Wrongful Trading by Directors

Published bySteven Docherty

15th April 2016

The English High Court recently looked at the question of when directors can be found to have traded wrongfully for the purposes of the Insolvency Act 1986, and what the consequences are.  

This WJM Briefing Note looks at the case, and in particular what the court found were the principles to be applied.

Background 

Section 214 of the Insolvency Act 1986 provides that, if the court is satisfied that a director of a company which has gone into insolvent liquidation knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, the court can order that director to make such contribution to the company’s assets as the court thinks proper. 

However, the court cannot make such an order if the court is satisfied that the director took every step which he should have taken, with a view to minimising the potential loss to the company’s creditors.  

Re. Ralls Builders Limited (In Liquidation) [2016] EWHC 243 

Section 214 was considered by the English High Court in the above case, in February 2016.  

A short summary of the factual position is that the company was a construction company which built up significant losses after the housing crisis hit in 2008.  As a result, by June 2010, it was under severe pressure from its creditors, including HMRC and trade creditors.  However, the company was not placed into Administration (and later, liquidation) until October 2010, by which time the company had run up a further £1.13 million of additional debt.  The liquidators brought an action under Section 214 to ask the court to order the company’s directors to contribute this sum (which was reduced during the course of the action) to the assets of the company, so that the creditors would benefit. 

The liquidator’s argument was that the directors should have known by June 2010 that the company could not survive, but the directors’ argument was that, after that date and before the Administration, they were taking steps (including trying to find a wealthy investor to “buy in” to the company) which had a reasonable prospect of rescuing the company and avoiding liquidation. 

In ultimately finding for the directors, the judge concluded that they had traded wrongfully but that doing so had not caused any additional losses, so they were not required to contribute anything to the company’s assets. 

Discussion 

In the Ralls decision, the judge highlighted a number of important points, often forgotten in such “wrongful trading” cases.  These points of note were:- 

• First, just because a company may be insolvent but continues to trade, it does not necessarily follow that the directors will be liable for wrongful trading if the company does not survive.  The judge highlighted that many companies suffer short-term (often “balance sheet”) insolvency from time to time, but have very real prospects of being able to trade out of difficulty and avoid insolvent liquidation. 
   
• Second, the test under Section 214 involves looking at what the “reasonably diligent person having the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as those of the director” would have done, as well as looking at the knowledge, skill and experience that the particular director does have.  In other words, the judge confirmed that this is largely an objective test – what would this director have done if acting as a reasonably diligent, skilful and experienced director would have done? 
   
• Third, directors cannot indulge in “wilfully blind optimism” about the state of their company’s finances, or to “close their eyes to the reality of the company’s position” in the hope that “something might turn up”.  They must make a genuine attempt to grapple with the company’s real position.
   
• Finally, the “every step which he should have taken” test for a director’s defence in Section 214 is intended to be a high hurdle for the directors to cross.  The director must not only show that his actions were intended to reduce the net deficiency in the company’s position with its creditors, but that those actions were appropriately designed so as to achieve the aim of minimising the risk of loss to individual creditors.
   

In the case itself, the judge heard evidence that the directors clearly knew the company could not survive, but the question was whether they had a reasonable expectation that the wealthy investor would “buy in”.  In the end, the judge found that there were no reasonable grounds for such an expectation, so the directors had indeed traded wrongfully, albeit on the facts he found that they should make no contribution to the assets of the company as no additional losses were found to have been incurred by the company during the period of wrongful trading. 

This case serves as a useful reminder to directors to keep a close eye on the finances of your business, and make realistic decisions and assessments on how and whether the business can continue to trade profitably.  If the wrong decision is made, directors can be personally liable to contribute potentially significant sums of money. 

Insolvency practitioners should also take note, as it will be important to only bring Section 214 proceedings when the test has been met.

For more information, please contact Steven Docherty or Graham Bell in WJM's Insolvency Team.