Wrongful trading is a civil offence and involves trading irresponsibly. It is pursued by an insolvency practitioner under Section 214 of the Insolvency Act 1986.
It occurs when directors of a company continue to trade when they knew or should have known that insolvent liquidation couldn’t be avoided.
As detailed in the Insolvency Act 1986, they failed to take “every step with a view to minimising the potential loss to the company’s creditors.”
When this occurs, directors can become personally liable where there is sufficient evidence that they intentionally traded the company to the detriment of its creditors. Not just during but prior to terminal insolvency, directors are required to act reasonably and responsibly by putting creditors’ interest first above their own to avoid allegations of wrongful trading.
When a company is insolvent and enters liquidation, the liquidator or licensed insolvency practitioner must investigate the conduct of every director appointed in the three years prior to the liquidation. If substantial evidence of wrongful trading is found, it’s then submitted to the Secretary of State (SoS), which may disqualify the director from holding office again for a maximum of 15 years. Directors can become personally liable for the company’s debts from the point when it became clear that the company was terminally insolvent. In addition to disqualification, they can also face fines or even a custodial sentence.
The following are some warning signs that directors may be wrongfully trading:
- Failure to file annual returns at Companies House
- Failure to file annual or audited accounts at Companies House
- Building up tax arrears by operating VAT, NIC and PAYE schemes badly
- Directors have unjustifiably high salaries that the company cannot afford
- A director loan to the company is repaid whilst other creditors remain unpaid
- Obtaining credit from suppliers, knowing that the company will be unable to honour repayment terms
- Amassing high levels of debt
- Customer deposits are being taken, knowing that the order has no prospect of being fulfilled
- Delivery of stock, materials and goods are being taken, knowing that the company is unable to make payments for them.
When a business is performing well, the first duty of a director is to the company’s shareholders. However, when things start to go awry, this duty moves from the shareholders to protecting the company’s creditors. Contractors directing a limited company that is in trouble must operate the company in the interests of its creditors above all others considerations. If they fail to do this, they risk being held for the company’s losses.
Companies that wrongfully trade continue to carry on their day-to-day operations whilst terminally insolvent, which means that they are unable to pay their debts as they fall due and their debts exceed the value of their assets. Typically, directors hope that things will improve even though they are unable to stop the downward spiral.
Here are some of the tell-tale signs of wrongful trading, and what contractors can do to protect themselves from allegations of wrongful trading.
In defence, directors should do the following:
- Maintain good documentation – once contractors are aware that there is a problem, they should keep a record of major decisions; namely what they are doing and why. This will act as a defence as some of the decisions taken may not be the right ones, but this isn’t important as long as certain principles are followed
- Cease trading – ensure no creditor is worse off because the business has continued beyond tipping point where insolvency was inevitable
- Avoid showing preference – creditors should be treated equally and individual creditors must not be paid ahead of others unless there is a clear justification that this benefits all creditors
- Avoid entering into transactions at undervalue – assets must not be sold too cheaply to raise funds
- Don’t be tempted to abandon ship – directors should take stock, establish their position and determine what they believe to be the best way forward. Resigning is unlikely to be considered “taking every step possible in view of minimising losses to creditors”.
- Take independent professional advice from a licensed insolvency practitioner at the earliest opportunity and then follow it to ensure compliance and minimise the potential damage caused.
This may involve considering the following options:
- HMRC Time to Pay arrangements
- Creditors Voluntary Liquidation
- Company Voluntary Arrangements
If you are a contractor directing a limited company in trouble and are concerned that you may be in breach of the Insolvency Act 1986 in terms of wrongful trading, please call 08000 746 757 or email firstname.lastname@example.org for free and confidential advice from one of our professional advisers.