Wrongful trading
Encyclopedia
Wrongful trading is a type of civil wrong
found in UK insolvency law
, under s 214 Insolvency Act 1986
. It was introduced to enable contributions to be obtained for the benefit of creditors from those responsible for mismanagement of the insolvent company.
. Unlike fraudulent trading, wrongful trading needs no finding of 'intent to defraud' (which requires a heavy burden of proof). Wrongful trading is therefore a less serious, and more common offence than fraudulent trading.
Under UK insolvency law, wrongful trading occurs when the directors
of a company have continued to trade a company past the point when they:
Wrongful trading is an action that can be taken only by a company's liquidator
, once it has gone into insolvent liquidation
. (This may be either a voluntary liquidation - known as Creditors Voluntary Liquidation, or compulsory liquidation). It is not available to the directors of a company while it continues in existence, or to other insolvency office-holders such as an administrator.
Where, during the course of a winding-up, it appears to the liquidator that wrongful trading has occurred, the liquidator may apply to the Court for an order that any persons who were knowingly parties to the carrying on of such business are to be made liable to make such contributions to the company's assets as the court thinks proper.
directors (that is directors who were formally appointed and their appointment was registered with Companies House
. It can apply to de facto
directors (that is people who assumed the role of director of a company without being appointed), or shadow directors (that is people in accordance with whose direction the de jure directors were accustomed to act.
Initially, there was uncertainty among banks and insolvency and restructuring professionals who assisted and advised companies facing insolvency that they may be caught by the wrongful trading provisions. This has not proved to be the case (as of July 2006), and professionals are unlikely to be covered by these provisions except in exceptional circumstances.
The facts a director ought to have known were those a reasonably diligent person—having both the skill and experience possessed by a reasonable director—together with the skill and experience actually possessed by that individual. This means that there is a two-fold test for knowledge. There is a general level of skill required for all directors under the first part of the test. Under the second, a higher standard of knowledge is required by those with specialist skills. (These are likely to be accounting or legal skills). This principle has been confirmed in a 1999 case where an executive husband had to pay £210,000 to the liquidator compared with his non-executive wife's £50,000.
The normal approach to wrongful trading actions is that the liquidator will try to establish a date at which the company can be shown to be balance sheet insolvent, and then show why it was unreasonable for directors to continue to trade after this. In the UK, and contrary to many misconceptions, it is not an offence to trade a company while it is insolvent. Indeed in some situations, if the directors genuinely believe that the position will be turned around and the position of creditors will improve, it is the correct thing to do. When it becomes wrongful trading is when it should have been realised that the position of the creditors would likely deteriorate from that position onwards and the company would proceed into liquidation. Once a director realises that his or her company is insolvent, one important thing for them to do is to seek immediate professional advice from a licensed insolvency practitioner
.
Many legal systems (including English law) recognise the blue sky defence; which broadly provides that, if the directors, in good faith, believed the company was about to turn the corner and improve, they would not normally be held liable for continuing to trade. Liability only attaches when the company has no realistic prospect of avoiding insolvent liquidation.
The Court however has wide discretion, and may award just a percentage of this. It awarded 70% of the drop in net assets in Re Brian D Pierson (Contractors) Ltd
[1999] BCC 903. This was on the basis of the judge’s "guesstimate" that 70% of the drop in net assets was due to the actions of the directors, and 30% could be attributed to extraneous causes.
s. It then followed that the costs of a wrongful trading action could not be drawn from the company’s assets held by the liquidator, and fell to be paid personally either by the liquidator (which he would not do), or would require a unanimous decision of unsecured creditors. The position has now been clarified with the Enterprise Act 2002
changing the law to allow the costs of wrongful trading actions to be included as a cost of the liquidation. These can be met from the company’s assets.
As is often the case, a company in liquidation has no assets with which to bring an action for wrongful trading. How can the liquidator bring, or fund an action? Can the liquidator sell or assign the claim to a specialist litigation company?
Because a claim for wrongful trading is a personal action brought by the liquidator, it follows that if it is unsuccessful, the liquidator is personally liable for the legal costs of the defendants. This was found to be the case following a 5 months trial in which the liquidator of Continental Assurance Company of London plc sued a number of its directors. Although the costs of an action (whether successful or otherwise) can now be properly paid by the liquidator out of company assets where there are adequate funds available, the House of Lords in 2004 altered the hitherto accepted priority of costs in a liquidation, making the liquidator's costs (including the legal costs of a wrongful trading action) rank last in priority behind both preferential creditor
s and the sums due to debenture
holders. The decisions in Continental Assurance and Leyland Daf make wrongful trading actions unattractive to liquidators.
It is now usual practice for liquidators to enter into conditional fee arrangements
with lawyers and have insurance against adverse costs in place in the event that he is unsuccessful. The liquidator is able to assign the action regardless of the normal rules relating to champerty and maintenance
. (He is empowered by statute to sell any of the company’s property). As an alternative, there are commercial litigation funding organisations that take over management and funding of the entire claim, and pay the liquidators a percentage of recoveries.
Civil wrong
A civil wrong or wrong is a cause of action under the law of England and Wales. Tort, breach of contract and breach of trust are types of civil wrong.Something that amounts to a civil wrong is said to be wrongful....
found in UK insolvency law
UK insolvency law
United Kingdom insolvency law deals with the insolvency of firms and individuals in the United Kingdom. The important statutes are the Insolvency Act 1986, as amended by the Enterprise Act 2002, as well as the Company Director Disqualification Act 1986 and the Companies Act 2006.Insolvency is a...
, under s 214 Insolvency Act 1986
Insolvency Act 1986
The Insolvency Act 1986 is an Act of the Parliament of the United Kingdom that provides the legal platform for all matters relating to personal and corporate insolvency in the UK.-History:...
. It was introduced to enable contributions to be obtained for the benefit of creditors from those responsible for mismanagement of the insolvent company.
The Insolvency Act 1986
The principle of wrongful trading was introduced in the Insolvency Act 1986, to complement the concept of fraudulent tradingFraudulent trading
Fraudulent trading is an insolvency law concept, and in particular a UK insolvency law concept. It refers to a company that has carried on business with intent to defraud creditors.-Law:...
. Unlike fraudulent trading, wrongful trading needs no finding of 'intent to defraud' (which requires a heavy burden of proof). Wrongful trading is therefore a less serious, and more common offence than fraudulent trading.
Under UK insolvency law, wrongful trading occurs when the directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
of a company have continued to trade a company past the point when they:
- "knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation"; and
- they did not take "every step with a view to minimising the potential loss to the company’s creditors".
Wrongful trading is an action that can be taken only by a company's liquidator
Liquidator (law)
In law, a liquidator is the officer appointed when a company goes into winding-up or liquidation who has responsibility for collecting in all of the assets of the company and settling all claims against the company before putting the company into dissolution....
, once it has gone into insolvent liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
. (This may be either a voluntary liquidation - known as Creditors Voluntary Liquidation, or compulsory liquidation). It is not available to the directors of a company while it continues in existence, or to other insolvency office-holders such as an administrator.
Where, during the course of a winding-up, it appears to the liquidator that wrongful trading has occurred, the liquidator may apply to the Court for an order that any persons who were knowingly parties to the carrying on of such business are to be made liable to make such contributions to the company's assets as the court thinks proper.
Who may be liable?
Section 214 Insolvency Act 1986 has very wide scope, since it applies not only to de jureDe jure
De jure is an expression that means "concerning law", as contrasted with de facto, which means "concerning fact".De jure = 'Legally', De facto = 'In fact'....
directors (that is directors who were formally appointed and their appointment was registered with Companies House
Companies House
Companies House is the United Kingdom Registrar of Companies and is an Executive Agency of the United Kingdom Government Department for Business, Innovation and Skills . All forms of companies are incorporated and registered with Companies House and file specific details as required by the...
. It can apply to de facto
De facto
De facto is a Latin expression that means "concerning fact." In law, it often means "in practice but not necessarily ordained by law" or "in practice or actuality, but not officially established." It is commonly used in contrast to de jure when referring to matters of law, governance, or...
directors (that is people who assumed the role of director of a company without being appointed), or shadow directors (that is people in accordance with whose direction the de jure directors were accustomed to act.
Initially, there was uncertainty among banks and insolvency and restructuring professionals who assisted and advised companies facing insolvency that they may be caught by the wrongful trading provisions. This has not proved to be the case (as of July 2006), and professionals are unlikely to be covered by these provisions except in exceptional circumstances.
What is expected of directors?
In order to establish liability, the liquidator needs to demonstrate, using the civil burden of proof (i.e. on the balance of probabilities) that the directors continued trading the company beyond a point in time when they knew, or ought to have ascertained, that insolvent liquidation was inevitable.The facts a director ought to have known were those a reasonably diligent person—having both the skill and experience possessed by a reasonable director—together with the skill and experience actually possessed by that individual. This means that there is a two-fold test for knowledge. There is a general level of skill required for all directors under the first part of the test. Under the second, a higher standard of knowledge is required by those with specialist skills. (These are likely to be accounting or legal skills). This principle has been confirmed in a 1999 case where an executive husband had to pay £210,000 to the liquidator compared with his non-executive wife's £50,000.
The normal approach to wrongful trading actions is that the liquidator will try to establish a date at which the company can be shown to be balance sheet insolvent, and then show why it was unreasonable for directors to continue to trade after this. In the UK, and contrary to many misconceptions, it is not an offence to trade a company while it is insolvent. Indeed in some situations, if the directors genuinely believe that the position will be turned around and the position of creditors will improve, it is the correct thing to do. When it becomes wrongful trading is when it should have been realised that the position of the creditors would likely deteriorate from that position onwards and the company would proceed into liquidation. Once a director realises that his or her company is insolvent, one important thing for them to do is to seek immediate professional advice from a licensed insolvency practitioner
Insolvency practitioner
In the United Kingdom, only an authorised or licensed Insolvency Practitioner may be appointed in relation to formal insolvency procedures.Quite often IPs have an accountancy background...
.
Many legal systems (including English law) recognise the blue sky defence; which broadly provides that, if the directors, in good faith, believed the company was about to turn the corner and improve, they would not normally be held liable for continuing to trade. Liability only attaches when the company has no realistic prospect of avoiding insolvent liquidation.
The amount of the award
The Court has wide discretion over the contribution that it can require. Traditionally this has been compensatory, rather than punitive. The starting point for assessing the appropriate amount was the difference between the net assets of the company at the date that the directors should not have traded beyond, and the net assets at the date of liquidation.The Court however has wide discretion, and may award just a percentage of this. It awarded 70% of the drop in net assets in Re Brian D Pierson (Contractors) Ltd
Re Brian D Pierson (Contractors) Ltd
Re Brian D Pierson Ltd [1999] BCC 26 is a UK insolvency law and company law case, concerning misfeasance and wrongful trading.-Facts:...
[1999] BCC 903. This was on the basis of the judge’s "guesstimate" that 70% of the drop in net assets was due to the actions of the directors, and 30% could be attributed to extraneous causes.
Barriers to wrongful trading actions
It was thought prior to 1997 that the amount paid by a director following a wrongful trading claim was simply paid to the liquidator and it became available to swell the assets of the company generally. In most instances there would have been substantial bank borrowings secured by a debenture and personal guarantees given by the directors. Many directors chose not to fight the claims, reasoning that any amounts paid to company (hence the bank under its mortgage security) via a wrongful trading claim, simply reduced the director’s liability under their personal guarantees. It was therefore irrelevant how the directors repaid the bank. This changed with the Court of Appeal’s decision in 1998 that a claim for wrongful (or fraudulent) trading, is different from a normal 'asset' of the company. In particular, it held that such claim cannot be secured by a debenture. The Court held that the fruits of a claim for wrongful trading are instead held in trust by the liquidation for the general body of unsecured creditorUnsecured creditor
An unsecured creditor is a creditor other than a preferential creditor that does not have the benefit of any security interests in the assets of the debtor....
s. It then followed that the costs of a wrongful trading action could not be drawn from the company’s assets held by the liquidator, and fell to be paid personally either by the liquidator (which he would not do), or would require a unanimous decision of unsecured creditors. The position has now been clarified with the Enterprise Act 2002
Enterprise Act 2002
The Enterprise Act 2002 is an Act of the Parliament of the United Kingdom which made major changes to UK competition law with respect to mergers and also changed the law governing insolvency bankruptcy.-Structure:*Part 1 The Office of Fair Trading...
changing the law to allow the costs of wrongful trading actions to be included as a cost of the liquidation. These can be met from the company’s assets.
As is often the case, a company in liquidation has no assets with which to bring an action for wrongful trading. How can the liquidator bring, or fund an action? Can the liquidator sell or assign the claim to a specialist litigation company?
Because a claim for wrongful trading is a personal action brought by the liquidator, it follows that if it is unsuccessful, the liquidator is personally liable for the legal costs of the defendants. This was found to be the case following a 5 months trial in which the liquidator of Continental Assurance Company of London plc sued a number of its directors. Although the costs of an action (whether successful or otherwise) can now be properly paid by the liquidator out of company assets where there are adequate funds available, the House of Lords in 2004 altered the hitherto accepted priority of costs in a liquidation, making the liquidator's costs (including the legal costs of a wrongful trading action) rank last in priority behind both preferential creditor
Preferential creditor
A preferential creditor is a creditor receiving a preferential right to payment upon the debtor's bankruptcy under applicable insolvency laws....
s and the sums due to debenture
Debenture
A debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note...
holders. The decisions in Continental Assurance and Leyland Daf make wrongful trading actions unattractive to liquidators.
It is now usual practice for liquidators to enter into conditional fee arrangements
Contingent fee
A contingent fee or conditional fee is any fee for services provided where the fee is only payable if there is a favourable result...
with lawyers and have insurance against adverse costs in place in the event that he is unsuccessful. The liquidator is able to assign the action regardless of the normal rules relating to champerty and maintenance
Champerty and maintenance
Champerty and maintenance are doctrines in common law jurisdictions, that aim to preclude frivolous litigation. "Maintenance" is the intermeddling of a disinterested party to encourage a lawsuit...
. (He is empowered by statute to sell any of the company’s property). As an alternative, there are commercial litigation funding organisations that take over management and funding of the entire claim, and pay the liquidators a percentage of recoveries.
Text of section 214
The wrongful trading provision in s 214 IA 1986 is as follows.Case list
- Re Produce Marketing Consortium Ltd (No 2)Re Produce Marketing Consortium Ltd (No 2)Re Produce Marketing Consortium Ltd [1989] 5 BCC 569 was the first UK company law or UK insolvency law case under the wrongful trading provision of s 214 Insolvency Act 1986.-Facts:...
[1989] 5 BCC 569 - Re Brian D Pierson (Contractors) LtdRe Brian D Pierson (Contractors) LtdRe Brian D Pierson Ltd [1999] BCC 26 is a UK insolvency law and company law case, concerning misfeasance and wrongful trading.-Facts:...
[2001] 1 BCLC 275 - Re Continental Assurance Co of London plcRe Continental Assurance Co of London plcRe Continental Assurance Co of London plc' [2007] 2 BCLC 287; [2001] All ER 229 is a UK insolvency law case on wrongful trading under s.214 of the Insolvency Act 1986.-Facts:...
(Singer v Beckett) [2001] BPIR 733, Ch D, [2007] 2 BCLC 287 - Re Cubelock Ltd [2001] BCC 523