Insolvency considerations for directors – wrongful trading

What is wrongful trading and when do directors need to prioritise the interests of creditors?

Wrongful trading occurs when directors of a company continue to trade at a point when they knew, or should have known, that there was no reasonable possibility of avoiding insolvency. The consequences of wrongful trading can be severe and so in periods of financial uncertainty, directors need to carefully consider the risks that arise under the Insolvency Act 1986 (IA).

Most directors are familiar with duty under the Companies Act to act in the best interests of their company and its shareholders, but less so with the need to balance that with the interests of a company’s creditors, and to minimise their losses, when an insolvency event arises.

Even the most well intentioned of directors can be tripped up, by the understandable desire to keep trading in order to save the business – if their actions result in further losses to creditors, however, it could leave them exposed to a liability for wrongful trading.

In this context, ‘insolvent’ means that the company’s liabilities exceed its assets (the balance sheet basis) or that the company cannot pay its debts as they fall due (the cash-flow basis), or is bordering on such an insolvency. The closer or more likely insolvency becomes, the more the interests of creditors must be prioritised.

If there is no reasonable prospect of avoiding insolvency, directors are obliged to manage the affairs of the company with a view to minimising potential losses to creditors. Usually they are likely to be well advised to place the company into an insolvency process such as liquidation or administration. However, it may be difficult to identify precisely when this might be necessary.

What are the consequences of wrongful trading?

If a claim for wrongful trading is successfully brought against a director by a liquidator or an administrator, the director can be held personally liable, at the Court’s discretion, for the additional losses caused to creditors.

A director held liable for wrongful trading may also be the subject of a disqualification order.

Wrongful trading is a civil, rather than a criminal offence, and there does not need to be any intent to prejudice the position of the creditors for a director to be found guilty.

How can directors avoid claims for wrongful trading?

Directors should always keep an eye on the financial position of their company, particularly when the business is struggling. If the directors consider that the company may be insolvent on either a balance sheet or cash flow basis, or is bordering on insolvency, they should be aware that their obligation to act in the best interests of the company and its shareholders is no longer absolute.

The closer or more likely an insolvency becomes, the more the interests of the creditors must be prioritised. In these circumstances, directors should consider taking professional advice on their duties, and the options available to them.

From a practical perspective, they should liaise regularly with their fellow directors (if applicable) to decide on an appropriate course of action. It would be prudent to keep a record of the decisions that have been made by the directors, and the reasons for them, so that if a claim for wrongful trading is instigated, there is a paper trail of evidence justifying the decisions that were made.

Will continued trading in periods of financial difficulty always lead to claims of wrongful trading if the business does not recover?

Whilst directors would be wise to take a cautious approach to continued trading in times of financial difficulty, claims for wrongful trading are fact specific, and continuing to trade does not in and of itself mean a director will be found to be liable for wrongful trading.

The Court will not make an order for wrongful trading, if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration, the director took every step with a view to minimising the potential loss to the company’s creditors as the director ought to have taken. In some cases, continuing to trade might well be in the best interests of creditors, therefore.

If the financial position of the business deteriorates further as a consequence of continued trading, it is possible that the directors may be able to justify their course of action. For example, if there was a cash flow issue, the directors may be able to justify continuing to trade if it was in expectation of an important contract with a customer being fulfilled and payment of an invoice.

It may be that the expected benefit does not materialise and the financial position worsens, but the directors will not necessarily be found to be personally liable for wrongful trading. In this scenario, the directors would need to convince a Court that continuing to trade was an objectively reasonable course of action to take, and it was not envisaged that the position of the creditors could be prejudiced further.

As noted, therefore, continually monitoring and reviewing the situation will be key, including the potential impact of decisions on creditors. Taking professional advice will help to inform your duties and the steps to be taken, and maintaining accurate financial records and notes of decisions and your reasoning will provide a vital evidential trail to rely on.

If you have any questions about the topics raised in this article, please get in touch.