loss to the company’s creditors".

Wrongful trading is an action that can be taken only by a company's liquidator, once it has gone into insolvent liquidation. (This may be either a voluntary liquidation - known as Creditors Voluntary Liquidation, or compulsory liquidation). It is not available to the directors of a company while it continues in existence, or to other insolvency office-holders such as an administrator.

Where, during the course of a winding-up, it appears to the liquidator that wrongful trading has occurred, the liquidator may apply to the Court for an order that any persons who were knowingly parties to the carrying on of such business are to be made liable to make such contributions to the company's assets as the court thinks proper.

Who may be liable?

Section 214 Insolvency Act 1986 has very wide scope, since it applies not only to "de jure" directors (that is directors who were formally appointed and their appointment was registered with Companies House. It can apply to "de facto" directors (that is people who assumed the role of director of a company without being appointed), or "shadow directors" (that is people in accordance with whose direction the "de jure" directors were accustomed to act.

Initially, there was uncertainty among banks and insolvency and restructuring professionals who assisted and advised companies facing insolvency that they may be caught by the wrongful trading provisions. This has not proved to be the case (as of July 2006), and professionals are unlikely to be covered by these provisions except in exceptional circumstances.

What is expected of directors?

In order to establish liability, the liquidator needs to demonstrate, using the civil burden of proof (i.e. on the balance of probabilities) that the directors continued trading the company beyond a point in time when they knew, or ought to have ascertained, that insolvent liquidation was inevitable.

The facts that a director ought to have known were those which a reasonably diligent person having both the skill and experience possessed by a reasonable director, together with the skill and experience "actually possessed" by that individual. [s256(4) Insolvency Act 1986] This means that there is a two-fold test for knowledge. There is a general level of skill required for all directors under the first part of the test. Under the second, a higher standard of knowledge is required by those with specialist skills. (These are likely to be accounting or legal skills). This principle has been confirmed in a 1999 case where an executive husband had to pay £210,000 to the liquidator compared with his non-executive wife's £50,000. ["Re Brian D Pierson (Contractors) Ltd" (1999) BCC 26 ]

The normal approach to wrongful trading actions is that the liquidator will try to establish a date at which the company can be shown to be balance sheet insolvent, and then show why it was unreasonable for directors to continue to trade after this. In the UK, and contrary to many misconceptions, it is not an offence to trade a company while it is insolvent. Indeed in some situations, if the directors genuinely believe that the position will be turned around and the position of creditors will improve, it is the correct thing to do. When it becomes wrongful trading is when it should have been realised that the position of the creditors would likely deteriorate from that position onwards and the company would proceed into liquidation. Once a director realises that his or her company is insolvent, one important thing for them to do is to seek immediate professional advice from a licensed insolvency practitioner.

Many legal systems (including English law) recognise the "blue sky" defence; which broadly provides that, if the directors in good faith believed that the company was just about to turn the corner, and things would soon improve, then they would not normally be held liable for continuing to trade. Liability only attaches when the company has no realistic prospect of avoiding insolvent liquidation.

The amount of the award

The Court has wide discretion over the contribution that it can require. Traditionally this has been compensatory, rather than punitive. The starting point for assessing the appropriate amount was the difference between the net assets of the company at the date that the directors should not have traded beyond, and the net assets at the date of liquidation.

The Court however has wide discretion, and may award just a percentage of this. It awarded 70% of the drop in net assets in "Re Brian D Pierson (Contractors) Limited" [1999] BCC 903. This was on the basis of the judge’s "guesstimate" that 70% of the drop in net assets was due to the actions of the directors, and 30% could be attributed to extraneous causes.

Barriers to wrongful trading actions

It was thought prior to 1997 that the amount paid by a director following a wrongful trading claim was simply paid to the liquidator and it became available to swell the assets of the company generally. In most instances there would have been substantial bank borrowings secured by a debenture and personal guarantees given by the directors. Many directors chose not to fight the claims, reasoning that any amounts paid to company (hence the bank under its mortgage security) via a wrongful trading claim, simply reduced the director’s liability under their personal guarantees. It was therefore irrelevant how the directors repaid the bank. This changed with the Court of Appeal’s decision in 1998 ["Re Oasis Merchandise Services Limited" [1998] 1 Ch 170 ] that a claim for wrongful (or fraudulent) trading, is different from a normal 'asset' of the company. In particular, it held that such claim cannot be secured by a debenture. The Court held that the fruits of a claim for wrongful trading are instead held in trust by the liquidation for the general body of unsecured creditors. It then followed that the costs of a wrongful trading action could not be drawn from the company’s assets held by the liquidator, and fell to be paid personally either by the liquidator (which he would not do), or would require a unanimous decision of unsecured creditors. ["Re Floor Fourteen Ltd" (2000) ETC 416 ] The position has now been clarified with the Enterprise Act 2002 changing the law to allow the costs of wrongful trading actions to be included as a cost of the liquidation. These can be met from the company’s assets.

As is often the case, a company in liquidation has no assets with which to bring an action for wrongful trading. How can the liquidator bring, or fund an action? Can the liquidator sell or assign the claim to a specialist litigation company?

Because a claim for wrongful trading is a personal action brought by the liquidator, it follows that if it is unsuccessful, the liquidator is personally liable for the legal costs of the defendants. This was found to be the case following a 5 months trial in which the liquidator of Continental Assurance Company of London plc sued a number of its directors. ["Re Continental Assurance Company of London plc" [2001] BPIR 733] Although the costs of an action (whether successful or otherwise) can now be properly paid by the liquidator out of company assets where there are adequate funds available, the House of Lords in 2004 altered the hitherto accepted priority of costs in a liquidation, making the liquidator's costs (including the legal costs of a wrongful trading action) rank last in priority behind both preferential creditors and the sums due to debenture holders. "Re Leyland Daf Ltd" [2004] UKHL 9 ] . The decisions in "Continental Assurance" and "Leyland Daf" make wrongful trading actions unattractive to liquidators.

It is now usual practice for liquidators to enter into Conditional Fee Arrangements with lawyers and have insurance against adverse costs in place in the event that he is unsuccessful. The liquidator is able to assign the action regardless of the normal rules relating to champerty and maintenance. (He is empowered by statute to sell any of the company’s property [ Insolvency Act 1986 Sch 4 para 6] . As an alternative, there are commercial litigation funding organisations which will take over the management and funding of the entire claim, and pay the liquidators a percentage of any recoveries.

Footnotes

ee also

*Trading while insolvent
*Fraudulent trading
*Insolvency
*Liquidation

External references

* [http://www.littletonchambers.com/ARTICLES/OutFundInsolvLit.doc Outside Funding of Insolvency Litigation - Pitfalls and Progress]