When directors can be personally liable on company insolvency
Two recent cases have clarified when directors can be made personally liable for their company’s debts under ‘wrongful trading’ laws, if it goes into insolvent liquidation.
A director of a company that is wound up because it is insolvent can be made personally liable for such of its debts as the court sees fit, if there has been ‘wrongful trading’.
There has been wrongful trading if, at some time beforehand, a director knew (or ‘ought reasonably to have concluded’) that there was no reasonable prospect of avoiding the insolvent firm winding up, but did not take ‘every step’ to minimise the potential loss to the company’s creditors. In deciding whether a director took every step to minimise the loss to creditors, the court assumes he knew there was no reasonable prospect of the company avoiding the insolvent liquidation, even if in fact he did not.
The aim of the wrongful trading laws is to make directors of companies that are getting into financial trouble, who might otherwise try to trade out of trouble, stop and think carefully about whether they are being over-optimistic about the company’s prospects.
When judging what the director knew or ought to have concluded, and the steps he should have taken, the court asks itself two questions.
- First, it looks at the director’s functions. It asks what a reasonably diligent person with the general knowledge, skill and experience required of someone exercising those functions would have concluded and the steps he would have taken. This is an objective test, under which, say, a finance director will be expected to reach the minimum threshold of competence required of all finance directors.
- Second, it looks at the general knowledge, skill and experience that the director actually has – a subjective test, under which a director with specialist skills or experience is expected to apply them, and is therefore subject to a higher standard than a director without those skills or experience.
In the first case a start-up company was set up in late 2002. By August 2005 the original, substantial, external investment in the company had been used up, the company had lost a major customer and its revenue was insufficient to reduce the overall losses it had built up. It was wound up as insolvent by a creditor in 2007.
The liquidator alleged wrongful trading because, for example:
- There was no evidence that the directors had considered the company’s worsening financial situation and its potential effect on creditors. They ought to have done so and ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation.
- The directors had not economised – they had continued to spend money as they had previously, including paying themselves salaries and expenses. They had not taken ‘every step’ with a view to minimising the loss to creditors.
The court decided they were guilty of wrongful trading, from June 2005.
In the second case, the directors behaved much better. The company started trading in Spring 2004. By December 2005 it was having trouble finding external funding. The directors took advice from a specialist insolvency practitioner and decided to carry on. However, a major supplier withdrew its services in January 2006 and the company was unable to find a replacement. The directors immediately decided to stop trading and the company was put into liquidation by creditors.
The liquidator alleged wrongful trading at four separate times. However, the court said that, even though the company was under-capitalised and always had cashflow problems, the court could understand why the directors had behaved as they did at each of those times. Particularly as their decisions had been objectively justifiable and they had:
- taken creditors’ interests into account in their decision-making.
- made sure they knew the company’s financial position at all times.
- actively tried to find fresh funding.
- monitored and controlled the company’s debts.
- tried to find new business.
- taken specialist advice.
- made their own decision to stop trading.
Directors of companies in financial trouble who wish to avoid allegations of wrongful trading should take the following steps:
- Ensure they always have adequate and timely financial information.
- Be alert to danger signs, such as pressure from creditors.
- Draw conclusions from the circumstances that a reasonably prudent business person would have drawn.
- Hold regular board meetings to discuss/review the company’s situation.
- Ensure they consider the interests of creditors as well as comply with their statutory directors’ duties.
- If there is a prospect of insolvency, do not incur new liabilities as if there was nothing wrong.
- Record conclusions.
- Take specialist, professional advice, consider it carefully and follow it unless there are very good reasons not to.
- Consider stopping trading and starting appropriate insolvency proceedings before creditors do.