Wrongful Trading - big bark, small bite

Business Recovery & Reconstruction E-alert: News & view from the bridge

Where a person who has been a director (or shadow director) of a company, on application of the liquidator, the Court may declare that that person is liable to make such contribution to the company’s assets as the Court thinks proper.

The Section applies where:

The Court will not, however, make an order of compensation where the director concerned took “every step” with a view to minimising the potential loss to the company’s creditors that he ought to have taken in the circumstances. This defence is, therefore, available to the director even if the company continued to trade past the point where there was no reasonable prospect of the company avoiding insolvent liquidation.

The SBEE Act has made some amendments to the provisions regarding wrongful trading, such as providing that a claim can now be made by an administrator with regard to any action carried out by the directors of a company after 1 October 2015 (Insolvency Act 1986 Section 246 ZA and Section 246 ZB).

Section 247 ZD allows for office holders to assign causes of action that vest in the office holder including Section 214 actions. This provision is not retrospective and applies only to companies entering into liquidation or administration post-1 October 2015.

The liquidator will generally need to adduce evidence to show that there was a point where the company was balance sheet insolvent. This is not a simple ‘point of no return’ test but instead a more nuanced assessment of assets and liabilities.

Whilst when assessing a company’s solvency (see BNY Corporate Trustees v Eurosail [2013] UKSC 28 and Casa Estates (UK) Ltd [2014] EWCA Civ 383) on a balance sheet basis one cannot take account of contingent or prospective assets, these could be relevant factors as to the director’s reasonable belief that insolvent liquidation can be avoided; which is part of the knowledge condition.

A company need not be insolvent at the point when insolvent liquidation was inevitable, and insolvency is not on its own sufficient to establish liability for wrongful trading; e.g. the company may be able to trade out of difficulties or obtain third party funding.

As a result, the Court will consider factors which establish not just that the company was insolvent but whether the directors knew or should have known that insolvent liquidation was inevitable. These may include:

The knowledge condition is subject to Section 214(4) i.e. assessed according to the knowledge that the director has, or which it may be reasonably expected that the director should have had, or which he should have obtained. The knowledge condition is, therefore, subject to a subjective and objective assessment.

The subjective assessment is a question of fact (what did the director know). One needs to consider what the director actually knew by having regard to contemporaneous correspondence, professional advice and admission under cross examination.

The objective assessment is a question of fact and law (what should the director have known). Here the director is assessed according to what a reasonable director should have known in the circumstances. There is, however, a subjective element to this objective test. The ‘reasonable director’ being one that has the knowledge, skill and expertise that may reasonably be expected of a director, who carries out the same functions as the director, in relation to the company.

To amplify this point in Re Produce Marketing Consortium Limited (1989) 5 BCC 569 Knox J held, in a case where there had been a failure to prepare annual accounts, the Court will consider not only the factual information that was available to the director, but the information which a reasonable diligent director with an appropriate level of general knowledge, skill and experience would have found ascertainable.

The Robin Hood Centre plc has established that despite commentary to the opposite effect the onus is on the directors to establish the statutory defence that they took ‘every step’; the onus is not upon the liquidator to establish that the director had failed to take ‘every step’. The case also contains some very useful guidance on the application of Section 214.

The case resulted in a ten day hearing before Registrar James who was required to investigate the affairs of a company that had run a Robin Hood themed tourist attraction in Nottingham. Not only is it of note for establishing the above proposition, it also provided useful guidance as to how the Courts are likely to approach a claim of wrongful trading.

Background

The company encountered significant financial difficulties throughout its entire period of trade, which were exacerbated by the VAT treatment of discount vouchers. The company had received advice in 1999 that the scheme adopted in regards the use of vouchers was tax efficient and effective but a material change in the VAT Regulations in 2003 caused problems of which the directors were unaware until February 2006. In September 2006, a tax investigation resulted in a large VAT bill which the company was unable to settle (the assessment being £130,000 to £150,000).

During this time, a report was also obtained in June 2006 as to the viability of the business. The report concluded that the company had little value, had accumulated losses of nearly £1.4 million and had provided no surplus profit in a five-year period. It was determined that the attraction would require considerable investment, and it was noted that the visitor protections originally anticipated were woefully overstated, with visitor numbers being one tenth of that anticipated. It was recommended that the business model needed to be re-adjusted.

In August 2007 after a further year of loss, there was a substantial increase in the rent and a rejection of HMRC’s appeal meaning that the VAT liability was now payable.

Despite these factors the company continued to trade until the end of January 2009.

The Insolvency Condition

The liquidator pleaded his case on the basis that the point of insolvency could have been on a variety of different dates between January 2005 and August 2007. The Court made clear that it was open to a liquidator to plead various different dates; indeed the liquidator simply had to establish that the company was insolvent at a particular point in time prior to the liquidation in order for Section 214 to have application. The only caveat to this is that the director must know the case that is being put against them and consequently the Court considered it appropriate to state a variety of different dates.

The Director’s defence

The directors argued that although the business was accumulating losses, this principally was caused by an accounting policy which recorded an annual depreciation in asset values but that in reality the business produced a small trading profit. Even if the loss had arisen, the directors argued that they took every step to minimise loss, including attempts to sell the business; they had obtained professional advice and at all times kept creditors informed of the position.

The directors pointed to the fact that from 2008 onwards they had worked with Mazars on a strategic development plan which would move the business to focus on education and obtain charitable status. The directors argued they had been working on a plan and had informed creditors of this change of direction from 2008 onwards.

Continuation of Trade - Hindsight

The Court held that there was no duty upon the directors not to trade whilst insolvent or to ensure the company did not trade at a loss; see Secretary of State v Gash (1997) BCC 172 where it was held that it was legitimate for the company to trade at a loss in anticipation of future profit which would be of benefit to existing creditors. Section 214 is designed to deal with irresponsible, unreasonable behaviour on the part of the directors. A director is entitled to continue to trade where there is a rational expectation that the continuation of trade would be of benefit to creditors but must not carry on trading in the mere hope that ‘something would turn up’.

In Re Hawkes Hill Publishing Co Limited (2007) BCC 937 in considering whether directors were justified in continuing to trade it was observed that the directors were not clairvoyant and that the court should avoid applying hindsight. The fact that the decision taken by the directors to trade proved to be wrong is not in itself enough to establish wrongful trading.

The Court also held that in considering whether it is appropriate to continue trading the directors do not have to conclude that such trading would clear all debts. The directors are entitled to take time to investigate the options available and conversely could be criticised for acting too precipitously.

On the facts, the Court found that once HMRC’s liability was established (and the appeal rejected) there was no realistic expectation that the company could avoid insolvent liquidation. It was therefore for directors to show that from that date (i.e. 31.01.2007) they took every step to minimise loss to creditors.

Guidance provided by Registrar James as to what may constitute ‘Every Step’:

Adverse Consequences of Insolvency

When considering whether it is appropriate to trade and thus minimise loss, the directors are entitled to also take into account the adverse consequences of insolvency such as:

In the Robin Hood case, the directors were unable to rely on the ‘every step’ defence because they had spent an 18 month period in which they had not progressed a sale and had traded by discriminating against the landlord and HMRC; these creditors effectively provided the working capital to the business. Despite some discussions, there was no evidence that these creditors had agreed to this treatment.

Therefore, despite the fact that trade creditors were being paid during the period, the liability to the creditors as a whole was increasing; the directors were failing to address adequately the interests of these two creditors and acknowledge the deteriorating financial position of the company.

The Compensation Award

The Judge made some observations about the measure of the award:

In the Robin Hood case, there had been some benefit in the decision to continue to trade, in that it had reduced the bank overdraft by £16,000 and trade creditors had been paid to the extent of £89,000. This ‘benefit’ was however at the expense of the landlord, HMRC and the City Council.

In the exercise his discretion the Judge was satisfied that the discrimination was not dishonest and was not with intent and consequently reduced the award of compensation by 50%. The final award of £40,000 was clearly dwarfed by the cost of a ten day trial.

Background to the claim

This case concerned the affairs of a building contracting firm and resulted in a 14 day hearing in front of Mr Justice Snowdon.

The firm had run into financial difficulty due to poor weather in January/February 2010 which had meant that the sites were closed for a four to five week period; furthermore, a sub-contractor’s defective work had caused loss to the company. On 12 March 2010, HMRC demanded £102,000 for a VAT quarter, which could not be paid. In April 2010 the company contacted Leonard Curtis to review the financial position and potentially negotiate a ‘time to pay agreement’ with HMRC, however, the directors failed to instruct them to put forward an offer and instead said that they would deal with it directly. This they failed to do.

By the time end of year (31/10/09) accounts were prepared in June 2010 it was confirmed that the company would need to write off work done for Fareham Football Club in the sum of £600,000 and also write off a debt of £286,000 due from the Club. Fareham FC being connected to the directors of the company. This made the company balance sheet insolvent to the tune of £582,000.

Not unsurprisingly following the release of the audited accounts, discussions which were in already in progress with the company’s bankers regarding the renewal of the company’s overdraft facility, became difficult. Due to concern as to the company’s position, the Bank demanded cross guarantees from various group companies. The directors prevaricated and sought advice from an insolvency practitioner; who advised in early August that the company’s plan to pay creditors over a period of five years was simply not viable.

In parallel to this, the directors were seeking a investment from a third party. The third party provided a letter of intent which was produced to the Bank and persuasive in securing the Banks extension of the overdraft facility to the end of August. After this date and for a period of six weeks the company completed various contracts during which time the Bank regulated payments out of the account and saw the overdraft cleared.

In September, the company instructed Solicitors to prepare a share purchase agreement and various resolutions to increase the share capital which would have facilitated the third party investment. However by the end of September, the third party had to still invest and the directors took steps to put the company into administration.

The wrongful trading claim

The liquidator claimed that from July 2010 the directors should have concluded that insolvent liquidation was inevitable and the continuation of trading past that point had caused a net deficiency to creditors of £1.1 million between 31 July 2010 and the date of administration on 13 October 2010. It is of note that the continuation of trading had meant that the secured debt to the bank was paid in full but new unsecured creditors had been incurred and remained unpaid.

The liquidator argued that the offer of third party funding could not be relied upon; it was unrealistic to expect that this offer was capable of being delivered, taking into account the lack of material progress made by the investor.

The Defence

The directors’ defence was that throughout the period of trading they had been seeking third party investment, the trading period enabled the completion of profitable contracts and thereby maximised recoveries for creditors.

The Judgment

The Judge rejected any assertion being made that the potential for obtaining third funding was false or misleading and found on the facts that the directors genuinely believed that an offer was going to be made.

Snowden J commented on the fact that the company was insolvent either on a cash flow or balance sheet basis and carried on trading does not mean the director, even one who has knowledge of the facts of insolvency, will be liable to wrongful trading if the company fails to survive. As per Lewison J in Hawkes Hill Publishing Co Limited (2007) BCC 937 the question to be asked is not whether the company was or was not insolvent but whether the director knew or ought to have concluded there was no reasonable prospect of avoiding insolvent liquidation.

Furthermore in CS Holliday Limited (1997) 1 WLR 407 Chadwick J held that directors may take a proper view, although the company is insolvent, it is in the interest of the creditors as a whole to continue to trade through its difficulties; some loss making trade should be accepted if it is in the reasonable anticipation of future profit.

In the circumstances, therefore, the directors need to have a rational expectation of what the future may hold and while the directors are not clairvoyant, the fact that they failed to see what eventually comes to pass does not mean they are guilty of wrongful trading. The court should not look at the issue of wrongful trading with 20/20 hindsight and instead should establish whether there was no rational basis for the belief that the events which would save the company would come about (see re Kudos Business Systems (2011) EWHC 1436) and Roberts v Frohlich (2011) EWCH 257 where Norris J held that the directors contention that they could have avoided insolvent liquidation was a wilful blind optimism, a belief that something might turn up was insufficient).

In the Ralls Builders Limited case, it was held that at no relevant time could it be said that by trading alone the balance sheet insolvency would be eliminated. Instead, one needed to determine whether there was a reasonable prospect of avoiding insolvent liquidation by reason of the funding from the third party. It held significant that an insolvency practitioner had been involved in discussions in July/August 2010 and did not question the potential likelihood of the investor providing the monies.

On the facts, it was established that by the end of August there was no longer a rational basis for holding a belief that the money would be provided by the third party. However, the court pointed out that such a finding did not automatically mean the directors should make a contribution. Instead, the court was tasked to find whether they thereafter took every step to minimise creditor loss and/or look to see whether there has been an increase in the net deficiency to creditors.

The liquidator argued that the fact that new credit had been incurred and had resulted in trading to the detriment of certain creditors meant that the directors have failed to establish they took ‘every step’ to minimise loss. The Court disagreed with this approach the starting point is to ask whether there is an increase or decrease of the net deficiency as regards all unsecured creditors it does not matter that some creditors are created by the trading and some creditors paid one needs to look at the overall position.

The directors were thus successful in arguing that between the end of August and the demise of the company on 13 October 2010 trading had allowed the completion of contracts which had provided for a better realisation for creditors as a whole. On the balance of probabilities, the net deficiency to creditors had not increased. It was not appropriate to simply point to the increase in trade creditors incurred over that six week period in circumstances where there had been an increase in debt offset by the repayment of the liabilities.

As in the Robin Hood case the Court rejected and allegation that the directors should forego reasonable salaries during the period.

The two cases have provided very rare judicial guidance on the issue of wrongful trading. The application of the statutory provisions since 1986 has been well known but in this time, few cases have reached court.

It must be remembered that the Court not only needs to establish the point of insolvency but also take a view as to the reasonableness of the actions of the directors past that point. The subjective/objective criteria applied in making this assessment mean that a full and thorough investigation into the material circumstances surrounding the insolvency is required.

The two cases amply demonstrate how complex and time consuming this assessment can be and as a result in general on a costs benefit analysis unless the net deficiency is considerable such claims may be unattractive for the Liquidator to pursue. Where claims are mounted directors similarly will be aware of the time and costs may be willing to settle on a without prejudice basis without any admission of liability.

Whether the assignability of Section 214 creates a market in such claims, with funders willing to invest in such seemingly speculative claims remains to be seen. However if potential defendant directors are faced with a well-funded, committed and ‘specialist’ claimant it could be their willingness to settle fosters and encourages the growth of such a market.