Wrongful trading legal advice

Wrongful trading is the overall term often used to describe a variety of potential civil law offences which directors may be face in relation to company insolvency.

The most common form of wrongful trading is insolvent trading. This creates potential personal liability for directors who have continued trading when they know, or should have known, that there was no reasonable prospect that the company would avoid insolvent liquidation. This civil law provision is set out in section 214 of the Insolvency Act.

When a company is in financial difficulties, directors must start balancing the interests of shareholders with their duty to consider the best interests of the company’s creditors. This is not always straightforward as many companies financial positions deteriorate gradually.

Minimising the risks of allegations of insolvent trading means in practice that if a company is insolvent or is approaching insolvency, either on a balance sheet or cash flow basis (see below), the directors should take appropriate steps to protect creditors' interests and minimise further losses.

Types of wrongful trading

Confusion can be caused because the term wrongful trading is also often used to describe potential director liabilities other than trading when insolvent, such as section 213 of the Insolvency Act which relates to fraudulent trading and transactions at an undervalue.

Triggers for insolvent trading claims against directors that may lead to them being found liable to contribute to the company’s assets out of personal funds include:

• Allowing the company to trade when there is no reasonable prospect of avoiding insolvent liquidation;
• Failing to take steps after it becomes clear the company cannot keep going to minimise potential loss to creditors. For example, poor cash control management and/or inadequate debt collection;
• Failing to generally carry out the legal duties required of a director, such as to exercising independent judgment and avoiding conflicts of interest.

Difference between wrongful and fraudulent trading

The clearest distinction between the various ways in which directors can be liable on company insolvency is between wrongful and fraudulent trading.

With fraudulent trading, which may well result in criminal liability and is defined in section 213 of the Insolvency Act,  there is a required element of dishonesty or intent to defraud creditors or for another fraudulent purpose, and the consequences can be more severe. This element of fraud or dishonesty is lacking in wrongful trading. Fraudulent trading can involve transactions where company assets are sold or disposed of at an undervalue, although this is not the only form it can take.

If you are a director worried about the possibility of any allegations against you in the lead up to insolvency, whether wrongful trading or otherwise, please do get in contact.

Consequences for directors

Typically, the first thing an insolvency practitioner (IP) does after being appointed is to issue a questionnaire to directors asking them to explain their recent activities. This allows the IP to find out whether there are any breaches which give rise to claims they should pursue against the directors on the company’s behalf. Directors are legally bound to co-operate with liquidators.

The potential consequences for directors of wrongful trading are that a liquidator can apply to court to seek a declaration requiring the director to make a personal financial contribution towards the assets of the company for the benefit of creditors.

If the directors can show that they took steps with the intention of minimising potential losses to the company’s creditors, this may be taken into account when determining the amount of any contribution. Documentation such as board minutes to show the care taken to avoid insolvency and to demonstrate an awareness that the business may be close to insolvency should be kept.

How to reduce the risk of insolvent trading

There are several tests for insolvency.  In practice, directors may not always be aware that they have crossed the line into insolvency and are now running an insolvent company.  Regular review with someone who understands accounts and finances is a must. Common tests include:

• the cashflow test
• the balance sheet test . This is often more troublesome for growing businesses and can be triggered by an imbalance between assets and liabilities or by a technical event of default under a loan agreement
• an inability to pay a judgment debt or a debt detailed in a statutory demand is a significant indicator of insolvency.

Defending wrongful trading claims

Successfully defending wrongful trading claims generally  boils down to presenting a convincing account of the director having understood their duties to creditors and having taken appropriate steps in the circumstances. Evidence which is likely to help in defending a wrongful trading claim usually includes :

• Having obtained legal and financial advice once insolvency was clear – this will demonstrate that the directors  have taken prudent actions and sought external, professional advice when considering whether trading should continue.
• Having held regular board meetings – document discussions and decisions where your business may be insolvent and keep detailed minutes of concerns raised and any actions taken.
• Showing you kept creditors and others informed  – can you demonstrate you made reasonable attempts to communicate with and keep informed creditors, lenders, suppliers and customers? 
• Satisfying the requirement to act with the necessary skill and judgment expected of a director – the definition of wrongful trading in section 214 of the Insolvency Act provides that part of the test is to consider whether a reasonably diligent person would have continued trading. This is a combined objective and subjective test and the actual skills and experience of the actual director will be taken into account.
• Showing that the ultimate result would have been the same – it is open to directors to argue that trading on whilst insolvent has had limited or no overall impact on the end result for creditors.
• Mitigating circumstances – where it may not be advisable or possible to successfully fully refute allegations of insolvent trading, the director(s) may be able to show that their responsibility was limited and seek to reduce any amount they are ordered to contribute.

Advice for directors

If you are worried about being questioned or investigated by an Insolvency Practitioner, we can advise you on your position and the best steps to take.

Please do call us to discuss your case.