Trading insolvently or trading out of difficulty? Are we being naughty or did we have the best intentions? Part 2

Duties and Implications of financial Information in s.214 claims

Introduction

This article follows Part 1 in which I set out the key issues we have recently seen and the case law arising in Misfeasance and Wrongful Trading claims. This Part 2 considers the duties and implications surrounding the financial information that is available to directors when faced with a s.214 wrongful trading claim.

This is important because two major issues arise out of the deemed knowledge test: (1) what factual information about the state of the company was or should have been available to the directors; and (2) what conclusions the directors should have been drawn from this information.

Obtain and verify the information yourself

The cases show that directors are expected to have provided themselves with such adequate and timely accounting information as is necessary to monitor the solvency of the company. The Supreme Court in BTI 2014 LLC v Sequana SA and ors noted that directors are under a duty to inform themselves about the company’s affairs, and that the rule in West Mercia (sometimes called the creditors’ duty) will incentivise directors to keep the solvency of the company under careful review. Note however that this is not, strictly speaking, a duty to creditors, but the existing duty to the company which tips in favour of creditors as insolvency looms. Directors must therefore ensure that management accounts provide anaccurate picture of the company’s financial position.

In a case where the directors failed to deliver statutory accounts on time, Knox J held that s.214(4) permits a court to impute factual information that would have been ascertainable with reasonable diligence. Thus for s.214(2) it was assumed that the size of the deficiency of assets over liabilities that would have been shown by statutory accounts were known by the directors by the time the accounts were due. Indisputably therefore, there is a duty to interrogate the information available, to consider the implications and not simply to accept them at face value.

Gore-Browne comments that directors are not expected to have the expertise of professional accountants.

In Re Continental Assurance, the liquidators argued that appropriate accounting policies had not been applied. Park J concluded that even if he had accepted the adjustments argued for by the liquidators (which would have shown insolvency), he would not have held that the directors should have been aware of the position. Knowledge of basic accounting principles was required, but an understanding of specialised accounting concepts was not (even when the directors included non-practising chartered accountants and a previous finance director).

That said, recent cases that we have seen allege a higher duty on directors to question the financial information they are provided with and to have a solid understanding of what that information means.

Is ‘it’s not within my expertise’ a credible excuse?

Directors can in some circumstances rely on the greater expertise or knowledge of other directors.

In Re Sherborne Associates, two NEDs who were recruited for reasons quite different from their financial expertise were entitled to rely on the information provided by an active chairman, who had far greater involvement with the company and experience with its figures.

In Re Continental Assurance, it was held to be reasonable for other directors to rely on figures presented by a finance director, provided they did not simply accept the figures in a blind and unquestioning way, but probed and discussed them in as much length/depth as they thought needed. Curiosity to satisfy yourself that the information you are being provided with must therefore be exercised at all times. 

Prudence v risk

Assuming that a director has the information to demonstrate that there is a reasonable prospect of avoiding insolvent liquidation, “the standard to be applied is that of the reasonably prudent businessman, a breed which is likely to be less temperamentally cautious than lawyers and accountants”. That dictum is found in Re Brian D Pierson, where the director was found to have refused to face facts, ignored the negative side of equations and failed to account for the expenses which would be incurred in obtaining income.

Similarly, Singla v Hedman (No. 1) confirmed that the standard is “of a reasonably prudent businessman acting without unwarranted optimism and on a realistic factual basis”.

The cases often afford a significant margin of discretion to directors. In Re Hawkes Hill Publishing, it is said that the test at s.214(2) “does not depend on a snapshot of the company’s financial position at any given time; it depends on rational expectations of what the future might hold. But directors are not clairvoyant and the fact that they fail to see what eventually comes to pass does not mean that they are guilty of wrongful trading”. Whilst therefore directors are not expected to have crystal balls, the common theme of the case law is that taking figures at face value and not giving sufficient consideration to future risks, is simply not acceptable. 

Parks J came to a similar conclusion in Re Continental Assurance, including in relation to reliance on business forecasts. However in Nicholson v Fielding, it was said that the wrongful trading test should not be looked at in an economic vacuum. It was held to have been reasonable to continue to trade despite apparent balance sheet insolvency given the trading realities. Perhaps not the safest test to now rely on.

Causation still must be proven  

The importance of causation in a s.214 claim has been most recently highlighted in the appeal judgment in Chandler v Wright where Edwin Johnson J held that there must be loss for a s.214 claim and a causal connection between the continuation of trading and the loss. He relied on Re Ralls Builders Ltd where Snowden J reviewed the cases and stated the correct approach was ascertaining “whether the company suffered loss which was caused by the continuation of trading” after the knowledge date until the administration date. But “there has to be some causal connection between the amount of any contribution and the continuation of trading. Losses that would have been incurred in any event as a consequence of a company going into a formal insolvency process should not be laid at the door of directors”.

It is not therefore acceptable to automatically attribute any and all losses arising from insolvency on the directors if they would have arisen inevitably from the process.

Discretion to order a contribution

If the s.214(2) test has been met, the court has a very wide discretion as to whether or not to order that the director make a contribution to the company’s assets, and the amount of that contribution (s.214(1)). “Prima facie the appropriate amount that a director is declared to be liable to contribute is the amount by which the company’s assets can be discerned to have been depleted by the director’s conduct which cause the discretion under s.214(1) to arise”.

It has been held in several cases that the contribution is primarily compensatory as opposed to penal but that of course does not make the prospect any less serious or one which should be avoided any less.

In Re Produce Marketing Consortium Ltd, it was held that whilst it would frustrate Parliament’s intention to award a nominal or low figure because there was no fraudulent intent, it would not be right to ignore that fact totally. This suggests that there is room for varying the contribution according to culpability.

Certain cases suggest that the courts do look closer into the circumstances. For instance, in Re Brian D Pierson, the defendant directors were a married couple. The husband ran the company and the wife carried out primarily clerical-type duties and took no active part in management decisions. The court held that one cannot be a ‘sleeping director’, however only ordered that the wife contribute a quarter of the sum that her husband was ordered to on a joint and several basis.  

It was also remarked in Re Continental Assurance that the starting point where a claim is brought against a number of directors is that liability is several and not joint and several. The position therefore of each individual has to be separately assessed, and payment by one does not discharge the liability of the other.

Knowledge and duty to creditors

As far as the duty to creditors is concerned, the recent Supreme Court judgment in BTI 2004 LLC v Sequana is complex, with subtly different approaches to the test, and the content of the duty, from the different Justices. In one sense the judgment is in fact very narrow, given the relevant ratio was simply that the duty is not triggered when there was a real but not remote risk of insolvency. The opinions as to when the duty was otherwise triggered, and content of the duty, appear to be obiter. There are likely to be lengthy submissions in future cases as to the law on this issue and a close eye should therefore be kept.

In the Supreme Court, most of the Justices agreed that the duty was triggered at least when a company was insolvent. For Lord Reed, that meant cashflow or balance sheet insolvency. Lord Briggs (with whom Lord Kitchen and Lord Briggs agreed) appeared to proceed on the same basis. Lady Arden agreed that this was at least the starting point.

It will doubtless assist if a director can demonstrate that they knew about this duty and tried to act in accordance with it. It is wise therefore to instruct advisers to consider creditors interests in the circumstances to rebut any argument that the directors were oblivious to the creditors’ duty.

Even if the duty is engaged, the Supreme Court gave little guidance on what the duty actually entailed or how it might apply in specific cases.

An area of particular complexity (and legal novelty) is a situation where an individual is a director of the holding company but not the subsidiaries. The question therefore arises as to whether (or at least the extent to which) the director’s duties required them to look into the affairs of subsidiaries. For instance, are you obliged to consider the financial positions and/or the solvency of the subsidiaries, in order to fully comply with any duty to take into account the interests of the holding company’s creditors? We have seen this pleaded but of course in reality, this creates a tension between the creditors’ duty and the more orthodox principle of separate legal personality of companies.

Perhaps the claim is strengthened if there are grounds that the individual was a de facto or shadow director of the subsidiaries and in some circumstance there may be a level of crossover if for example the holding company and the subsidiary company board meetings are held concurrently and where that director remains in attendance. The question arises as to what situation is more favourable there in this situation. One where the director has no regard whatsoever for the performance of the subsidiaries and does not involve themselves in their affairs or alternatively, where they are present at meetings but then choose not to delve into the detail to the same extent as that of the holding company. The obvious question arises as to whether something is better than nothing or are you safer to steer clear completely?

In light of the above case law, the below are likely to assist in the event of a claim;

• Instruct reputable professional advisors (accountants and lawyers) to advise throughout on solvency issues. Although this is not an absolute defence, it is an important factor which the courts will take into account when the objective test for wrongful trading is applied, provided the financial position has been fully disclosed to the advisors.
• Ensure the consideration to the possibility of insolvency and analysis of the wrongful trading test is well documented to avoid any suggestion that the directors blithely carried on the business regardless. Demonstrate careful consideration was given. This is not a place for hindsight.
• Balance sheet insolvency is not always easy to detect, particularly in the absence of regular management accounts containing reasonably accurate trial balance sheets. Ensure therefore that these are available for consideration and analysis;
• Allied to the above, as emphasised by the Supreme Court in Sequana, companies may be cash flow or balance sheet insolvent for a period but that does not mean insolvent liquidation or administration is unavoidable. As Lord Briggs observed in Sequana at [120]: “Insolvency takes two forms. Either may exist without the other. The first is usually called balance sheet insolvency, where the value of the company's assets is exceeded by the value of its liabilities: see section 123(2) of the 1986 Act. The second is what is generally known as commercial insolvency, where the company is unable to pay its debts as they fall due. What matters is that neither will necessarily be permanent, nor fatal to the long-term success of the company, although of course either may be, and commercial insolvency often is. A company may experience short- term commercial insolvency due to a temporary adverse balance between the liquidity of its assets and the maturity of its debts. Many start-up companies are balance sheet insolvent before a new invention or business product is sufficiently developed to be brought to market so as to generate revenue or goodwill value, and yet the company later becomes spectacularly successful, and its shareholders become millionaires. In both cases the directors may perceive that there is a reasonable prospect that the company will be able to trade out of insolvency, for the benefit of both creditors and shareholders, a perception often labelled as seeing light at the end of the tunnel.”
• Ensure there is a reasonable and credible basis for any assumptions made. Never follow suit and simply agree with the majority.

Conclusion

For the reasons set out above, this area remains complicated, subjective and fact specific in terms not only of a particular director’s knowledge and the extent of the scope of their responsibility but also in terms of the unique characteristics of each entity considered. One cannot guarantee the limit of liability that may attributed to each and every director based upon the available case law however one can be certain that a similar thread of interrogation is likely to ensue in relation to what extent the director availed himself of the information, cross examined its credibility, considered it’s potential consequences and sought consistent advice on the same.