A wrongful claim of wrongful trading?

Ss.171-177 Companies Act 2006 set out the statutory duties owed by a director of a company to the company. Certain of these duties become especially significant during the early stages of a company’s insolvency – the so-called ‘twilight zone’, when company directors’ focus is expected to shift away from shareholders to creditors’ interests. Where a director knew, or ought to have known, before the commencement of an insolvency process, that there was no reasonable prospect that the company would avoid going into such process, they could be held liable for wrongful trading under S.214 Insolvency Act 1986. If found liable, company directors can also be required by the Court to make such contribution to the company’s assets as the Court thinks fit, unless it can be shown that the directors made decisions with a view to minimising the potential loss to the company’s creditors.

The recent decision in Ralls Builders Ltd (in liquidation) [2016] EWHC 243 (Ch) has however provided a warning to liquidators and others about being too hasty in making wrongful trading claims against former directors of companies in financial difficulty.

The Ralls case involved a South East building company that went into administration in October 2010 and was subsequently moved into liquidation in January 2011. The liquidators applied to the Court for a declaration of wrongful trading pursuant to S.214 IA 1986 and sought a £1.5m contribution to the company’s assets from three former directors. The liquidators made their application on the basis that the directors knew, or ought to have known, by the end of July 2010, or at the very latest the end of August 2010, that the Company would not avoid insolvent liquidation. They argued that the statutory accounts for the financial year ended 31 October 2009, published in June 2010, clearly showed that the company was significantly balance sheet insolvent, as well as being under considerable pressure from HMRC and trade creditors at this stage. The liquidators also sought to recover, from the directors, their additional costs and expenses incurred as a result of the work done in pursuing the claim.

The directors contended that their decision to continue trading during the summer months of 2010 was made to improve the financial position of the company, thereby increasing assets available for distribution to the creditors.

In February 2016, Judge Snowdon handed down his substantive judgment in relation to the claim for wrongful trading only. He held that, although the directors ought to have known that the Company had no reasonable prospect of avoiding insolvent liquidation by the end of August 2010, it would not be appropriate to order them to pay a contribution to the assets of the Company, since the liquidators had failed to establish that the directors’ decision to continue trading had caused any loss to the company.

This judgment clarified five main points:

1. The Court has a discretion under S.214 IA 1986 to declare that directors of a company in insolvent liquidation are liable to make a contribution to the company’s assets as it sees fit;
2. Directors will not be automatically liable for wrongful trading as a result of the continuation of trade during the twilight zone, even if the company is eventually liquidated; in the Ralls case, the directors’ expectation of improving the position of the company was considered justifiable and likely;
3. A contribution under S.214(1) IA 1986 should be quantified with regard to the loss arising as a result of the continuation of trade – in Ralls, there was no loss;
4. Directors are entitled to have regard to expert advice from insolvency practitioners or others when making decisions concerning the company’s financial position and likelihood of becoming insolvent; in the Ralls case, the expert advice received suggested they were not trading wrongfully; and
5. To successfully rely on the defence in S.214(3) IA 1986, that being that the directors took “every step with a view to minimising the potential loss to the company’s creditors …”, the directors must show an intention to reduce the net deficiency to creditors and to minimise the risk to individual creditors.

The Judge reserved, for further argument, the part of the liquidator’s claim that an order should be made requiring the directors to contribute to the expenses of the administration and liquidation.

The liquidators maintained their argument that wrongful trading had taken place and, accordingly, that this gave the Court the power to order investigation costs, so as to ensure that no loss was caused to the unsecured creditors as a result of the claim. The directors’ counter argument was based on the general principle that litigants cannot claim, by way of damages, the costs they incur in investigating and bringing a claim.

In July 2016, Judge Snowdon held that it was appropriate and correct to apply the general litigation principles on recovery of expenses to a liquidator bringing an unsuccessful claim for wrongful trading. Just as a litigant cannot recover the value of his time by way of damages, similarly, nor can a liquidator: there was no exception to the general rule that expenses of litigation must be recovered through costs orders.  It was further held that the directors’ decision to continue trading did not cause the costs and expenses claimed and that more than a ‘but for’ test of causation is applicable to S.214 IA 1986 claims. It would therefore have been “illogical” to decline to make an order in respect of the wrongful trading claim, but then to order the directors to pay costs and expenses incurred by the liquidators in this respect.

Judge Snowdon’s subsequent judgment clarifies that, even where there is a finding of wrongful trading, it is possible that administrators’ and liquidators’ costs will not be recovered. This situation could negate any benefit of the contribution ordered following a successful claim and so is likely to pose an interesting balancing act for insolvency practitioners and others in future.

For further information regarding this topic, please contact Simeon Gilchrist – Partner, Sophia Mew – Associate, or any member of the Edwin Coe Restructuring & Insolvency team.

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