Wrongful Trading Insolvency Act

What is Wrongful Trading (Insolvency Act 1986)?

Wrongful trading is a concept under Section 214 of the Insolvency Act 1986. Wrongful trading occurs when the directors of a company continue to trade when they knew, or ought to have known, that there was no reasonable prospect of avoiding insolvent liquidation.

Under Section 214 of the Insolvency Act 1986:

(2) This subsection applies in relation to a person if—

(a) the company has gone into insolvent liquidation,

(b) at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation [or entering insolvent administration], and

(c) that person was a director of the company at that time;

The purpose of wrongful trading provisions is to discourage directors from carrying on a business when it is clear that the company cannot avoid going into insolvency. The aim is for the company to minimise losses to creditors in an insolvent administration.

If a director is found to have engaged in wrongful trading, they may be held personally liable for the company’s debts and may face other sanctions.

It’s important to note that wrongful trading is distinct from fraudulent trading, where there is evidence of dishonesty or intent to defraud creditors.

Wrongful trading is more concerned with the director’s awareness of the company’s financial situation and whether they took appropriate action in response to that knowledge.

Steps to Avoid Wrongful Trading

Directors must take steps with a view to minimising the potential loss to the company’s creditors. Outlined below are steps that a company could take to avoid wrongful trading:

Regular Financial Monitoring:

Directors should regularly review the company’s financial statements, cash flow, and other key indicators to stay informed about its financial health.

Seek Professional Advice:

Directors should seek advice from qualified professionals, such as insolvency practitioners, to assess the company’s financial viability and explore restructuring options.

Develop a Contingency Plan:

Having a contingency plan in place allows directors to respond promptly to financial difficulties, considering alternative funding, negotiations with creditors, or restructuring.

Document Decisions:

Directors should document their decision-making processes, demonstrating that decisions were made with due care and diligence.

Hold Regular Board Meetings:

Regular board meetings facilitate discussions on financial matters and enable informed decision-making.

Implement Cost Controls:

Directors should implement cost controls to manage expenses effectively and preserve the company’s financial resources.

Stay Informed about the Business Environment:

Directors need to stay up to date on industry trends and market conditions. They should adapt to changes that may impact the company’s financial stability.

The key to avoiding wrongful trading (Insolvency Act) lies in acting responsibly. Directors must use knowledge, skill, and experience, and make decisions that prioritise the long-term viability of the business.

Directors’ Obligations to Creditors

Directors have several obligations to creditors. These obligations are primarily aimed at ensuring fairness and transparency in the treatment of creditors, especially when a company is facing financial difficulties. The duties of directors to creditors include:

Fiduciary Duty:

Directors owe a fiduciary duty to act in the best interests of the company. Whilst this duty is owed to the company itself, it indirectly benefits creditors by preserving the company’s value.

Duty to Avoid Wrongful Trading:

Directors must not allow the company to trade whilst insolvent. They should not continue to trade if there is no reasonable prospect of avoiding insolvent liquidation.

Duty to Exercise Care, Skill, and Diligence:

Directors are required to exercise reasonable care, skill, and diligence in managing the company’s affairs. This includes making informed decisions about the company’s financial position to avoid actions that could harm creditors.

Duty to Preserve Company Assets:

Directors must take steps to preserve the company’s assets for the benefit of all stakeholders, including creditors. Diligent asset management helps maximise the resources available to satisfy creditor claims.

Duty to Keep Proper Books and Records:

Directors are obligated to maintain accurate and up-to-date accounting records. Proper financial records are crucial for assessing the company’s financial health and ensuring fair treatment of creditors in case of insolvency.

Duty to Consider the Interests of Creditors in Insolvency:

In times of financial distress, directors should consider the interests of creditors as a whole. This may involve seeking professional advice, engaging in negotiations with creditors, and exploring restructuring options.

Duty to Communicate:

Directors should maintain open communication with creditors, keeping them informed about the company’s financial situation. Transparent communication fosters trust and may lead to negotiated solutions.

Duty to Cease Trading:

When it becomes clear that the company cannot avoid insolvency, directors should consider whether it is in the best interests of creditors to cease trading and commence insolvency proceedings.

Personal Liability and Company Assets

Section 214 of the Insolvency Act 1986 grants the court power to make an order for a person to contribute to the company’s assets as the court thinks proper. This means that directors may face personal liability, contributing to the company’s debts out of their own assets.

It’s important to note that not only formal directors, but also shadow directors (those whose instructions the formal directors are accustomed to follow), may be held liable for wrongful trading. This extends the scope of personal liability to those who exert significant influence over the company’s decision-making.

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