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Case law: Directors’ defence to personal liability for ‘wrongful trading’ clarified

Directors of companies facing administration or insolvent liquidation should ensure they treat creditors equally and take professional advice, or risk being unable to defend a charge of ‘wrongful trading’, following a recent ruling.

Legal Alert

This update was published in Legal Alert - April 2016

Legal Alert is a monthly checklist from Atom Content Marketing highlighting new and pending laws, regulations, codes of practice and rulings that could have an impact on your business.

A director of a company that is wound up or goes into administration because it is insolvent can be made personally liable for such of its debts as the court sees fit, if there has been ‘wrongful trading’

There has been wrongful trading if, at some time beforehand, a director knew (or ‘ought reasonably to have concluded’) that there was no reasonable prospect of avoiding the administration or insolvent winding up, but did not take ‘every step’ to minimise the potential loss to the company’s creditors. In deciding whether a director took every step to minimise loss to creditors, the court assumes the director knew there was no reasonable prospect of the company avoiding the administration or insolvent liquidation, even if in fact they did not.

The aim of wrongful trading laws is to make directors of companies in financial trouble (who might otherwise try to trade out of trouble) stop and think carefully about whether they are being over-optimistic about the company’s prospects.

When judging what the director knew or ought to have concluded, and the steps they should have taken, the court considers two questions:

  • The director’s functions: the court asks what a reasonably diligent person with the general knowledge, skill and experience required of someone exercising those functions would have concluded and the steps they would have taken. This is an objective test so, for instance, a finance director will be expected to reach the minimum threshold of competence required of all finance directors
  • The general knowledge, skill and experience of the director: the court considers this subjective test, under which a director with specialist skills or experience is expected to apply them. They are therefore subject to a higher standard than a director without those skills or experience

In a recent case, a company liquidator alleged the directors had been guilty of ‘wrongful trading’. One issue the court had to consider was whether the directors could rely on the defence that they had taken ‘every step’ to minimise loss to creditors. The court said this was a ‘high hurdle for directors to surmount’.

The directors had carried on trading hoping that the usual summer upturn in their industry, the completion of various projects and a successful outcome to negotiations with a potential investor, would improve the situation.

However, the court said this had meant some creditors – particularly the bank – had been paid while the company continued to trade, while others had not. It found that, by definition, paying off some creditors and not others could not amount to taking every step to minimise the loss to creditors. The directors could not therefore rely on the defence in this case.

The court helpfully clarified that directors taking a reasonable salary for work carried out while the company was in difficulties did not, of itself, preclude them from relying on the ‘every steps’ defence.

The court made constant references to the importance of directors taking professional advice at the right time, and updating it if circumstances changed, in order to be able to rely on the defence.

Operative date

  • Now

Recommendations

  • Directors faced with a potential administration or insolvent liquidation should ensure they treat creditors equally and take professional advice, or risk being unable to establish a defence to a wrongful trading charge

Case ref: Ralls Builders Limited (in liquidation) [2016] EWHC 243

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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