Directors' personal liability for losses when company continues trading wrongfully

Re Ralls Builders Limited (in liquidation) [2016] EWHC 243 (Ch)

Recently, the English High Court found that although the directors of a company which had entered administration had continued trading wrongfully, their actions did not increase the net deficiency of the Company. As a result the directors would not be personally liable to contribute to the Company’s assets for distribution to creditors.

Insolvency Liquidation Directors Personal Liability Court Law Scotland

Background

Ralls Builders Limited (“the Company”) operated in the construction industry for some 119 years and had been profitable until October 2008. The following year to October 2009 saw the Company make a trading loss due to disrupted trading in the winter months and a claim brought against them due to defective works of a sub-contractor. Despite seeking external funding and advice from solicitors and a specialised insolvency and restructuring firm, the Company entered administration in October 2010 and liquidation in January 2011.

The joint liquidators brought an action against the Company, claiming that the Company had continued to trade wrongfully before entering administration - they believed trading should have ceased in July or August 2010. The joint liquidators sought a declaration that the Directors should contribute personally to the losses incurred in the period after they should have realised the Company was doomed to insolvent liquidation, and the costs and expenses incurred in the administration and liquidation.

The arguments

The joint liquidators argued that the Directors should have foreseen the insolvency of the Company by July or August 2010. They should not have continued trading and incurring further and new creditors, despite the Company having paid back some existing creditors. The Directors should pay some contribution to the loss made in the period from July/August 2010 to October 2010 when the Company entered administration.

The Directors argued that they did not know insolvency was inevitable. They had been in continued negotiations with an external investor and their professional advice did not suggest a real prospect of insolvency. In any event, continuing to trade was, in terms of section 214(3) of the Insolvency Act 1986 (“the 1986 Act”), taking steps to minimise loss to creditors and improve business prospects. Since their continued trading did not increase the net deficiency in the Company (in fact slightly improving the Company’s position) and the cost and expense of administration and liquidation would have been incurred anyway, there should be no contribution ordered.

Decision of the court

Snowden J held that the test under section 214(2) of the 1986 Act was not whether the Company was insolvent, but rather whether the Directors knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation. Through July 2010 the prospect of increased work and potential investment was reasonable but this was not the case by August 2010 at which point the court considered insolvent liquidation would have been inevitable. Until this point the Directors had been advised by expert insolvency practitioners that they were not trading wrongfully and did not doubt the prospect of investment.

The defence under s214(3) of the 1986 Act is that the directors take "every step to minimise loss" which is an intentionally high hurdle whereby the directors must 'demonstrate not only that continued trading was intended to reduce net deficiency of the company, but also that it was designed appropriately so as to minimise the risk of loss to individual creditors' according to Snowden J. It was found that the Directors had not taken every step to minimise loss to creditors since the Directors had incurred new creditors in order to pay off some of the debt owed to the bank and existing creditors. However, Snowden J pointed out the possible shortcoming in s214 of the 1986 Act that liability only arises when the creditors as a whole have suffered and this does not take account of individual creditors.

In considering the quantum of any contribution due by the Directors it was necessary to decide whether there had been an “increase or reduction in the net deficiency of the company” during the period in which they traded wrongfully. Moreover any wrongful trading must have led to the increased deficiency. In this case Snowden J looked at the financial position of the Company over various dates and held that the continued (wrongful) trading had actually led to “a modest improvement in the net deficiency of the company”. Furthermore, since the cost and expense incurred by the administration and liquidation were not caused by the wrongful trading, these could not be recovered.

The court held that the Directors had continued trading wrongfully but since there was no deterioration in the Company’s financial position they would not require to contribute personally to the Company’s assets. Thus, despite wrongfully trading, there was no contribution required of the directors.

Points to note

Directors should be aware of the financial position of their Company and be reactive to changes. Where they know, or ought to have known, that insolvent liquidation is inevitable they must act to move towards insolvency procedures and minimise the risk of being held personally liable. Any professional advice sought and received by the Directors will be important in analysing the decisions made by the Directors.

Section 214(3) sets a high standard for Directors to show that they have taken “every step” to minimise the loss to individual creditors, new and old. The court will analyse company finances to conclude how the actions of the company affected the position of creditors. If the position is worsened it will be difficult to prove that “every step” was taken to minimise risk to creditors. The liquidator must show that the loss was caused by the Directors’ conduct.

Considerations

  1. It may not be appropriate to make an order against the Directors where wrongful trading does not cause the company’s debts to increase;
  2. The court will consider the professional advice received by the Directors in the period leading up to liquidation; and
  3. Directors will not necessarily be held liable where trade was continued during a time where it was expected to be more profitable and fulfilled existing contracts.

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The small print: This blog is for information purposes only and should not be construed in any way as providing legal advice.