Wrongful Trading

The current tough financial climate will inevitably and sadly lead to insolvencies. But directors of insolvent limited liability companies are not necessarily protected from their creditors if they do not follow the rules.

One of the foundations of our business system is the ability for companies to trade with limited liability. A company is a distinct legal entity, separate from the individuals who are its shareholders and directors. This should enable shareholders to own a business and directors to manage a business, without risking their personal assets in the process.

This arrangement works well for shareholders and directors but it is much less attractive for the creditors of those companies. When a business becomes insolvent and is unable to pay its debts, the creditors are inclined to review how the business was managed. Creditors find it very frustrating when they realise that the directors took unnecessary risks leading to the collapse of the company but are not exposed to any personal loss.

The injustice of that situation led to the wrongful trading provision in the Insolvency Act in 1986. This enables a company’s liquidator to ask the court to order a director of a company to contribute to the company’s assets.

In considering the application, the court must be satisfied that the company continued to trade after the director knew or ought to have realised that there was no reasonable prospect of avoiding insolvency. The liquidator has to establish that the company was worse off at the date of liquidation, than if it had ceased trading when the director ought to have realised that insolvency was inevitable.

To counter this, the director has to show that he took reasonable steps to minimise the potential loss to creditors, but he is not expected to be clairvoyant. Taking professional advice and then carefully considering the facts, before making the decision to proceed, will certainly work in his favour. In most cases where directors were found liable, they had deliberately ignored the company’s real position.

The court views the director’s behaviour by comparing it with directors in similar businesses and expects the level of general knowledge and experience to be less in the case of a small company than a large sophisticated multi-national.

As a rule, there is no distinction between executive and non-executive directors and so non-executive directors should expect to be assessed by the same standards.

If the case is proved a director can be ordered to pay an amount into the liquidation. This will reflect the extent to which the director’s conduct has depleted the company’s assets, since the point when he should have realised that insolvency was inevitable. It could be a very substantial payment from the director’s own assets.

The court can also link this with an order to disqualify the director from acting as a director of a limited company.

So the sanctions facing directors are severe and in a tough financial climate professional advice should be sought sooner rather than later.

Contact Julian Trahair for further information and advice.

Published 11/09/2008. The author of this article is Julian Trahair