Our website is set to allow the use of cookies. For more information and to change settings click here. If you are happy with cookies please click "Continue" or simply continue browsing. Continue.

Law for Business

Knowhow - guidance - precedents

11 SEP 2012

Wrongful trading, SMEs and the illusion of limited liability

Shareholders in SMEs will be aware that they enjoy the benefit of limited liability. If the company fails, they will not be liable in respect of creditors' claims against it.

If, however, a shareholder is also a director, he faces the risk that, upon the company's demise, he will be ordered to contribute to its assets under the wrongful trading provision in section 214 of the Insolvency Act 1986. In such circumstances, the benefit of his limited liability as a shareholder may be considerably reduced, and since limited liability is often a key motivating factor in the decision to carry on a business through a corporate vehicle it is crucial that shareholders who have a place on the board understand the scope of their potential exposure under section 214.

Section 214

Section 214 is designed to protect creditors. In broad terms, it gives the court the power to order a director of a failed company to contribute to its assets if he caused it to continue trading beyond a point at which he "knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation".

The potential reach of section 214 depends largely on the courts' interpretation of the phrase in quotation marks. In particular, assuming that a director does not know that there is no reasonable prospect that the company will avoid insolvent liquidation, in what circumstances ought he to have concluded that this was the case? In answering this question, the courts will ask themselves whether a reasonably diligent person having both the knowledge and skill expected of someone in the director's position, and the knowledge and skill which the director in fact possesses, would have concluded that the company was beyond saving (section 214(4)).

Earp v Stevenson

The courts' approach to the question is illustrated by the High Court's decision in Earp v Stevenson, Re Kudos Business Solutions Ltd (In Liquidation), [2011] EWHC 1436 (Ch). The relevant facts of the case were as follows. 

  • Mr Stevenson was the sole director of a private company.
  • Through a certain Mr Ramsden, the company entered into contracts to provide a DX mailing service to various customers.
  • The company received significant advance payments under the contracts.
  • Mr Stevenson did not have reasonable grounds for believing that Mr Ramsden would fulfil the contracts, and he took no steps to fulfil the contracts himself.
  • In the event, the contracts were not fulfilled.
  • Mr Stevenson failed to keep himself fully informed as to the company's deteriorating financial situation, and in due course the company went into insolvent liquidation.

The company had ceased to trade in July 2006, and the liquidators brought proceedings against Mr Stevenson for wrongful trading, arguing that he ought to have concluded in March 2006 that there was no reasonable prospect that the company would avoid insolvent liquidation. In assessing their claim, Sarah Asplin QC, sitting as a deputy High Court judge, adopted the approach taken in Ward v Perks, Re Hawkes Hill Publishing Company Ltd (In Liquidation) [2007] BCC 937, where the judge suggested that a director's conduct should be based on ‘rational expectations of what the future might hold'. Ms Asplin felt that Mr Stevenson had, at best, ‘a speculative hope' that the contracts would be fulfilled, and that fact, taken together with the fact that the company was in financial difficulties (details of which he was not, but ought to have been, aware), meant that by March 2006 the rational expectation would have been that the company could not avoid going into insolvent liquidation. Since the company had continued to trade beyond that date, Mr Stevenson was held liable to contribute to its assets under section 214.

Avoiding liability for wrongful trading

The implication of Earp v Stevenson is not that directors are expected to be able to see into the future. Certainly, directors have to adopt a rational approach to their assessment of the company's prospects, and will be at risk if they keep the business going on the basis of a merely speculative hope that it might survive.1 However, the courts are very much alive to the danger of punishing legitimate business judgments as to the company's chances of survival which, with the benefit of hindsight, may have been misjudged.

In Earp v Stevenson itself, Ms Asplin made the point that she was not dealing with a case in which a director had formed a considered view that the interests of the company and its creditors would be best served by an attempt by the company to trade its way out of trouble. Similarly, in Burke v Morrison, Re Idessa (UK) Ltd (In Liquidation) [2011] EWHC 804 (Ch), the judge observed in connection with section 214 generally that ‘particular care should be taken not to invoke hindsight and proper regard must be had to the difficult choices which often confront directors when deciding whether to continue to trade and on what basis'. Most colourfully, perhaps, the judge in Re Hawkes Hill Publishing commented that ‘directors are not clairvoyant and the fact that they fail to see what eventually comes to pass does not mean that they are guilty of wrongful trading'.

In other words, whilst the courts will be ready to punish directors whose decision to continue trading is not based on realistic expectations of the company's prospects of survival, they will be slow to uphold a wrongful trading claim against a competent director who weighed up all the evidence and had reasonable grounds for concluding that the company's business could be salvaged.

Conclusion

It is in the nature of SMEs that shareholders will often wish to take a seat on the board, and there is no reason why they should not do so, as long as they understand what the role involves. Just as they need to be aware of a director's obligations in relation to the company's accounts, for example, so they need to be aware that section 214 requires a director to take a realistic and responsible approach to his assessment of the company's prospects. A shareholder who does not appreciate what section 214 requires of him in his capacity as a director runs the risk of discovering, in the event that the company fails, that the protection afforded to him by the principle of limited liability in his capacity as a shareholder is, in practical terms, little more than an illusion.2

 

Another case of interest in this connection is Roberts v Frohlich [2011] EWHC 257 (Ch), in which the finances of a property development company deteriorated to such an extent that eventually, the judge found, the directors were operating on the basis of ‘wilfully blind optimism; the reckless belief that ... something might turn up'. Concluding that their hopes were not objectively justified, he held that the company had been engaging in wrongful trading.

The risk is neatly illustrated by the High Court's decision in Singla v Hedman [2010] EWHC 902 (Ch), where a shareholder who was apparently convinced that he would be safe in the event of the company's failure was ordered to contribute to its assets in his capacity as a director under section 214.

Jordan Publishing Employment Law

Jordan Publishing Employment Law

"exceptional value for money in today's challenging legal environment" John Mitton, PG Legal

Available in Employment Law Online
Jordan Publishing Health and Safety Management

Jordan Publishing Health and Safety Management

"The manual is a must for any employer that needs clear practical advice on managing health and...

Available in Health and Safety Law Online
Subscribe to our newsletters