Generally, directors are focused on making a success of the business to which they are appointed and the prospect of insolvency and the potential for personal liability often seems remote. Indeed, many directors will never have to face the difficult decisions associated with a struggling business. However, when they do, they often rely on the advice of experienced insolvency professionals.
The High Court of Justice, Chancery Division recently reconsidered the law on wrongful trading, personal liability and the defences available to directors. In In the matter of Ralls Builders Limited Mr Justice Snowden reviewed the law of wrongful trading and provided helpful guidance on a number of issues. This included clarifying:
- the reliance that directors may place on advice from insolvency professionals;
- what directors ought to be mindful of when considering the likelihood of new investment; and
- the circumstances in which directors should be ordered to make a contribution to the company's assets.
Wrongful trading – the law
Section 214(1) of the Insolvency Act 1986 gives the court discretionary jurisdiction to declare that a director of a company in insolvent liquidation is "liable to make such contribution (if any) to company's assets as the court thinks proper". That power may be exercised where the court is satisfied that "at some time before the commencement of the winding up of the company, that person [the director] knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation".
Upon Section 214(1) of the act coming into play, the court must then also consider the limitation set out in Section 214(3) of the act. This provides that the court should not order a contribution if it is satisfied that, after the relevant time, there was no reasonable prospect of avoiding insolvent liquidation and the director:
"took every step with a view to minimising the potential loss to the company's creditors as (assuming him to have known that there was no reasonable prospect that the company would avoid going into liquidation) he ought to have taken."
In deciding what conclusion a director ought to have reached in regards to the prospects for the company, the courts have been prepared to place some weight on evidence that the directors took professional advice and, if so, what that advice was.
The fact a company is insolvent(1) – on either a balance-sheet or cash-flow basis – and carries on trading does not mean that a director will be liable for wrongful trading, even if the director possesses full knowledge of this fact and even if the company ultimately fails. Many businesses show a balance-sheet deficit from time to time and trading businesses often suffer cash-flow insolvency.
While the question of whether a director knew that there was no reasonable prospect of the company avoiding insolvent liquidation is one of subjective fact, what the director ought to have concluded is objective. Section 214(4) of the act provides a two-stage test, which addresses:
- the facts which the director ought to have known, the conclusions which the director ought to have reached, and the steps which the director ought to have taken (which would have been known, reached and taken by a reasonably diligent person having the general knowledge, skill and experience that may be reasonably expected of a person carrying out the same functions as those of the director); and
- the general knowledge, skill and experience which that director actually possesses.
The question of solvency (or lack thereof) is fluid and does not depend on a snapshot of a company's financial position at any given time. Instead, solvency depends on the rational expectations of what the future may hold.(2) The court does not approach the question of whether a director ought to have concluded that his or her company had no reasonable prospect of avoiding an insolvent liquidation with the benefit of 20:20 hindsight.
The case considered(3) an application by the joint liquidators of Ralls Builders for a declaration pursuant to Section 214 of the act. It was stated that between July 31 2010 and August 31 2010 the directors of Ralls Builders knew or ought to have concluded that there was no reasonable prospect that the company would avoid entering into insolvent liquidation. The liquidators contended that instead of ceasing to trade immediately, the directors caused the company to continue to trade wrongfully and incur further credit with unsecured trade creditors until it was eventually placed into administration on October 13 2010.
The directors denied that, at any time until they made a decision to put the company into administration in late September 2010, they either knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation. The directors stated that throughout the relevant period (from the end of July 2010) they were taking steps which had a reasonable prospect of rescuing the company and avoiding insolvent liquidation. These steps included the injection of funds from an ostensibly wealthy third party which would have rebalanced the balance sheet and enabled the company to pay pressing creditors. The directors also sought to rely on the defence that they had received an assurance from an insolvency practitioner that it was reasonable for them to continue to trade or, at least, they were never told it was inappropriate for them to do so.
Ultimately, the proposed third-party injection failed to materialise and a key question considered by the court was whether, and if so when, the directors ought to have concluded that there was no reasonable prospect of completing that deal.
While the court considered that the directors could be criticised for how they had conducted the business of the company during the relevant period, it was entirely plausible that such continued activity did not cause loss to the company overall or worsen the position of its creditors as a whole. Accordingly, the court refused to make a declaration under Section 214(1) of the act requiring the directors to make a contribution to the company's assets.
It was not disputed that by July 31 2010, Ralls was insolvent on both a balance-sheet and cash-flow basis, and had been for some time. It was also clear that the directors were well aware of the scale of the company's insolvency. However, the fact that Ralls was, and was known to be, insolvent by that stage did not mean that insolvent liquidation was unavoidable. The real issue for consideration, at least under Section 214(1) of the act, was the directors' treatment of the potential investment.
Considering the investment required an assessment of what a reasonably diligent person with the same general knowledge, skill and experience of the directors would have concluded. When assessing what conclusions a director ought to have reached as regards the prospects for the company, the court placed weight on the advice given by appropriate professionals. The directors both sought and received expert advice, with the response being that they were not trading wrongfully. In light of this, the court did not have a sufficient basis to conclude otherwise. As a result of the professional advice, the court decided in favour of the directors as regards the allegation of wrongful trading from July 31 2010; it did not deal with the alternative date of August 31 2010.
The court found that by the end of August 2010, there was no longer a rational basis on which it could be expected that the potential investor would provide the money urgently needed by the company. A realistic assessment by the end of August 2010 should have led the directors to conclude that the potential investor could not be relied upon. At that point there was no reasonable prospect of the company avoiding insolvent liquidation.
Contribution and loss
As set out above, the power of the court to order a director to make a contribution pursuant to Section 214 of the act is discretionary and is to be exercised only where the court is satisfied that the director, at some time before the commencement of winding up, knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation (an exception exists under Section 214(3) of the act for taking every step to minimise the potential loss to the company's creditors that he ought to have taken).
The court's finding that the directors had not taken every reasonable step did not necessarily result in the directors being required to make a contribution to the company's assets. Instead, the court held that the correct approach to determining whether the directors should be required to make a contribution under Section 214(1) of the act was to ascertain whether the company had suffered a loss which was caused by it continuing to trade after August 31 2010 until it went into administration in October 2010. The court considered that, as a starting point, this calculation should be approached by asking whether there had been an increase or decrease in the company's net deficiency as regards creditors between the two dates.
It was held that, due to the directors' failure to take steps that they ought to have taken to protect the interests of new creditors, Section 214(3) of the act could not be relied on. Despite the overall loss not being materially different, the matrix of creditors was in effect altered from being secured to unsecured.
That said, the court held it was entirely plausible that the continued activity did not cause loss to the company overall or worsen the position of its creditors as a whole. Therefore, an order for a contribution to the company's assets was not justified.
Many will view the Ralls decision as sensible - particularly in regard to the finding supporting the entitlement of directors to rely, to a certain extent, on professional advice. However, it does provide some caution that such advice will not be a complete defence to action and directors' reliance on that advice needs to be reasonable in the circumstances. The general advice to directors will remain the same: if in doubt, seek professional help.
However, the court did provide some guidance on the interpretation of the exemption set out in Section 214(3) of the act. Directors should exercise some caution when considering whether they have in fact reached what the court described as a "high hurdle". Every step will be construed strictly and a director seeking to rely on this defence will need to demonstrate that the course of action pursued not only intended to reduce the net deficiency of the company, but also it was designed appropriately so as to minimise the risk of loss to individual creditors.
For further information on this topic please contact Louise Verrill, Joe Speakman or Mark Beardsworth at Brown Rudnick LLP by telephone (+44 20 7851 6000) or email (email@example.com, firstname.lastname@example.org or email@example.com). The Brown Rudnick LLP website can be accessed at www.brownrudnick.com.
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