Trading in periods of financial uncertainty

01/09/2008

By James Herbert, Partner and Head of Corporate & Commercial.

In times of financial uncertainty, directors not only have to continue to run the company in the best interests of the shareholders, they must also have an eye on their own potential liability and avoid continuing to trade when they should not.

Businesses are starting to feel the pressure of financial uncertainty. The Insolvency Service reported in May that company liquidations increased in the first quarter of 2008 by 2.0% on the previous quarter and 4% on the same quarter a year ago. It is worth highlighting that trading when a company may be in financial difficulty raises a number of concerns for directors. The key areas of law relate to the consequences that may follow an insolvent liquidation - wrongful trading and fraudulent trading.

Wrongful trading

A director may have to compensate the company where, before an insolvent liquidation, the company entered into a transaction where the director knew or ought to have concluded that there was no reasonable prospect of the company avoiding going into liquidation.

Fraudulent trading. The fundamental element of fraudulent trading is the dishonest intent of a director to defraud. The offence will apply where, during the course of a winding-up, it is apparent that the directors have carried on the business of the company with the intent to defraud creditors.

The court has the power to undo transactions entered into by the directors and/or to bring proceedings against directors to compensate the company for its loss if dishonest intent is proved.

Disqualification in circumstances of insolvency

In addition to the potential for personal liability of the director, the court has power to disqualify a director in certain circumstances relating to the insolvency of a company:

• where the director is found liable for wrongful or fraudulent trading, and/or
• where the conduct of the director of a company which becomes insolvent makes him unfit to manage a company.

The minimum period of a disqualification order is two years and the maximum is 15 years.

The key difficulty for directors of a company facing financial difficulties is deciding whether it is possible to trade through that difficult period or whether the company should cease trading. The director faces a difficult choice between the risk of being accused of an unnecessarily early liquidation and potential liability for wrongful trading if the company continues its attempts to trade out of trouble for too long.

Directors in that situation should seek independent professional advice, ensure that the company has adequate and proper up to date financial information, hold regular board meetings to consider the financial prospects of the company and carefully minute the reasoning for their decisions to keep trading on the basis of up to date financial information.