Wrongful Trading

Reviewed by

Christopher Andersen

Reviewed by Christopher Andersen

Chris is an Insolvency Practitioner regulated by the ICAEW since 2014,. He is experienced in contentious insolvency with excellent analytical skills and strong knowledge of both general and technical insolvency matters.

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25th July 2024

Understanding the concept, consequences, and legal implications of wrongful trading in the UK.

What is Wrongful Trading?

Wrongful trading occurs when directors continue trading after they know or should know; there is no reasonable prospect of avoiding insolvency. This concept is enshrined in UK law under Section 214 of the Insolvency Act 1986^[1]Trusted Source – GOV.UK – Insolvency Act 1986, Section 214.

Under this legislation, when a company becomes insolvent, directors’ primary duty shifts from promoting the success of the company to acting in the best interests of creditors. Continuing business activities without attempting to minimise creditor losses can lead to directors being personally liable to contribute financially to the company’s assets.

Crucially, wrongful trading liability is not contingent upon directors knowingly acting improperly. The landmark case of Re Produce Marketing Consortium Ltd (1989)^[2]Trusted Source – Wikipedia – Re Produce Marketing Consortium Ltd established that directors can be held liable for wrongful trading even if they did not have actual knowledge of the company’s insolvency, provided they ought to have known based on the information available to them.

The key characteristics of wrongful trading are as follows:

1. Directors continue operating the company despite knowing or having reason to believe it is insolvent.
2. Directors must have actual or constructive knowledge of the company’s insolvency. Constructive knowledge arises when directors ought to have known the company’s financial situation, and that insolvency was imminent.
3. Directors fail to take every step to minimise potential losses to creditors. This is judged against the standard of a reasonably diligent person with the general knowledge, skill, and experience that may reasonably be expected of a person in their position, as well as the actual knowledge, skill, and experience of that particular director.
4. There must be a worsening of the company’s financial position as a result of continued trading, typically measured by an increase in net deficiency to creditors.
5. The wrongful trading must occur in the lead-up to formal insolvency proceedings, either insolvent liquidation or insolvent administration.

What are the Consequences of Wrongful Trading?

The consequences of wrongful trading could include:

What Do Liquidators Need to Prove in a Wrongful Trading Claim?

To succeed in a wrongful trading claim, liquidators or administrators must establish three key elements:

(1) The “Tipping Point”

The liquidator must identify the specific moment when the director knew or should have known that the company could not avoid insolvent liquidation or administration. This is known as the “tipping point.”

• This requires a fact-specific analysis of the company’s financial situation and the information available to the directors at the time.
• The court will consider financial data, correspondence, board minutes, and other relevant evidence to determine when this point occurred.
• In Re Ralls Builders Limited (in liquidation) [2016] EWHC 243 (Ch)^[4]Trusted Source – Insolvency Lawyers Association – Re Ralls Builders Limited (in liquidation) [2016] EWHC 243 (Ch) the court held that the directors ought to have concluded six weeks prior to ceasing trading that the company could not have avoided insolvent liquidation.

(2) Director’s Standard of Care

The liquidator must demonstrate that a reasonable director with the same level of skill, knowledge, and experience as the director in question would have recognised that the company was approaching a tipping point.

• This involves a two-fold test, as established in cases like Dorchester Finance Co Ltd v Stebbing [1989]^[5]Trusted Source – Wikipedia – Dorchester Finance Co Ltd v Stebbing [1989]: a) An objective test: What would be expected from a reasonably diligent person carrying out the functions of a director? b) A subjective test: What additional knowledge, skill, and experience did the particular director actually possess?
• For example, a director who is a chartered accountant may be held to a higher standard regarding financial matters than a director without such qualifications.

(3) Financial Loss

The liquidator must prove that the director’s failure to act reasonably at or before the tipping point resulted in financial losses for the company and its creditors.

• This involves demonstrating what steps a reasonable director would have taken to mitigate damages and how those actions would have reduced the overall financial impact.
• The liquidator typically needs to show an increase in the company’s net deficiency between the tipping point and the onset of formal insolvency proceedings.
• In cases like Brooks v Armstrong [2015] EWHC 2289 (Ch)^[6]Trusted Source – Wikipedia – Brooks v Armstrong [2015] EWHC 2289 (Ch), the court emphasised the need for a causal link between the wrongful trading and the loss to creditors.

It’s important to note that the burden of proof lies with the liquidator, and these elements must be established on the balance of probabilities. Directors have a statutory defence if they can show they took every step to minimise potential loss to creditors that they ought to have taken.

Examples of Wrongful Trading

The list provided below is not a definitive list but covers the most common types of director conduct which may amount to wrongful trading and warrant further investigation by the liquidator:

1. A director paying his own salary whilst PAYE/NI for employees is not paid;
2. Buying goods on credit when there is no means to pay for them;
3. Using customer deposits for cash-flow purposes with no means of supplying goods;
4. Repaying personal guarantees in preference to other creditors;
5. Failing to pay HMRC when other creditors are being paid;
6. Continuing to trade claiming VAT and either not being registered for VAT, or not paying VAT;
7. Any transfer or sale of assets at anything less than a fair and reasonable commercial value.

Key Considerations

Here are some crucial points to keep in mind:

1. Shift in Focus to Creditors’ Interests
   • When insolvency becomes a possibility, directors’ primary duty shifts from promoting the company’s success to protecting creditors’ interests.
   • This may require reassessing the viability of continuing to trade.
2. Balancing Act: To Trade or Not to Trade
   • Continuing to trade isn’t always detrimental to creditors. In some cases, it may be beneficial due to:
     • Short-term cash flow issues that can be resolved
     • Expected incoming funding or financing
     • Potential for business turnaround
   • The fact that a decision to continue trading turns out to be wrong doesn’t automatically lead to wrongful trading liability.
3. Decision-Making Process
   • Directors should make decisions that are reasonable and justifiable at the time they are made.
   • This involves:
     • Staying fully informed about the company’s financial situation
     • Seeking and considering professional advice
     • Regularly monitoring and re-evaluating the company’s position
     • Holding frequent board meetings to discuss and assess options
4. Documentation is Crucial
   • Maintain detailed records of all decision-making processes, including:
     • Minutes of board meetings
     • Financial forecasts and their underlying assumptions
     • Professional advice received
     • The rationale behind key decisions
   • This documentation can be vital evidence if directors’ actions are later questioned.
5. Standard of Care
   • Directors are judged not only by their own knowledge and skills but also by an objective standard of what a reasonable person in their position would do.
   • This includes:
     • Having a sufficient understanding of the company’s finances
     • Implementing appropriate financial controls
     • Staying informed about the company’s operations and market conditions
6. Financial Information and Controls
   • Ensure access to up-to-date and accurate financial information.
   • Implement robust financial controls and reporting systems.
   • Regularly review cash flow forecasts and financial projections.
7. Professional Advice
   • Seek advice from insolvency practitioners, accountants, or lawyers when in doubt.
   • Consider the advice carefully, but remember that ultimately, decisions rest with the directors.
8. Continuous Assessment
   • Regularly reassess the company’s position and the appropriateness of continuing to trade.
   • Be prepared to change course if circumstances change or new information comes to light.

FAQs on Wrongful Trading