In simple terms, wrongful trading can be better thought of as ‘irresponsible trading’ and mismanagement of an insolvent company.
Wrongful trading or trading irresponsibly is a kind of civil law (on balance of probabilities) covered under section 214 of the Insolvency Act 1986. It was brought about so creditors could recover at least some contribution from directors; who wilfully traded irresponsibly and acted without care or consideration for the creditors and in doing so increased the debts to them. 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.
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.
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.
What is a Shadow Director?
A shadow director is a term for any individual who may not have a director title, but does have control over the direction of a limited company, in practical terms. For example, where other directors of the same limited company may take instructions or decisions made by the ‘individual’ the individual will be regarded as a shadow director of the limited company.
Keep in mind that shadow directorships will be investigated by any liquidator if brought to their attention.
What are the penalties for Wrongful Trading?
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.
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.
What kind of actions would be investigated 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 but either not 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.
I have concerns about my personal liability prior to liquidation can I discuss these with an insolvency practitioner?
A common and understandable misunderstanding made by directors is to confuse their personal concerns and their fiduciary legal responsibilities as a director when liquidating learn more here at the ICAEW website. For example a director, understandably, may be concerned about the implications of a personal guarantee signed at the bank when the sole focus should be on the company interests. So, where a director has concerns over his/her personal interests they should seek professional specialist advice.
If you have concerns over wrongful trading, or need advice on personal matters arising from an insolvent company you can contact us on 08000 746 757.