Directors can be held liable to contribute to company assets if they knew or ought to have known at a point before the commencement of administration or insolvency that there was no reasonable prospect that the company would avoid this process. This is known as wrongful trading (section 214 of the Insolvency Act).
The liquidators of Ralls Builders Ltd (Ralls) brought a claim against its former directors for wrongful trading on the basis that the directors should have known by a certain date that the company was doomed to insolvent liquidation. The court agreed but the directors were not required to contribute to company assets because their trading had not caused any deterioration in the financial position of the company.
Ralls, a company in the construction industry, was profitable until October 2008. In October 2009, the company made a trading loss, in October 2010 it entered administration and then went into liquidation in January 2011.
Given that Ralls had continued to trade until October 2010, the liquidators sought a declaration from the court under Section 214 of the Insolvency Act 1986 – namely that the former directors should be personally liable to contribute to the company in respect of its losses, as a consequence of trading after the point when there was no reasonable prospect of the company avoiding insolvent liquidation i.e. after July 2010. The liquidators argued that the directors caused Ralls to continue to trade wrongfully and incur credit with unsecured trade creditors until it was finally placed into administration.
The directors argued that from July 2010 they were taking steps which had a reasonable prospect of rescuing Ralls, including trying to secure an injection of cash from a third party. The directors also relied on advice they had received from an insolvency practitioner, who had assured them that it was reasonable for Ralls to continue to trade.
The legal test
In order to make a declaration under section 214, the court has to apply a two-stage test: (i) the objective test: what facts ought the director to have known, what conclusions should they have reached and what steps should they have taken; and (ii) the subjective test: what knowledge, skill and experience did the director actually possess. If the court is then satisfied that the director should have concluded that there was no reasonable prospect that the company would avoid going into liquidation, a director may defend this finding on the basis of section 214(3), that he took every step he ought to have taken in that period "with a view to minimising the potential loss to the company's creditors".
It was accepted by all parties that by 31 July 2010, Ralls was insolvent on both a cash-flow and balance sheet basis. However, the court considered the potential investment into the company and the professional advice which the directors received assuring them that they were not trading wrongfully. Based on these two factors, the court found in favour of the directors.
Nevertheless, the court held that by the end of August 2010, when the promised investment had failed to materialise, the directors should have concluded that there was no reasonable prospect of avoiding insolvent liquidation. Hence the court found that the directors had been wrongfully trading under section 214 between August and October 2010.
The court then went on to analyse the impact on the company during this period of wrongful trading. While the overall position of the creditors as a whole was not worsened, the court noted that the creditors had largely changed from secured to unsecured, and so section 214(3) was not satisfied. Fortunately for the directors, however, as the company's net position was improved by its continued trading, albeit modestly, they were not ordered to make a contribution.
While the directors escaped making any contribution to Ralls, the court did find against them on the allegation of wrongful trading. It is therefore worth remembering that while directors can rely on professional advice, this in itself will not be a complete defence to such allegations. Further, the court's analysis of the directors' defence under section 214(3) shows that it will not be enough for directors to show that continued trading was intended to reduce the net deficiency of the company overall; they will also have to show that they sought to minimise the risk of loss to individual creditors as well.