Wrongful trading legal advice

Potential director liabilities on insolvency

Wrongful trading is the overall term used for a variety of civil law offences which directors may be held liable for relating 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 breach 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 a duty to also act in the best interests of the company’s creditors. This is not always straightfoward as many companies fianncial positions deteriorate gradually.

Minimising the risks of allegations of insolvent trading means in practice that if a company is or is on the brink of insolvency, either on a balance sheet or cash flow basis (see below), the directors should cease trading and take all necessary steps to minimise losses to creditors.

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 debt out of personal funds include:

  • Allowing the company to trade whilst there is no reasonable chance the company can keep going;
  • Failing to take steps after it becomes clear the company cannot keep going to avoid potential loss to creditors. For example poor cash control management and/or poor debt collection;
  • Failing to generally carry out the legal duties required of a director such as to exercise independent judgment and to avoid 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 deliberate intent to disadvantage creditors and the penalties are more severe. This intention is lacking in wrongful trading. The most common form of fraudulent trading is selling or disposing of assets of the company  for no money or at a clear undervalue, generally within a maximum period of 2 years before liquidation.

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 does after being appointed is 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 trading wrongfully are that a liquidator can apply to court to seek a declaration requiring the director to make a personal financial contribution towards 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 the penalty can be reduced or mitigated depending upon the facts. 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 passed the line 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 troubleseome for growing businesses and can be triggered by an imbalance in medium to long term assets vs debts or a technical event of default in 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 been aware of the duty to creditors and having acted appropriately.  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 to guide on the question of solvency.
  • 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 director has acted with the necessary judgment expected when deciding whether to continue trading. This is a part objective, part subjective test and the actual skills and experience of the actual director will be taken into account. A strong defence and/or mitigation can sometimes be mounted where a director is inexperienced or is a sole director spending all his or her time just trying to run the business on an operational level.
  • 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 only partial fault and 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 help. We also advise creditors who believe there has been wrongful or insolvent trading and want legal advice on approaching the liquidator to take action.

Contact our lawyers as we have dealt with many cases over the years and can get to the point quickly. Please do call us to discuss your case.

Let us take it from here

Call us on 020 7438 1060 or complete the form and one of our team will be in touch.

Alex Kennedy

I know that when the noise dies down there is a solution to be found. I set about that task as quickly as possible.