This article will explain the concept of wrongful trading in detail, and how this may affect you if you’re the director of an insolvency company.
What is Wrongful Trading?
Wrongful trading can be better thought of as ‘irresponsible trading’ and mismanagement of an insolvent company.
It was created as a statutory offence so creditors could recover money from directors who wilfully traded irresponsibly (and acted without care or consideration for the creditors) and in doing so increased the debts to them.
In short, wrongful trading is where directors continue trading despite being aware that the company is insolvent.
What is the Definition of Trading Insolvently?
The state of insolvency is one in which liabilities outweigh assets or where a company cannot pay debts when they fall due. If company directors continues to trade once this state is reached they are trading insolvently.
Trading whilst insolvent is different from wrongful trading, however, because there is usually a period when the directors realise suddenly that things have reached a tipping point, and they may have traded for some period of time in that same state. Doing so ‘knowingly’ however is the key point of difference.
Once the directors ‘knowingly’ continue trading despite having reached the state of insolvency, then wrongful trading is occurring.
Directors Legal Responsibilities
Company directors have a legal mandate to know what’s happening with their finances at all times, which is a key factor in wrongful trading law.
While many directors claim they ‘simply didn’t know’ what was happening, this is not considered a valid excuse because simply assuming the role of company director comes with the responsibility to understand what this entails.
Wrongful Trading in Company Law
Section 214, Insolvency Act 1986
Wrongful trading or ‘trading irresponsibly’ is a kind of civil wrong covered under Section 214 of the Insolvency Act 1986. For this reason, industry professionals often refer to it simply as ‘Section 214.’
Designed as a counterpart to fraudulent trading, the principle of wrongful trading is that the director of a UK limited company becomes fully aware of their company’s insolvency yet does not act in a way that minimises the loss to company creditors.
Under Section 214, wrongful trading is defined when a director of a company allows the business to trade past the point where they:
- ‘knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation’;
- ‘did not take “every step with a view to minimising the potential loss to the company’s creditors’.
Companies Act 2006, Section 993
Where fraud is concerned, the Companies Act 2006 makes clear that every person ‘knowingly a party to the carrying on of the business in that manner’ can be held accountable. The penalties could be up to 10 years imprisonment and/or a fine.
The full wording is here.
Who Can be Liable for Wrongful Trading?
The wrongful trading laws apply to limited company directors (whose appointment is registered with Companies House) but also to:
- De facto directors – A director who, while not officially appointed, makes the decisions of a director. He/She may be treated by other directors as a director, and may sign company documents
- Shadow Directors – A shadow director is someone who acts in a position of influence behind the scenes as a director, while having another carry out the actions for him. An example of this could be where a director has received a disqualification order but then appoints his partner as director and continues to function in the role.
Is Wrongful Trading a Criminal Offence?
Wrongful trading, which is based on negligence or irresponsibility, is a civil offence. While it is a serious matter and can lead to directorial disqualification, it’s significantly less serious than the knowing attempt to defraud creditors implied by fraudulent trading.
What is Fraudulent Trading?
When a director sets up to deliberately defraud creditors it is known as fraudulent trading. Covered in Section 213 of the Insolvency Act, fraudulent trading is crucially not applicable to merely directors but to “any persons who were knowingly parties to the carrying on of the business”.
Is Fraudulent Trading a Criminal Offence?
It is covered by Section 993 of the Companies Act 2006 which lists fraudulent trading as a criminal offence which could be punished by up to ten years in prison. It also renders guilt parties personally liable for contributions to the company assets.
What’s the Difference between Wrongful and Fraudulent Trading?
A common question we are asked concerns the differences between wrongful and fraudulent trading.
The key point here is intent. Many directors carry on trading while insolvent, for example, simply out of ignorance. So this qualifies as wrongful trading. Fraudulent trading, on the other hand, is where someone has continued to trade knowingly, with the intention of deceiving the creditors.
Both are serious offences, carrying the potential for disqualification of the directors and can may mean that directors could become personally liable for debts.
The judge has wide ranging powers and discretion over what compensation may be repaid to creditors, but of course there are other implications too.
As part of any compulsory or voluntary liquidation any liquidator must report on the director’s conduct by completing an online questionnaire covering various of a director’s actions that have impacted adversely on the company’s insolvent situation. This ‘blameworthy, or dishonest’ activity is reported to the Insolvency Service who may decide to investigate the director further.
Some of the actions taken will involve the liquidator seeking to reverse the offending transaction i.e. seeking repayment of company monies from the recipient. Others involve a contribution from you as a former director to the loss sustained by the limited company arising from that act.
Asset Stripping to Keep Money from Creditors
This will be particularly the case where directorial misfeasance is found. An example of this might be where a director has disposed of an asset at undervalue as a means of trying to keep it from being liquidated and used to repay creditors.
Any wrongful trading that has been identified as ‘blameworthy, or dishonest’ may lead to a director being disqualified for 2-15 years and or fined and in the worst cases imprisonment.
Fraudulent trading penalties can run far higher because the amounts to be repaid do not necessarily stop with the money defrauded, but may include compensation, and a punitive element. There will also be legal costs.
How Long is the Director’s Limitation Period for Wrongful Trading?
Unless another time-frame is specified by the court, the limitation period is automatically set for 6 years, as per the guidelines of the Insolvency Act 1986.
Is There a Test for Wrongful Trading (Section 214)?
There are three distinct parts to be considered when assessing wrongful trading and they are:
- Has the company ended in an insolvent liquidation
- Prior to the start of the company winding up should the director have concluded the company could not have avoided ending in an insolvent liquidation
- Was the individual a director or regarded as a shadow director
A company becomes insolvent when it can no longer pay its bills when due or its liabilities, including contingent liabilities (such as redundancy payments) outweigh its assets.
A clear indicator of a company becoming insolvent is a creditor’s court judgement for a debt such as a County Court Judgement. The county court judgement would be used as evidence the company director should have known the company was insolvent.
Directors Personal Liability
So, if a director is aware the company is insolvent and continues to trade and increases the amount of company debt owed, then the director can be held personally liable for those amounts if the company is insolvent when liquidated.
A perfect example of a situation that both of these terms could refer to would be: Increasing the liabilities of your company or taking out a loan from the company when you know, or ought to have known that the company was going to end up in an insolvent liquidation.
The most common occurrence is increasing the company’s PAYE or VAT tax debts. This alone can lead to an accusation of wrongful trading from a creditor in the hope that money can be recovered from the directors personally. There are cases where directors in the past have been sentenced to terms in prison for buying a company car when the VAT should have been paid instead.
If the company is insolvent, it is a good idea to seek advice from an insolvency practitioner immediately, as they may be able to advise on a potential insolvency solution such as administration, depending on a number of factors surrounding the state of the business.
What are the Directors’ Duties in Insolvency?
Showing preference to one creditor over another is another area of confusion among directors when insolvent.
The reality is that it is not illegal to show preference to one creditor over another on the face of it as most directors have to do this on a day to day basis in the normal course of trading. What offends is where preference has been shown to one creditor over another in an insolvent situation and there is a clear benefit, or incentive, to the director/s whilst doing this.
The most common example is when a director pays off an overdraft or a bank loan where personal guarantees are held. The bank is clearly a creditor and there is a clear benefit and incentive to the director/s. This is a clear demonstration of how showing preference in certain circumstances could cause the director/s to be held personally accountable for the debts and the money would be simply taken back from the bank.
In summary, the directors may be held personally liable if there are insufficient funds to repay creditors when the directors continued to trade and increased the liabilities when they understood, or should have reasonably understood that the company could not avoid an insolvent liquidation.
Directorial Investigations in Insolvent Liquidation
The list provided below is not a definitive list but it is simply provided to show the most commonly reported incidents whilst the company was insolvent that will warrant further investigation by any liquidator:
- A director repaying a director loan made to the company whilst other creditors were not paid;
- Repayment of a loan to a family member;
- A director paying his own salary whilst PAYE/NI for employees was not paid;
- Buying goods on credit when there is no means to pay for them;
- Buying a company car on finance;
- Using customer deposits for cash-flow purposes with no means of supplying goods;
- Repaying bank personal guarantees over other creditors;
- Not keeping proper accounting records;
- Falsification of company records;
- Fraudulent trading;
- Failing to pay HMRC when other creditors are being paid;
- Continuing to trade claiming VAT and either not being registered for VAT, or not paying VAT;
- Any transfer or sale of assets at anything less than a fair and reasonable commercial value.
My company is insolvent and I am worried about bank guarantees. Can’t I just pay them off?
No. When a limited company becomes insolvent a director’s responsibilities are to the creditors interests and this must be demonstrated. All creditors must be treated equally and fairly and without preference on what is called a pari-pasu basis.
Where a director deliberately repays personal guarantees at the bank or another creditor in preference to other creditors then this would be regarded as a preferential payment and likely to be wrongful trading.
The other point to note here is that a director should be putting the creditors at the forefront of each decision not the interests of the director.
Help is at Hand
If you have concerns over wrongful trading and would like to speak with an insolvency practitioner, or need advice on personal matters arising from an insolvent company; you can contact us on 08000 746 757.