Trading insolvently or trading out of difficulty? Are we being naughty or did we have the best intentions? Part 1

This article is a part one of two series that explores the key issues we have recently seen and the case law arising in Misfeasance and Wrongful Trading claims.  

Introduction

What is Wrongful Trading?

Wrongful Trading is a statutory offence under section 214 of the Insolvency Act 1986. Once a director or shadow director of a company concludes (or should have concluded) that there is no reasonable prospect of the company avoiding an insolvent liquidation or insolvent administration, they have a duty to take every step that a reasonably diligent person would take to minimise potential loss to the company’s creditors. If, after the company has gone into insolvent administration or liquidation, it appears to the court that a director or shadow director has failed to comply with this duty, the court can order them to make such contribution to the company’s assets as it thinks proper. Such a claim is usually brought by the Liquidator, the objective of which is to force the director(s) to put their hands in their own pockets to recoup any (or at least a proportion of) sums owed to creditors, on the basis that had they placed the company into insolvency at an earlier stage, the additional losses would have been avoided.

Section 214 claims are often brought alongside claims for Misfeasance pursuant to section 212 of the Insolvency Act 1986.

The claims

The litany of complex claims that we see can include, by way of non-exhaustive list; the overpayment of directors by way of salary or bonuses, stripping of cash from the company, unjust payment of dividends, approval of high interest loans in the absence of any realistic prospect of repayment, inadequate security for loans, failure to competently consider business plans and unrealistic projected sale prices for properties.  Liquidators may rely on one of the above or the cumulative effect of a number of the above to allege misfeasance and/or that insolvency was inevitable and that directors should have known that this was the case at relevant stages, often referred to as ‘knowledge dates’.

The test

To succeed in any claim, a Liquidator has to show that the director “knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation” or administration (s.214(2)(b) IA 1986), and when that was.

This is a different and more difficult test than simply knowing when a company is insolvent. Liability is not triggered by mismanagement which brings a company to the brink of insolvency, but a failure thereafter, when the writing is on the wall, to take proper steps to protect creditors.

Does expert advice offer protection in s214 claims?

We have seen cases where the directors have obtained the advice of expert accountants and insolvency practitioners along the way, such to the extent that those experts attended board meetings, at which their advice that it was safe to continue to trade was well documented. Nevertheless, claims were brought in any event. This is despite the authorities’ suggestion that it is reasonable for a director to rely on advice, or the absence of any warning, from experts.

It seems therefore that the days are gone where a director can sleep easy that they will be absolved from responsibility by virtue of the mere instruction of an expert, regardless of the level of experience or the magnitude of its cost.  Whilst obtaining expert advice will achieve a certain degree of protection, directors will likely face interrogation in relation the veracity of any investigations undertaken to ensure the accuracy of the information provided to the experts, rather than being safe to assume that any expert will pick up on any potential mistakes or misrepresentations. 

Are we being naughty or did we have the best intentions?

Even if a director knows the company to be insolvent, there is no liability if there is a reasonable prospect that the company could trade out of its difficulties. There is a distinction between how the court will treat directors who can demonstrate they are aware of the possibility and consequences of insolvency, have considered the position carefully and decided to trade on, and cases where there is no real attempt to consider and address the issue at all.

Directors may properly take the view that it is in the interests of creditors for a company to continue to trade out of its difficulties even though it is insolvent, and that loss-making trade should be accepted in anticipation of future profitability. Judges are astute to the reality that many companies can show a balance sheet deficit, or can fail to pay their creditors on time, but are able to recover that position. Hindsight, however, is not permitted and neither therefore is it ever a wise argument to raise. As one judge put it, “picking over the bones of a dead company in a courtroom is not always fair to those who struggled to keep going in the reasonable (but ultimately misplaced) hope that things would get better”. In other words, “wilfully blind optimism”, “reckless belief”, or where the “directors closed their eyes to the reality of the company’s position”, are terribly unlikely to gain any sympathy from a judge. On the contrary, if directors “shut down too soon”, they are exceedingly likely to attract criticism from creditors who believe they should have stuck it out on the basis that it would have come right in the end.

A potential gap?

Where there isn’t a clear answer from the authorities is whether a court would find the s214 test to be met even when the company is solvent at the alleged knowledge date. In other words, if all was relatively rosy at the specified time but the directors knew or indeed ‘should have known’ doom was impending.

What ought a director have known or done?

In determining actual or deemed knowledge, a blend of objective and subjective factors are applied. By s214(4), the facts which a director ought to know, conclusions which he ought to reach, and steps which he ought to take, are those of a reasonably diligent person. That reasonably diligent person is taken to have both (1) the general knowledge, skill and experience that “may reasonably be expected of a person carrying out the same functions as carried out by that director”; and (2) the general knowledge, skill and experience that that director actually has. In short, (1) provides a minimum standard, and (2) provides a higher standard depending on the director, referred to below.

Is there any scope to argue a NED is unique?

A non–executive director (a NED) is a member of the board who is (usually) not involved in the day–to–day management of the company. Whilst NEDs are responsible as part of the board for the success of the company, in contrast to executive directors, they do not have executive responsibilities.

As a NED and/or part time director, there is therefore certainly scope to argue that the “functions carried out by” the individual, are limited in comparison. Whilst it is trite that there is no immunity for NEDs, there are favourable authorities. By way of example, Goode confirms that a NED is not expected to possess the knowledge and skill of an executive director, still less to give his continuous time and attention to the company’s affairs. Similarly, a director in charge of marketing and sales cannot be expected to possess the financial knowledge and skills of a finance director. That said, this is unlikely to absolve him or her of any responsibility whatsoever.

Whilst in theory one of a NED’s duties is to monitor the performance of directors, they are not of course expected to overrule them in their specialist field. Indeed, in a recent High Court directors’ disqualification case, Secretary of State for Business, Energy and Industrial Strategy v Selby [2021], ICC Judge Prentis addressed the law on non-executive directors and stated that even if the duties are the same as executive directors’, “their application need not be”. It is therefore still necessary to look at how the particular company’s business is organised and the part which the director could reasonably have been expected to play. This is key and it would not be fair or realistic to apply a blanket set of principles.

Several cases refer to the necessity of delegation and division of responsibility in corporate life, as long as it does not amount to a total abdication of responsibility. The line however is certainly not yet definitively clear.

Thus, whilst there is indisputably diminished protection in seeking to rely on accountancy advice, there may still be some safety proffered in seeking to set apart a NED from the Executive or those with specialist roles, where circumstance permit.

Additional risks of bestowed responsibility pursuant to s214(5)

It is certainly worth noting that s.214(5) clarifies that the functions of the director (for the purposes of assessing a director’s knowledge) to include functions which he does not carry out but which have been entrusted to him. This puts sins of omission in the same category of sins of commission. Care should therefore be taken to check any service contract which set out any functions entrusted, potentially even in circumstances where the contract was not signed. The fact that the individual accepted what their role intended to entail (by virtue of any service contract or indeed in correspondence setting out the same) arguably represents that they are qualified to provide such expertise.

Small v Large company – is there any difference in the duty?

The general knowledge, skill and experience postulated by s.214(4) will be much less extensive in a small company in a modest business with simple accounting procedures, than in a large company with sophisticated procedures. There is scope for the argument here to cut both ways. On the one hand, it could be argued that the minimum standard is higher for a director of a parent company of a large corporate. On the other hand, it could be argued that an individual director could never be expected to know the intimate workings of a huge group with a multitude of offices and potentially thousands of employees. In such a case, perhaps the practical necessity of relying on other specialists is greater.

Every Step Defence

The court shall not make a declaration under s214, if after the date of deemed knowledge, the director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken. This is interpreted very narrowly by the authorities and places greater responsibility on the directors to keep the issues under constant review.

Conclusion

There will inevitably continue to be a fact sensitive balancing exercise undertaken by the court to weigh up the competing interests by reference to the degree of distress. What the directors knew, or ought to have known seems more under the magnifying glass than ever.  

The advice remains;

• to continue to document board decisions on material matters to ensure a paper trail and any rationale for decisions is available, as they will inevitably be considered;
• Whilst directors should certainly engage professional advice sooner rather than later, it is clear from the cases we are seeing that this is not sufficient for directors (nor indeed NEDs) to rest on their laurels having done so. Whilst there may be some merit in the argument that directors and NEDs do not and cannot be universal experts across all aspects of a corporation and that a division of responsibility (to some extent) is inevitable, directors should do their utmost to ensure that due consideration has been given to the information provided to experts, not least to ensure its accuracy but also should continue to actively review that financial information;
• Allied to directors’ actions being scrutinised is the obvious point that it is imperative that adequate D&O insurance cover is in place. It is common practice for there to be numerous directors, all of whom will have separate legal representation in any claim of this nature. Litigation is likely to involve substantial expert costs in their analysis and significant disclosure exercises, both of which will contribute significantly to potentially eye-watering costs being incurred, potentially even before any trial takes place. Directors may have competing interests and objectives, all of which have to be managed and considered by those that hold the purse strings to the insurance pot. They key therefore is to ensure that any pot is sufficient to ensure that any personal exposure is avoided.  

This area remains a particularly unpredictable area of litigation, where the individual’s previous experience (actual and ostensible), the current role and the complexity of the company and/or any group will be considered in assessing the extent of any liability.

If you want any further information on Misfeasance and Wrongful Trading claims, please get in touch with our team.