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Why wrongful trading poses an “out of the frying pan” risk for UK directors

The pandemic has presented considerable cash, financial and operational pressures for directors of UK businesses.

Unlike previous recessions there have been a significant number of government support measures available, such as bounce back loans and the Coronavirus Large Business Interruption Loan Scheme, moratoria on the issuing of winding up orders and suspension of wrongful trading liabilities.

Such measures, intended to ensure directors of otherwise viable businesses were given a lifeline to continue trading, have been successful. But they are starting to taper off, including the reintroduction from 1 July 2021 of the financial penalties directors will face if convicted of wrongful trading.

What is wrongful trading?

Wrongful trading is a right of action given to administrators and liquidators under Section 214 of the Insolvency Act 1986 to sue directors where those directors continue to trade and incur credit in circumstances where they ought to have concluded there was no reasonable prospect of avoiding insolvent liquidation.

Where successful, directors will have to make a personal financial contribution assessed against the incremental loss the court considers has been suffered by creditors.

A director will not be required to make a contribution if they can demonstrate they took every step with a view to minimising the potential loss to creditors.

Why is this now relevant?

As part of the government COVID-19 protection measures announced in April 2020 the financial liability for wrongful trading was suspended for the period from 1 March 2020.

While the obligation on directors to consider their wrongful trading position remained, as there was no financial penalty in the event they transgressed, the practical reality was that the entire provision could be dismissed. However, the financial penalties have been reintroduced adding bite to pre-existing obligations.

What should directors do?

The legislation is designed to deal with instances where directors are behaving in an irresponsible manner towards creditors. The key action directors should take is to ensure they are behaving responsibly. Some measures often cited by directors seeking to argue their behaviour has been responsible include:

  1. Preparing short term cash flow projections to assess the expected financial position and the extent to which creditors’ positions are being made worse by the decision to continue trading;
  2. Preparing longer term forecasts to show the business is viable; this is especially important given the changes COVID-19 is will have brought to many parts of the economy;
  3. Having regular board meetings where the financial position of the company is discussed and minuted;
  4. Engaging with shareholders, lenders and other providers of finance to ensure appropriate facilities are available to enable the company to continue to trade;
  5. Engaging with restructuring and legal advisers to provide support navigating the challenges as each situation is often unique.

Are there other risks?

In every insolvency, director conduct will be subject to a review by the Insolvency Practitioner to consider whether there are grounds for disqualification. As part of the disqualification review process The Insolvency Service has the powers under Section 15A of the Company Directors Disqualification Act 1986 (CDDA 1986) to apply to the court for a compensation order on behalf of the Secretary of State for Business, Energy & Industrial Strategy. The court can make a compensation order if the director is subject to a disqualification order or undertaking and their conduct has caused a quantifiable loss to one or more creditors of an insolvent company.

The Insolvency Service is unlikely to seek a compensation order if:

  • an insolvency practitioner has taken or is going to take civil recovery action against the director eg for wrongful trading;
  • the director has already made a contribution to the assets of the company.

Conclusion

Historically, more companies fail as economies emerge from recession particularly as working capital requirements put added pressure on already strained balance sheets. The subject of wrongful trading arises in almost all cases considering directors' duties and responsibilities before an actual insolvency appointment.

There is a real threat that having worked tirelessly to make ends meet during the pandemic, directors of companies that fail, who have not engaged advisers to help them navigate the myriad of challenges, will find themselves disqualified and on the receiving end of wrongful trading financial compensatory orders - a case of jumping out of the COVID-19 frying pan and into the wrongful trading fire.

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David Kelly

David Kelly

Markets and Services Lead, Business Restructuring Services, PwC United Kingdom

Tel: +44 (0)7974 332659

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