Case law: Court clarifies when directors of insolvent company can be personally liable for company's debts
Directors of companies in financial difficulty should carefully monitor their financial situation and prospects, so they can spot when there is no reasonable prospect of their company avoiding insolvent liquidation or administration - and minimise losses to creditors as a body rather than selecting particular creditors - or risk personal liability for company debts.
This update was published in Legal Alert - December 2015
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Under insolvency law, a director of a company that has gone into insolvent liquidation or administration can be made personally liable for its debts, or some of them, if the director is guilty of 'wrongful trading'. There is wrongful trading when a company carries on trading when the director knew, or ought to have concluded, that there was no reasonable prospect of it avoiding insolvent liquidation or administration.
When deciding what a director knew or ought to have concluded, the court applies the test of what a reasonably diligent person:
- with the level of knowledge, skill and experience reasonably expected of someone with the job role or function of that director would have known or concluded (an objective test), or
- with the general knowledge, skill and experience that director actually has would have known or concluded (a subjective test)
There is a defence if a director has taken every step to minimise the loss to creditors.
The aim of the law is to encourage directors to identify early when their company is heading for inevitable insolvency so they can close it down with minimal loss to creditors, rather than try to 'trade out of trouble' when there is no realistic prospect of doing so.
In this case a company went into liquidation, and the liquidators alleged the directors were guilty of wrongful trading:
- When the year-end accounts for 2005 and 2006 were produced
- As a result of professional advice received in relation to a major VAT liability
- As a result of the 2007 accounts. These showed a loss before accounting for the VAT liability, and without taking into account an expected rent increase
- When HMRC confirmed the VAT liability
The directors had made sure trade creditors were paid, but did not pay the VAT or rent due.
The directors raised a number of arguments. One was that the liquidator had to prove they knew or ought reasonably to have concluded that their company could not avoid going into insolvent liquidation at a particular date.
The court disagreed. It said the liquidator merely had to prove knowledge at some time before the liquidation, not at a particular date.
The court noted that it was not necessarily wrongful trading if directors carried on trading at a loss, or if their assessment of the company's prospects of going into insolvent liquidation later turned out to be wrong. However, although the VAT liability was being appealed, and the rent liability only came to light late in the day, the court ruled that in the circumstances the directors should have known or ought to have concluded there was no reasonable prospect of their company avoiding insolvent liquidation by January 2007.
The directors also argued that the onus was on the liquidator to prove the directors had not taken every step with a view to minimising the loss to creditors. The court disagreed again - the burden was on the directors to prove that they had.
This is a difficult hurdle for directors – especially if they did not actually know their company was heading for insolvent liquidation, but the court decides they ought to have concluded it was.
In fact, the court said the defence only applied if the directors had minimised the loss to creditors as a whole. The directors had instead been selective about which creditors to pay, which meant the defence was not available.
Directors of companies in financial difficulty should ensure they:
- Carefully monitor the company's financial situation and future prospects, so they can spot when there is no reasonable prospect of their company avoiding insolvent liquidation
- Minimise losses to creditors as a body, rather than selecting particular creditors
Case ref: Brooks and another v Armstrong; Re Robin Hood Centre plc (in liquidation)  EWHC 2289
Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.
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