Trading insolvently or trading out of difficulty? Are we being naughty or did we have the best intentions? Part 3
Why calculating potential claims under s214 Insolvency Act 1986 can be far from simple
This article is co-authored by Marian Cantrell of Evelyn Partners. Marian is an expert forensic accountant specialising in accounting and quantum advice for commercial dispute resolution.
This article follows Part 1, in which I set out the key issues and case law arising in Misfeasance and Wrongful Trading claims, and Part 2, in which I considered the duties and implications surrounding the financial information that is available to directors when faced with a s214 Wrongful Trading claim.
This Part 3 concludes this series by examining how s214 claims are quantified in practice and illustrating some important pitfalls that can occur in the calculation of such claims.
IND – the key to quantifying a claim
The key starting point when calculating potential s214 claims against a director is the increase in ‘net deficiency’. ‘Net deficiency’ itself refers to when the realisable value of the assets of a company are insufficient to satisfy its creditors, when including its contingent and prospective liabilities. Essentially, it measures the shortfall for creditors in an insolvency. An increase in net deficiency (‘IND’) describes a situation where net deficiency has worsened over time because the company continued to trade while insolvent.
When calculating a claim against a director, the typical approach is to calculate the net deficiency at the actual date of administration or liquidation compared to hypothetical earlier dates when the company should have been identified by the director as being unable to avoid insolvency. Any IND between the hypothetical and actual insolvency dates therefore represents the potential claim against the directors for alleged wrongful trading.
When acting for a defendant in a s214 claim, it is crucial to consider:
(a) whether the company had no reasonable prospect of avoiding insolvency at the hypothetical earlier dates identified by the claimants;
(b) whether any losses in the period were not caused by trading, for example through bad debt; and
(b) whether the claimants’ calculation of the IND at each date is correct.
Solvency – why it may not be clear-cut
We have recently acted for a Defendant where it was pleaded that the hypothetical insolvency dates were all some months before the actual date of administration. These dates were also across a period where the group of companies had taken advice from their accountancy experts on its cash flow and its business plan, the latter setting out its plans to turn the business around.
On analysis, without the benefit of hindsight there was no credible evidence that the directors should have known that the business plan would fail.
How can a pension liability distort the picture?
In our case, the group was balance sheet insolvent, but this was entirely due to a significant pension liability. Quantifying such a liability and its impact on solvency is not a straightforward task, given that pension deficits are usually reduced over a long period and can fluctuate significantly due to external factors such as market movements or actuarial assumptions. In addition, different methods can be used to value the liability.
In reality, a more relevant measure for the purposes of solvency testing is the company’s ability to pay the agreed ‘deficit repair contributions’ (i.e. extra payments that are made to reduce the shortfall of funding in a pension scheme). The reason for this is that pension trustees are generally unlikely to insist upon deficit repair contributions that would be unaffordable and lead to insolvency (as this would crystallise the shortfall).
The key point to note therefore is that consideration of a pension liability when reviewing balance sheet solvency is a contentious and subjective area in which expert advice will be essential.
Estimated IND – challenging the figures
There should always be an explanation for any IND, whether that be trading or other losses. In our case, the company had minimal activity, other than group financing and participation in a VAT group. However, the claimants’ expert report had produced an IND purportedly ranging between £15 to £50 million, fluctuating wildly across short periods and with no consistent trend in direction. On the face of it, these calculations appeared erroneous, even before examining the detail. How did the claimants calculate such a huge change in the gap between realisable assets and liabilities in a non-trading company?
Our analysis revealed some key shortcomings in the claimants’ calculations:
- The claimants had taken the atypical approach of identifying relevant assets and liabilities to include in the IND, as opposed to taking the company’s total net asset position from the balance sheet and then making necessary adjustments. The latter approach would have given a clearer picture of how the IND was estimated.
- A detailed review of the company’s ledgers revealed that certain assets and liabilities had been omitted entirely from the claimants’ expert report and that various errors had gone unchecked. Furthermore, timing mismatches (recognising related transactions at different hypothetical dates) had inflated the claimants’ supposed IND or caused it to fluctuate.
- The issue of subrogation was a further weak point in the claimants’ analysis of IND. Subrogation enables an entity to settle the liability of a debtor (e.g. under a guarantee) and legally ‘step into the shoes’ of the creditor, with all of the creditor’s rights to pursue repayment from the debtor. Without subrogation, a large cash loan taken by a parent company and secured on a subsidiary’s assets prior to insolvency would benefit the borrower’s creditors and reduce the IND, while leaving the creditors of the subsidiary worse off, with no recourse. Here, subrogation had not been correctly applied in the IND calculations by the claimants.
The largest omission was the report’s exclusion of direct third-party loan balances, on the basis that these were secured on the assets of subsidiaries and therefore would be settled by the subsidiaries, not the company, on liquidation. Despite this, the IND calculated by the claimants did include the related cash movements and intercompany balances. This one-sided treatment erroneously resulted in IND movements in line with loan drawdowns and repayments.
- Close analysis further revealed that the IND of the company at each hypothetical date was almost entirely related to a VAT balance arising through the group VAT registration from an asset sale by a subsidiary.
However, it is questionable whether a s214 claim against a director, based on the IND calculation of a non-trading company should even include a sizeable joint and several VAT liability that arose from the actions of the trading subsidiary’s directors (in undertaking a sale of a significant asset). The subsidiary’s creditors benefitted from the asset sale proceeds (including the VAT that was not paid over to HMRC) while creditors of other entities in the VAT group suffered an increase in net deficiency. The only available recourse to those creditors was a claim in the estate of the insolvent subsidiary, which was likely to yield (at best) pennies in the pound.
For these reasons, the contribution of the VAT balance to the IND calculation was clearly problematic.
As demonstrated above, quantifying s214 claims remains a complex and somewhat subjective area. Expert advice is essential to establish the level of any potential claim. Parties should also be aware that experts may employ differing approaches to calculating IND, and that the presence of certain elements can distort the overall picture. It is essential therefore that all parties to the litigation are clear as to the basis upon which the report is being approached and the mechanisms of any calculations are agreed at the outset. This should hopefully prevent significant costs being incurred in potentially numerous raucous fights between the accountancy experts and huge discrepancies in the numbers being returned, oddly based upon the same facts.
Having a forensic accountant on our case from the outset gave us a clear advantage in understanding and addressing these complicated issues.
For more information in relation to the above please do get in touch.