Wrongful Trading

Under section 214 of the Insolvency Act 1986, personal liability for wrongful trading may arise for directors of a company which has gone into insolvent Liquidation. Liability for wrongful trading is established if, on an application to court by a Liquidator, it can be shown that at some time before the company went into insolvent Liquidation (note: but not any other insolvency process) the person concerned who was a director at the time knew or ought to have concluded there was no reasonable prospect that the company would avoid insolvent Liquidation. However, such liability can be avoided if it can be shown to the court’s satisfaction that the director thereafter took every step they ought to have taken with a view to minimising the potential loss to the company's creditors.

The directors should never allow a company to accept credit if in their view there is no reasonable expectation of the creditor being paid, since this may render any persons who were knowingly party to a transaction in such circumstances liable to make such contributions to the company’s assets as the court deems proper.

The test applied to a director is that they should have known or concluded facts which ought to have been known or ascertained by a reasonably diligent person having:-

The general knowledge, skill and experience that can be reasonably expected of a person carrying out the functions of a director (i.e. "the reasonable company director"); and the general knowledge, skill and experience that they in fact possess.

The same "knowledge" test applies to the conclusions that the director ought to have reached as to the impending insolvency and, in the context of their defence, the steps they ought to have taken to minimise the loss to creditors.

There is no requirement to prove intent, dishonesty or fraud. The standard of proof is the civil standard of a balance of probabilities only. There is no requirement for positive misconduct; mere inadvertence can give rise to Liability if the Liquidator can show that the director knew or ought to have known of the impending insolvency.

The precise extent of this "duty" is a matter to be tested by the court in each case taking into account both objective and subjective criteria. In the first instance a director is judged by the standards of the "reasonable" director. Thus the mere fact that a director’s own knowledge, skill and experience were inadequate for the role undertaken by them has been held not to be a defence to an allegation of wrongful trading.

However, this line has been moderated by the court’s acceptance that it cannot simply make assumptions based on hindsight and it is clear that the standard of care expected of a director will vary depending on the responsibility of his particular job and upon the size and complexity of the company and its business: for example, the courts will often impose a higher standard of care upon a finance director than upon a non-executive or part-time director.

Preferences and Transactions at an Undervalue

Under sections 238 and 239 of the Insolvency Act 1986, an Administrator or Liquidator of a company may apply to the court to set aside or vary transactions at an undervalue and preferences entered into within a specified period before the commencement of the insolvency proceeding. In setting a transaction aside under either section 238 or 239 the court will make such order as it deems fit for restoring the position to what it would have been had the company not entered into the transaction. This may result in personal liability on the part of the directors of the company by way of contribution.

Transactions at an undervalue and preferences cannot be set aside unless the company was insolvent at the relevant time or became insolvent as a result of the transaction. In formulating a strategy to avoid an insolvency proceeding, the directors need to be aware of these provisions since, if transactions are set aside as being either at an undervalue or preferences, there is a risk that the court may make a disqualification order against any director responsible for the transaction concerned in addition to the risk of personal liability already mentioned.

Phoenixism and the Restriction on Re-Use of Company Names

Few things in our professional life are as emotive as the selling of an insolvent company’s business and assets back to the very people that are perceived as having orchestrated its insolvency – its directors.

There is a fine, often blurred line between directors as special purchasers and phoenixism and if we might be indulged in attempting to distinguish between the two, it might be helpful to what follows.

Directors do have emotional attachments to their businesses, staff, customers, advisers and even suppliers – not all directors of course, but a healthy majority. They often take the failure of the business of which they are custodians very personally, to the detriment of health and relationships in some cases. They are not all crooks, a blindingly obvious statement to make but one which puts their acquisition of their company’s business and assets very much into context.

Phoenixism on the other hand involves the deliberate, pre-determined folding of a company, generally to avoid liabilities, especially guarantees.

It is also relevant to remember that the prime purpose of the insolvency practitioner in any appointment is to maximise the return to creditors. If that can be achieved by way of a sale to a director who is happy to pay the best price for the assets as he wishes to see the creditors receive as much of their indebtedness as possible, how can we as insolvency practitioners refuse?

So a sale of an insolvent company’s assets back to its directors is something which may directly benefit creditors.

However, directors intending to use a similar name or trading style for newco should bear in mind Section 216 of the Insolvency Act 1986.

This states that if a company is placed into insolvent Liquidation (ie Compulsory or Creditors’ Voluntary Liquidation), directors or shadow directors in the preceding twelve months are prohibited from being directors or shadow directors of a company with a name by which the liquidating company was known by in that period of twelve months or a name which is so similar as to suggest an association.

So if John Smith Limited is placed into Liquidation, a director of that company cannot simply become a director of John Smith (Newco) Limited.

Trading styles are caught by the phrase "a name by which the liquidating company was known".

Please also note that as an Administrator cannot declare and pay a dividend to unsecured creditors, the most common mechanism to allow him to do so (which is often approved by creditors in the Administrator’s proposal) is Liquidation, thereby triggering section 216.

Without the leave of the court or "in such circumstances as may be prescribed" (for which read on), a director cannot for five years beginning with the date of Liquidation:

• Be a director of a company with a prohibited name.
• In any way, directly or indirectly, be involved in or take part in the promotion, formation or management of such a company.
• In any way, directly or indirectly, be concerned or take part in the carrying on of a business carried on (other than by a company) under a prohibited name.

The penalty for acting in contravention of the above is imprisonment, a fine or both.

In addition, pursuant to section 217, a person is personally responsible for all debts of a company if at any time:

• They are involved in the management of a company in contravention of section 216, or
• They are involved in the management of a company and willingly act on the instructions of a person who they know to be in contravention in relation to that company by section 216.

The exceptions to this are set out in Rules 4.226 – 4.230 of The Insolvency Rules 1986:

• Where the whole, or substantially the whole, of the business of the insolvent company are acquired by a successor company and the director gives notice to the insolvent company’s creditors and advertises in the London Gazette*.
• For an interim period (not exceeding six weeks) where an application is made to court within seven days from the date of Liquidation (for the purposes of 4 below).
• Where the successor company has been known by the name in question for at least the twelve months prior to the Liquidation and has not been dormant in that time.
• At the discretion of the court.

* The notice (form 4.73) must state the name of the person who it is intended will act in respect of the new company as well as the prohibited name. The prohibited name cannot be used until the notice has been given and published.

Directors have a fiduciary duty to ensure that any loss to creditors is minimised and should only therefore acquire the assets of their insolvent company only when the market has been properly tested for offers, either by them or the instructed insolvency practitioner or both. Transparency is vital and if claims of foul play are to be averted, being able to provide tangible evidence of such transparency helps everybody sleep well at night.

Paying Dividends

Picture the scene – a small (or even not so small) business, variable profitability, PAYE is a cash flow issue so the directors are advised to draw a set sum each month which will be taken care of by way of a dividend once the annual accounts have been prepared.

The rules governing payment of dividends can be found in the company’s memorandum and articles of association, in the Companies Act 1985, in the Insolvency Act 1986 and under common law.

Memorandum and Articles of Association

The power to declare dividends generally lies with the members at a General Meeting. Such a resolution requires a simple majority of votes and the payment in question cannot exceed the amount recommended for payment by the directors.

Generally directors are authorised to pay interim dividends with the approval of a board resolution in anticipation of shareholder consent in a General Meeting.

Companies Act 1985 ("CA85")

Subject to any restrictions in the company’s memorandum and articles, the payment of dividends is governed by section 263 CA85. This provides that a company may only make distributions out of accumulated, realised profit (to the extent not previously distributed or capitalised) less accumulated realised losses (to the extent not written off).

Section 277 CA85 provides that where a shareholder knows, or has reasonable grounds for believing, that at the time the distribution was made it failed to pass the section 263 test, that shareholder is liable to repay the dividend (or the offending part of it).

Insolvency Act 1986 ("IA86")

The directors or shareholders could be required to repay the amount of the dividend pursuant to section 238 IA86 if at the time of the payment:

• The company was insolvent.
• The directors had no reasonable grounds for believing the dividend payment would benefit the company.

Only a Liquidator or Administrator can bring an action under section 238 IA86.

Common Law

The fiduciary duties imposed on directors under common law provide that they must act at all times in the best interests of the company. Furthermore, that they will hold all the assets of the company on trust for the benefit of its members. Directors are in breach of these duties in the event that they make a payment without regard to the future cash requirements or future solvency of the company and can be ordered to repay the amounts distributed.

In Summary

Drawing dividends is all well and good only if the company does not thereafter enter into an insolvency process as this triggers a number of possible remedies against the director/shareholder who may only have been acting in good faith.