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Wrongful Trading: When should directors halt trading to act in the interests of creditors?
At what time does a director’s duty to act in the best interest of the company switch to that of its creditors, and what is the risk of wrongful trading? These are the common queries that directors of companies on the verge of insolvency have. The recent case of Brooks v Armstrong  EWHC 2289 (Ch) has detailed the court’s approach to the elements of a claim of wrongful trading and clarified where the burden of proof lies when establishing the defence of “minimising of loss”.
On 6 February 2009, Robin Hood Centre plc (the “Company”) entered into a creditors’ voluntary liquidation. The Company’s liquidator’s alleged, in reliance on section 214 of the Insolvency Act 1986 (the “Act”), that the Company’s directors should contribute to the Company’s assets. This was because, as a result of a number of losses and contingent liabilities that manifested themselves prior to 6 February 2009 they knew, or ought to have concluded, before that date that there had been no reasonable prospect of the Company avoiding insolvent liquidation. The liquidators also applied under section 212 of the Act for compensation from the directors for breach of duty. In turn, the directors relied on section 214(3) of the Act, known as the “minimising of loss” defence. This provision states that a director will not be liable for wrongful trading if that director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken.
The court was asked to decide whether:
- the liquidators had proved the Knowledge Condition (as defined below);
- the defence had been satisfied; and
- the directors were liable to contribute to the Company’s assets for breach of duty.
Section 214 – Wrongful Trading
A liquidator can apply to the court for a declaration that a director of a company makes a contribution to that company’s assets if the following conditions are satisfied:
- the company has gone into insolvent liquidation; and
- at some time before the commencement of the winding up of the company, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation (the “Knowledge Condition”).
The Knowledge Condition does not require proof of solvency or insolvency at the date of knowledge nor does it need to be proved at a specified date. The requirement is knowledge, sometime preceding the commencement of the liquidation, that there is no reasonable prospect of avoiding a future liquidation in which there will be insufficient assets to pay the company’s creditors. Directors could cause the company to trade while commercially insolvent without committing wrongful trading as long as the directors’ projections of avoiding a future liquidation were based on “rational expectations”. However, the court must bear in mind that directors will often be faced with decisions for which there is no right or wrong answer; the fact that a director’s decision may subsequently prove to be wrong does not, on the face of it, mean the director failed to act reasonably at the time – there is no “point of no return test”.
When considering whether the Knowledge Condition was satisfied, the liquidators put to the court five dates which they argued were points at which the Knowledge Condition was satisfied in relation to the Company. These dates were: 31 January 2005, 31 January 2006, 6 October 2006, 31 January 2007 and 3 May 2007. On the facts, the court concluded that the Knowledge Condition was satisfied on 31 January 2007 and continued to be satisfied as at 3 May 2007. This meant that the directors had to rely on the minimising of loss defence in relation to their actions between 31 January 2007 and 6 February 2009 to avoid a ruling of wrongful trading.
Section 214(3) – Minimising of Loss Defence
If the court determines that three conditions above are made out, then the directors must rely on the defence set out in section 214(3) of the Act. This provision states that a director will not be liable for wrongful trading if that director took every step with a view to minimising the potential loss to the company’s creditors as he ought to have taken.
What “every step” means is heavily dependent upon the facts of the case. However, as a matter of guidance the following factors should be considered by directors and kept under review when assessing financial decisions:
- ensuring accounting records are kept up to date with a budget and cash flow forecast;
- preparing a business review and a plan dealing with future trading including steps that can be taken to minimise loss;
- keeping creditors informed and reaching agreements to deal with debt and supply of goods where possible while ensuring to deal with creditors as a whole, not individually;
- regularly monitoring the trading and financial position together with the business plan both informally and at board meetings;
- ensuring adequate capitalisation of the business;
- obtaining professional advice; and
- considering alternative insolvency remedies.
When deciding on “every step”, the directors must judge decisions by reference to the body of creditors as a whole; it is creditors as a class that is protected by section 214 of the Act, not individual creditors. Therefore, the requirement to take “every step” must aim to minimise loss for all creditors, not just some. This is where the defence failed for the directors of the Company after 3 May 2007. In short, the Company’s directors had prioritised certain trade creditors over other creditors such as its landlord and HMRC. This meant that despite some creditors being paid, liabilities of the Company’s creditors as a class were increasing meaning that the directors failed to take every step to minimise loss to the Company’s creditors as a whole.
The judge in the case also confirmed that the burden of proof in assessing the merits of the defence in section 214(3) of the Act lay with the directors. As the directors of the Company did not adequately address their decision to prioritise certain trade creditors at the expense of others and why it was with a view to minimising loss for creditors as a whole in their evidence, the defence could not be upheld beyond 3 May 2007. As a result, the court ruled that the directors had been wrongfully trading since 3 May 2007.
Section 212 – Compensation
Section 212 of the Act allows a liquidator to apply to the court for an order to compel a director who has breached his fiduciary duties to contribute such sum by way of compensation in respect of the breach of duty.
The court’s discretion under this section is unfettered and the purpose is compensatory, not penal. This compensation is designed to recoup the loss to the company caused by wrongful trading and the compensation will be applied for the benefit of the creditors as a whole. The court will establish a maximum liability by assessing the amount the company’s assets have depleted and/or its creditors have increased.
The court, applying its discretion, found that the directors of the Company should provide compensation for the interest and penalties of the VAT liability and the increased PAYE and NICs accruing between the hypothetical date for liquidation (i.e. when the Knowledge Condition was satisfied) and the actual date of liquidation as otherwise these would have crystallised as at 3 May 2007. A small discount to this sum was made to take into account the success of the minimising of loss defence from the hypothetical date for liquidation up to 3 May 2007.
This case provides an insight into how the court approaches the various requirements of a wrongful trading claim, including an application for a compensatory award. Of particular note is that the case clarifies that the burden of proof in showing that “every step” was taken that ought to have been taken with a view to minimising loss to the company’s creditors lies with the directors, not the liquidators.
The case is an example of the need for directors to assess fully their options when a company is heading towards insolvency, especially at the crucial point at which a director’s duties shift from the company to creditors and a reminder that that duty is owed to creditors as a class, not certain constituents of them.
For more information, please contact John Alder, corporate associate