Wrongful Trading

Under the statutory provisions now in force, and particularly in the present economic climate, the moment a cloud is on the horizon, the Directors of a Company should behave with caution. Attempts to brazen through what is seen as a temporary period of impecuniosity now carry severe consequences and although the standards which shall be expected of a non-executive Director are of a lower order, the provisions apply to him equally.

The provisions on wrongful trading are contained in Section 214 of the Insolvency Act 1986. The operation of this section is triggered where a liquidator can establish that at some time before the commencement of the winding up a Director knew or ought reasonably to have concluded that there was no reasonable prospect that the Company would avoid going into insolvent liquidation. For the purposes of the section, a Company goes into insolvent liquidation if it goes into liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the winding up.

If the Company continues to trade after the point where the court considers that the Director should have concluded insolvent liquidation was inevitable, then the court must be satisfied that the Director took every step thereafter with a view to minimising the potential loss to the Company's creditors that he ought to have taken, otherwise wrongful trading will be established and the Director may be ordered to contribute to the assets of the Company for the benefit of the creditors.

In reaching these conclusions, the court will use both objective and subjective tests. The facts which a Director ought to know or ascertain, the conclusions he ought to reach, and the steps he ought to take are those which would be known, reached or taken by a reasonably diligent person having both (1) the general knowledge, skill and experience of a person carrying out the same functions as are carried out by that Director and (2) the general knowledge, skill and experience that the particular Director in question has thought.

A Director, therefore, has to match the standards of performance "reasonably expected" of Directors having similar functions. In each particular case the scope of a Director's functions in relation to the Company will therefore be of decisive importance. A Director may be executive or non-executive, full or part-time, he may be elected for his financial or business expertise, for his knowledge of a particular product or to provide technical expertise, and the court will take this into account in determining what the particular Director in question's functions are.

It is accepted that a non-executive Director has in principle the same obligations and is subject to the same liabilities as any other Director and this will apply to his duties to the Company. It is said that the non-executive Director generally has the duty to keep himself informed about the business activities and financial status of his Company, to attend Board Meetings with fair regularity and to check on the activities of the full-time Directors and the leading executives. If he fulfils these duties conscientiously the court may be inclined to look at his obligation to exercise skill, care and diligence as a Director in a more lenient manner. However, omission is punished as well as commission and it is beyond argument that passivity, let alone non-attendance at Board Meetings will be a ground of liability rather than an excuse. Therefore a Director who claims he was not "party" to the Company's conduct may very well convict himself.

Further, although these are the functions normally attributed to a non-executive Director, if a particular non-executive Director is in fact more involved in the Company's affairs, then naturally a higher standard shall be expected of him.

In any event and in any Company, and although the time may come later for a non-executive Director than an executive Director, there must come a point when a Director ought to realise from information which he has received that the Company faces solvency problems and at that point his duties will include the function of ascertaining the true position and, if necessary, taking action. The duty to supervise may be broken by an individual Director or by the body of Directors in failing to institute an adequate monitoring system. A non-executive Director cannot completely excuse his failure to fulfil his duties by simply saying that he relied upon the other Directors to do so but he may be very much less blameworthy if taking his circumstances and functions into account it can be said that he relied upon someone whom he had good and sufficient cause to believe was a proper person to rely on, and who was equally with himself responsible for the Company's affairs.

Once the Director is aware or is deemed ought to have been aware that the Company was in financial difficulties and insolvency seems unavoidable, his duties will include the taking of professional advice on the matter. Reliance on such advice in good faith may give a Director some protection against any allegation of wrongful trading by a liquidator.

The Director must take positive action to mitigate the consequences for the Company's creditors. He must follow the course of conduct which will not merely reduce but will reduce as far as possible the potential loss. Resignation from the Board of Directors is manifestly not such a course, although it may be that if this is the last step after unsuccessful efforts to persuade the Board to act in accordance with their duty, then this will offer protection to that individual Director.

It is difficult to avoid the conclusion that the section will make insolvency proceedings the likeliest course of action to be taken by Directors. However, proposing immediate liquidation will not necessarily be sufficient if a reasonable Director could have seen a realistic alternative such as sale of the undertaking. There may be cases where decision to trade on, albeit for a limited period, may be justified insofar as it appears likely to increase the assets available to the creditors. In any event, it is important to take advice on the matter and to carefully consider what course of action will best protect the creditors' interests.

The strict letter of the law on wrongful trading is harsh, even for non-executive Directors, and would appear to catch 99% of insolvency situations. However, very few cases have been brought under the section. The cases which there are involved situations where the Directors had not heeded the proper accounting procedures and had ignored very obvious solvency problems. In many cases where the Director's personal funds are limited any court action under the section will result in little or no benefit to the general body of creditors of the Company and this may discourage liquidators from incurring the cost of proceedings under the section.

Unlike fraudulent trading which includes an element of dishonesty or recklessness, wrongful trading is not a criminal offence. The liquidator may, however, also apply to the court to make an order disqualifying a Director from being involved in the management of a Company for a period from 2 to 15 years. This sanction applies more to those who cannot be seen to be fit to be involved in the management of a Company in the future rather than persons who have acted honestly and reasonably although perhaps not in accordance with the standards expected of them by the courts.

The watchword for Directors therefore seems to be that they must be vigilant and keep themselves informed of the Company's performance and prospects. However minor or subordinate the Director's role in the Company he has a positive duty to apply his own judgement to Company matters and if not satisfied with the information available or with the position which is disclosed from the information available then he must speak up and must persist in his enquiries if there is any apparent cause for unease. As a safeguard a record should be kept of his own activities in and out of the Board Meetings and if there is the slightest doubt in respect of the Company's position or prospects independent advice should be obtained, no matter how unpopular this may make the Director with his colleagues.