Wrongful trading developments – what is half of nothing?

June 2017 | EXPERT BRIEFING | BANKRUPTCY & RESTRUCTURING

financierworldwide.com

Case law on wrongful trading has developed significantly over the past two years, with cases such as Brooks and another v Armstrong and another [2016] increasing judicial consideration of the conduct of directors in the period preceding an insolvency.

The initial hearing before Mr Registrar Jones considered whether the directors of Robin Hood Centre plc (the company) were liable to contribute to the assets of the company’s insolvent estate as a result of wrongful trading (i.e., continuing to trade after the point at which the directors knew, or ought to have known, that the company could not avoid insolvent liquidation).

It was held that the directors had not acted as reasonably diligent directors should, and that they had failed to establish the statutory defence to wrongful trading under the Insolvency Act 1986. Consequently, the directors were held to be jointly and severally liable to pay a minimum contribution of £35,000 to the estate of the company. The appeal in Brooks considered appeals, based on various grounds, from both the liquidators and the directors of the company.

The liquidators challenged the registrar’s deemed starting point for wrongful trading as 3 May 2007 (i.e., the date from which the directors knew, or ought to have known, that the company could not avoid insolvent liquidation), the registrar’s order for the directors to pay £35,000 and the fact that the registrar made no order as to the costs of the case.

The directors also challenged the date from which the registrar concluded that wrongful trading had occurred, and the amount of compensation they were ordered to pay, although for different reasons.

The legal arguments on wrongful trading

The liquidators argued that a higher standard of conduct should be applied to the conduct of one of the directors, given that he was a director of a number of other companies, including some much larger than the company. The registrar rejected this argument. He held that the director was indeed experienced, but that such experience was in a different field and that the proposed higher standards did not “fit his cloth”. The judge upheld this decision on appeal.

The registrar also rejected the liquidators’ argument that the directors could not reasonably have proceeded to trade on the basis of making a profit without taking into account the position taken by HMRC in relation to the company’s treatment of VAT prior to the liquidation. He rejected this in light of wider considerations about the conduct of the directors. One factor was that, if the directors had immediately placed the company into liquidation, there would have been very little, if anything, left for its creditors. Therefore, he held that the decision to continue to trade had only a limited likelihood of further detriment to the company’s creditors. The judge also upheld this decision on appeal.

The directors argued that the registrar had unfairly and inappropriately taken into account various matters in reaching his finding that wrongful trading had commenced, because doing so required the benefit of hindsight. These matters included the registrar’s failure to take into account an element of rent which was paid, references to a rent review, an HMRC hardship letter of May 2007 and the company’s January 2008 accounts.

The judge held that the consideration of the rent (and the rent review) had been relevant, because the directors ought to have appreciated at the time that the rent review would likely lead to an increase in rent. He further held that the registrar had been entitled to draw an inference about the interplay between the hardship letter and the accounts, because the position the company recognised in the January 2008 accounts could not, in the absence of a suggestion that there had been a change in the company’s circumstances, be different to the position per the prior hardship letter. The judge held that the court had been entitled to infer that the deterioration shown in the accounts would have manifested itself to some extent in May 2007, particularly given the directors had reviewed the monthly management accounts produced in the interim period.

The amount of compensation

The liquidators argued that the court should quantify the maximum loss caused by wrongful trading as “all unpaid debts incurred after the date on which it was alleged the company should have stopped trading” (following precedent set in the Re Continental Assurance case). The registrar stated that this was “wrong and wholly unrealistic”, taking into account certain assumptions made by the liquidators in forming their opinion about the company’s finances and assets.

An insolvent company’s net deficiency is the amount by which its liabilities exceed its assets (i.e., the amount by which the directors’ continued trading reduced the assets of the estate which would be available to its creditors on an insolvency). The registrar assessed the increase in the company’s net deficiency from the point on which trading should have ceased. He then reduced this by requiring there to be a connection between the company’s loss and the directors’ conduct, having regard also to discretionary considerations. The registrar concluded that the increase in the company’s net deficiency was £78,500 and the directors were jointly liable to contribute around 50 percent of this, i.e., £35,000. The liquidators challenged this reduction in the amount payable by the directors.

The judge noted this challenge was open to criticism, referring to the fact that the directors had not been dishonest in their actions and had hoped to benefit the local tourist trade. He concluded that the liquidators had failed to establish that the wrongful trading had resulted in an increase in the company’s net deficiency and that the registrar had applied a flawed analysis. He did, however, add that the registrar had been entitled to take into account that the directors had not acted dishonestly.

The directors argued that the calculation was unfair and inappropriate, and that the registrar had adopted an approach of his own devising. The judge had sympathy for the registrar’s position, but held that this element of the directors’ appeal should succeed, because the parties had not been able to raise any legitimate objection to the calculation at the hearing.

The judge held that the registrar should not have ordered the directors to make any payment, primarily because the liquidators had failed to present a properly formulated case that there had been an increase in net deficiency during the period of wrongful trading.

Summary

The judge allowed the directors’ appeal against the award that they were liable to pay compensation of £35,000, because he found that the liquidators had not established that the directors had caused any increase in the company’s net deficiency. It should be noted that the liquidators have sought leave to appeal this decision, and therefore, the position may change in the future.

Comment

The calculation of net deficiency will always depend on the specific circumstances of the case but should, pursuant to Brooks, be carefully considered and evidenced to ensure that the court has the benefit of a clear assessment on the basis of which the parties may adduce evidence and, where appropriate, object. Liquidators and administrators should therefore take care when assessing the net deficiency of an insolvent company. It is clear that the courts are reluctant to order directors to make contributions to an insolvent company’s estate in the absence of clear wrongdoing.

When facing financial difficulty, directors should always take (at least) reasonable steps to protect their company. They should, importantly, have regard to the interests of creditors (rather than its shareholders) from the point at which they cannot reasonably conclude that the company can avoid insolvent liquidation.

Practical steps that can assist directors with this include: (i) closely monitoring the company’s financial and trading position, together with careful scrutiny of regularly produced financial reports and forecasts; (ii) considering the implications of potential liabilities (such as rental increases or tax liabilities) on the company’s ability to trade as a solvent entity; (iii) taking appropriate legal and/or financial advice; and (iv) considering all options available to the company in light of its current or reasonably foreseeable circumstances, and keeping these options under review by the board.

Charlotte Møller is a partner and Estelle Macleod is an associate at Reed Smith. Ms Møller can be contacted on +44 (0)20 3116 3472 or by email: cmoller@reedsmith.com. Ms Macleod can be contacted on +44 (0)20 3116 2985 or by email: emacleod@reedsmith.com.

Charlotte Møller and Estelle Macleod

Reed Smith