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Law for Business

Knowhow - guidance - precedents

26 APR 2016

Directors’ liability for wrongful trading – how real is the risk?

Directors’ liability for wrongful trading – how real is the risk?

When a new director seeks legal advice as to the extent to which his role might expose him to the risk of personal liability, he will be told that he owes certain duties to the company, including a duty to promote its success and a duty to avoid situations in which his own interests may conflict with those of the company, and that a breach of those duties may result in proceedings being brought against him. He will also be told that he may face criminal sanctions if he fails to comply – or fails to ensure that the company complies – with certain requirements of the Companies Act 2006, such as the obligation to file the company’s accounts within a certain period. A third risk to which he will be alerted is the risk that he could be required, in the event of the company’s failure, to contribute to its assets under the wrongful trading or fraudulent trading provisions of the Insolvency Act 1986.

The fraudulent trading provision is drawn rather narrowly, for it requires dishonesty on the part of the director. The wrongful trading provision, however, is drawn more widely, and on the face of it exposes directors to a much higher degree of risk. In practice, however, claims against directors for wrongful trading are relatively rare, and a recent decision of the High Court illustrates why this is so: the provision is not, in fact, as threatening to directors as it appears. In Grant v Ralls, Re Ralls Builders Ltd (in liquidation) [2016] EWHC 243 (Ch), the judge concluded that the company in question had traded wrongfully, felt that the company’s treatment of creditors acquired during the period of wrongful trading was not above reproach and yet did not require the directors to contribute to the company’s assets.

This article outlines the law on wrongful trading, examines the decision in Grant v Ralls and considers how concerned directors should be about the risk that they will be held liable for wrongful trading.

Wrongful trading - the law

The main provision dealing with wrongful trading is section 214 of the Insolvency Act 1986. Under section 214, a court may require a director of a company which has gone into insolvent liquidation to contribute to its assets (ie so as to help the company pay its debts) if:

  • at some point before the company was wound up, he knew or ought to have known that there was no reasonable prospect that the company would avoid insolvent liquidation; and
  • from that point onwards did not take every step he ought to have taken to minimise the loss to the company’s creditors.

The section specifies that, for these purposes, a director will be assessed by the standard of a reasonably diligent person who possesses both (a) the knowledge, skill and experience which someone occupying the director’s position would be expected to possess; and (b) any additional knowledge, skill and experience which the director himself happens to possess.

It will be apparent from this brief description that the essence of section 214 is that it allows a court to impose liability on a director who is negligent, but not dishonest. The companion provision to section 214, namely the fraudulent trading provision in section 213, will only catch a director who is knowingly party to trading which is carried on with the intention of defrauding creditors; in other words, it requires, as one judge put it, “actual dishonesty involving … real moral blame” (Re Patrick and Lyon, Ltd [1933] Ch 786, per Maugham J). Section 214, by contrast, will catch a director who, even if he is acting with the purest of motives, falls below the standard of competence which is to be expected of someone occupying his role.

Two questions should spring to the mind of a director who is told about section 214 for the first time:

  • “At what stage should I conclude that there is ‘no reasonable prospect’ of the company surviving?”
  • “Once that stage has been reached, what steps should I take in order to minimise the loss to creditors?”

Unfortunately, neither the Insolvency Act 1986 nor the case law on section 214 provides a helpful answer to these questions.  As far as the first question is concerned, the courts have been anxious not to judge directors’ actions with the benefit of hindsight, taking the view that they need do no more than base their assessment of the company’s prospects on “rational expectations of what the future might hold” (Ward v Perks, Re Hawkes Hill Publishing Co Ltd (in liquidation) [2007] BCC 937, per Lewison J). It is, nevertheless, a matter of fact in each case at what point, exactly, a company realistically can no longer avoid insolvent liquidation.  As far as the second question is concerned, it might seem that the only possible steps to take are those involved in ceasing trading, seeking expert insolvency advice and duly putting the company into administration or liquidation. However, there may well be cases in which more bespoke action is required, whether in the form of seeking to sell off perishable stock or introducing cost-cutting measures (see, for example, Burke v Morrison, Re Idessa (UK) Ltd (in liquidation) [2011] EWHC 804 (Ch), at [120]). In short, the precise steps required of a director will, again, always depend upon the facts of the case.

Wrongful trading – recent reforms

In the light of the account of the law set out above, it might be assumed that wrongful trading claims against directors must be extremely common. After all, section 214 casts its net widely and even the most diligent director might find it difficult to know whether he is complying fully with its requirements. In fact, section 214 claims are relatively rare, presumably because liquidators are reluctant to strain the failed company’s assets even further by undertaking legal proceedings which carry no guarantee of success. According to a government paper published in April 2014, there had been only “around 30” reported cases since 1986.

In an effort to strengthen the regime, two changes were implemented in October 2015 by the Small Business, Enterprise and Employment Act 2015. A relatively minor change was to provide for a wrongful trading claim to be made available to an administrator. More importantly, a new provision allowing a liquidator or administrator to assign the right to bring wrongful trading proceedings was introduced, thus paving the way, for example, for a large creditor to buy the right and pursue a section 214 claim against the directors at his own risk, but for his own benefit.

It is too early to say what the effect of these innovations will be, and it is possible that they will, indeed, result in a higher incidence of section 214 claims. However, neither reform addressed the substance of section 214, in that the underlying grounds on which a director may be held liable were not widened. Consider, for example, a hypothetical reform of the ‘no reasonable prospect’ test to the effect that liability would be triggered (subject to appropriate steps having been taken to minimise loss to the creditors) not if there was no reasonable prospect of avoiding insolvent liquidation, but rather if there was a realistic prospect that the company would go into insolvent liquidation. For better or worse, such a change would surely have given directors far greater cause for concern than either of the changes which were, in fact, introduced.


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Grant v Ralls, Re Ralls Builders Ltd (in liquidation) (2016)

The scenario with which the court in Grant v Ralls was faced was perhaps not uncommon: the directors of a company which was in financial difficulties had courted a prospective investor who had, in the end, failed to come to the company’s assistance.

In slightly more detail, the relevant facts were as follows.

  • The company, Ralls Builders Ltd, had suffered losses in the year to 31 October 2009. By June 2010, it was insolvent and under pressure from its creditors.
  • Since early 2010, the directors had entertained the hope that an outside investor, a Mr James, would inject funds into the group of which the company was a part.
  • From July 2010 onwards, the directors took expert advice from an insolvency practitioner, a Mr Tickell.
  • Until mid to late September 2010, the directors continued to believe that Mr James might yet inject money into the group.
  • In the event, Mr James did not make any investment, and the company went into administration on 13 October 2010.
  • The company subsequently went into liquidation in January 2011, and the joint liquidators (one of whom was Mr Tickell) began proceedings against the directors under section 214. Specifically, they sought a declaration that the directors knew or ought to have known either by the end of July 2010 or by the end of August 2010 that the company could not avoid insolvent liquidation, and that they were liable to contribute to the company’s assets on the ground that it had been trading wrongfully in the run-up to the onset of administration on 13 October 2010.

Snowden J considered first whether, by the end of July 2010 or August 2010, the directors knew or ought to have known that Ralls Builders had no reasonable prospect of surviving. He took the view that the company’s only hope of survival lay in the possible investment by Mr James, so the question was whether the directors knew or ought to have known that there was no reasonable prospect that the investment would materialise. Having concluded, as noted above, that the directors genuinely believed until mid to late September 2010 that a deal with Mr James was possible, he asked himself whether they ought to have concluded otherwise at either of the specified dates. On a close analysis of the facts, although he felt that it was still reasonable, as of the end of July, to believe that the funding from Mr James might be forthcoming, he held that the situation had changed by the end of August. Mr James knew that the company’s plight was extremely serious, had indicated that he would make funds available and yet still had not done so. In the judge’s view, a rational assessment of the company’s position as at the end of August was that it was doomed.

The next step in the judge’s analysis was to consider whether, from that date onwards, the directors had done all they could to minimise the loss to the company’s creditors. He adopted a narrow reading of this element of section 214, holding that a director of a company which continued trading beyond the point at which it was clear that it could not survive could be said to have done all he could to minimise the loss to creditors only if the trading was undertaken with a view to (a) reducing the company’s losses; and (b) minimising individual creditors’ losses. On the facts, he concluded that parties who became creditors after August 2010 were not treated fairly, since a significant portion of the money brought in by the company’s on-going trading was used to pay existing creditors, including the company’s bank. In other words, the directors had not done all they could to protect the company’s new creditors.

At this stage of Snowden J’s analysis, then, the position was that the directors ought to have known by the end of August 2010 that the company would fail and had not subsequently taken appropriate steps to protect creditors. The final question to which he turned his mind was whether he should, in the light of these conclusions, require the directors to contribute to the company’s assets, and it was here that the joint liquidators’ case hit a stumbling-block. On the basis of a careful review of the financial impact of the company’s trading activities in September and the first part of October, the judge decided that the wrongful trading had not caused the company itself (as opposed to any individual creditors) any loss, and in fact may have improved its position slightly. That being the case, he refused to order the directors to make any contribution to its assets.

(For the sake of completeness, it should be added that the judge left open the possibility that the directors could be required to make a contribution in respect of any costs of the administration and liquidation which were occasioned by the wrongful trading.)

Comment

The decision in Grant v Ralls helps to explain why wrongful trading proceedings are relatively few and far between. This was, after all, a case in which a company had engaged in wrongful trading, in the course of which it had acquired new creditors which it had not treated fairly, and yet the directors were not ordered to contribute so much as a penny to its assets. The judge himself accepted that this might be regarded as an unsatisfactory outcome, at least from the point of view of those new creditors. He commented on his conclusion that he was not justified in giving them relief under the wrongful trading provision in the following terms: “That may be thought to be a shortcoming in the structure of section 214, but I do not think it is one that I can remedy; any such change would be for Parliament.” Against this backdrop, it is easy to understand why liquidators might generally be disinclined to bring section 214 claims.

Directors certainly should not take the risk that they might one day be held liable under section 214 lightly, for successful claims are by no means unknown. Indeed, even unsuccessful claims are unlikely to be pleasant experiences. In Grant v Ralls, the decision ultimately favoured the directors, but they nevertheless had to endure lengthy legal proceedings in which their actions were scrutinised in minute detail and in which the judge held that they had not behaved rationally and had treated some of the company’s creditors unfairly. The fact is, however, that wrongful trading proceedings are rare, and the October 2015 reforms are unlikely to produce anything resembling an avalanche of litigation.

The fact that the risk of incurring personal liability under section 214 is rather low should not, however, lead directors to ignore the message which underpins the wrongful trading provision, which is that they must pay due attention to creditors’ interests. Section 214 is but a small part of the company law regime’s framework of creditor protection measures, which include the obligation to file accounts, the rules on trading disclosures and the obligation imposed on directors as part of their general duties to act in creditors’ interests when the company is approaching insolvency (section 172(3), Companies Act 2006, and see Colin Gwyer & Associates Ltd v London Wharf (Limehouse) Ltd [2002] EWHC 2748 (Ch), at [74]). A director who closes his eyes to the importance the law attaches to the protection of creditors’ interests may not necessarily face section 214 proceedings, but he may well be held to account on some other ground.
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