The English High Court has, in one of the few successful cases on wrongful trading, clarified when directors ought to know that there is no reasonable prospect of avoiding insolvent liquidation and where the burden of proof lies in such cases.
In Brookes v Armstrong (also known as Joint Liquidators of Robin Hood Centre Plc v Armstrong)  EWHC 2289 (Ch), the English High Court considered claims by Joint Liquidators against two directors of the insolvent company under the wrongful trading provision of the Insolvency Act 1986 (section 214). Claims had also been advanced under the breach of duty provisions of section 212.
The company had run a Robin Hood themed tourist attraction but entered liquidation on 6 February 2009. There were various key events in the timeline leading up to formal insolvency relating to the liquidators’ claim: (1) the year-end accounts for 2005 and 2006 showed trading losses, (2) receipt of professional advice in October 2006 in relation to a significant VAT liability, (3) the year-end accounts for January 2007 showing a loss not including the VAT liability or an expected increase in the rent, and (4) a letter from HMRC in May 2007 confirming the VAT liability following review.
The Court had to consider (amongst other things):
- how to assess a director’s knowledge that there was no reasonable prospect of avoiding insolvent liquidation and the relevance of company accounts;
- the burden of proof in respect of a wrongful trading claim; and
- the approach to the exercise of discretion to order the directors to pay compensation.
Director’s knowledge and date of insolvency
The Court concluded that the liquidators had to prove knowledge at some point in time before the start of the winding-up, rather than on a particular date (although the directors had to know the case to be met). Further, directors could legitimately trade at a loss if they anticipated profit to the benefit of existing creditors. Section 214 did not require proof of insolvency at the date of knowledge. Knowledge should also not be approached with hindsight and the fact that a decision proved to be wrong did not necessarily amount to failure to act as a reasonable director.
The Court considered in detail how company accounts should be construed on the basis of the “knowledge test” and the judgment provides useful guidance in this regard.
In the instant case, the Court concluded that on at least one of the dates advanced by the Liquidators in argument (specifically, following the year end accounts for January 2007 and subsequently in May 2007 once the HMRC review letter had been received) that the Directors knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation.
Burden of proof in relation to failure to take “every step”
Once the above had been proved, the Court concluded that, contrary to the previously generally accepted position, it was for the director (and not for the liquidator) to show that he had taken every step to minimise the potential loss to creditors so as to avoid liability under section 214. What “every step” meant would be fact specific.
Directors also had to show that the requirement to take every step to minimise loss to the company’s creditors applied to loss to the entire body of creditors. The directors could not continue to pay trade creditors whilst increasing liabilities to others e.g. in this case increasing the VAT liability and the rental liability to the landlord.
Here, the Court held the directors had not taken “every step” with a view to minimising loss to creditors so the defence was not available. On the question of the contribution to be made by the directors, the Court concluded the sum should be compensatory and not penal. Taking account of the directors’ conduct, the Court applied a deduction of over 50% to the compensatory award, based on the maximum amount the assets were depleted and/or sums due to creditors had increased because of the wrongful trading attributed to the directors (as opposed to loss which was not caused by the actions of the directors).
The Robin Hood case is notable for confirming where the burden of proof lies when a director is seeking to avail himself of the defence to a wrongful trading claim set out in section 214(3) (i.e. that the director took every reasonable step to minimise the potential loss to the company’s creditors). It is also a very useful summary of the Court’s approach to a wrongful trading claim, given the few successful reported decisions in this area and the detailed judgment provided.