Wrongful trading

In these turbulent economic times, companies are increasingly unable to pay their creditors and are thus being wound up or made subject to other insolvency processes. Given that this has the potential to leave the company’s creditors high and dry, due to the principle of limited liability, it is, perhaps not surprising that focus has recently turned to what is known as ‘piercing the corporate veil’: seeking to overcome limited liability by imposing personal, unlimited liability for a company’s debts on its directors.

A key route to imposing personal liability is to suggest a breach by the directors of their obligations, as prescribed by the Companies Act 2006 and/or the Insolvency Act 1986. One of these obligations is not to permit the company to indulge in ‘wrongful trading’.

What is Wrongful Trading?

A term that is commonly utilised with the term ‘wrongful trading’ is ‘trading whilst insolvent’. Indeed, they are often used interchangeably, despite being slightly different concepts. ‘Trading whilst insolvent’ means that the company is unable to pay its debts or it has liabilities that outweigh its assets.

Trading while insolvent is not wrongful per se. Is it in fact permissible to trade whilst insolvent, if there is a reasonable prospect of the relevant company avoiding an insolvent liquidation. However, it is the lack of this prospect that turns trading whilst insolvent into ‘wrongful trading’.

Consistent with this, section 214 of the Insolvency Act 1986 (which effectively defines ‘wrongful trading’) states:

Under this section, Directors may become personally liable to contribute (i.e. pay towards) to the assets of a company if the company was allowed to continue trading at a time when a Director knew (or ought to have known) that there was no reasonable prospect of the Company avoiding insolvent liquidation.

This being said, it is not advisable for a company to trade whilst insolvent, because it runs the risk of being classed as wrongful trading in due course.  It is simply not worth the gamble.  The directors of a company may believe that there is a reasonable prospect of the company avoiding an insolvent liquidation, but if that belief is subsequently found not to have been based on reasonable grounds (a decision which will be made with the advantage of hindsight), then wrongful trading will have occurred. 

What are the consequences of wrongful trading?

If wrongful trading is proven:

  • The directors of the company can be held liable to pay compensation equivalent to the estimated losses incurred by the company arising from the wrongful trading. This is calculated from the point that the directors knew or ought reasonably to have known that the company would be liquidated to the date of that liquidation.  These losses could be substantial.
  • Directors can be disqualified from acting as a company director for up to 15 years.

There could be greater impact. Trading while insolvent is a civil offence and not a criminal one. But if the relevant insolvency practitioner (again, with the benefit of hindsight) determines that directors have purposefully and deliberately continued to trade, accepted credit supplies from creditors or accepted orders from customers, despite knowing they cannot repay their creditors or fulfil customer orders, there may be an allegation of fraudulent, rather than simply wrongful, trading and this is a criminal offence.  

How can I recognise the potential for wrongful trading?

The first step to identifying potential wrongful trading is to consider whether a company is trading while insolvent.  Common signs of this include:

  • Issues with the company’s cash flow, such as refusal of credit, threatened legal action and consistent, unanswered demands for payment by creditors.
  • The existence of significant and/or unusual large debts due to creditors, such as lending companies, banks or HMRC. 
  • Delayed or incorrect financial decisions being made by the directors. 

What should I do if it seems wrongful trading may be alleged?

If there is concern that a company is potentially trading while insolvent, there are two main steps that may be undertaken:

  • The company’s directors should take immediate advice on whether wrongful trading is occurring (including as to the company’s solvency) and the consequences of it.  Their actions are likely to be scrutinised by the relevant insolvency practitioner under any insolvency process.  Remember:  the test as to whether wrongful trading has occurred is objective and not subjective, as explained above;
  • Any decision by the directors to continue to trade should be fully documented, complete with a thorough explanation of why the decision has been made.  This paper trail may be crucial in relation to the scrutiny referred to above.

This is only a short summary of wrongful trading and does not represent any form of advice. If you require specific advice on any particular scenario, or any other issue relating to directors’ duties, please do not hesitate to contact Tim at tim@londonlawcollective.com, by telephone on 0737 562 6184 or reach out via his LinkedIn.