Author: Nicola Sharp
1 May 2020
3 min read
Nicola Sharp of business crime solicitors Rahman Ravelli explains wrongful trading and the responsibilities placed on directors.
In response to the crisis caused by Covid-19, Business Secretary Alok Sharma announced in March a relaxation of the UK’s insolvency framework. Included in this – along with key payment safeguards for creditors and suppliers - was a temporary suspension of wrongful trading provisions with retrospective effect from 1 March, for an initial period of three months.
This article outlines briefly what the law defines as wrongful trading, how it differs from fraudulent trading and the responsibilities facing directors.
Wrongful trading was introduced into UK law by the Insolvency Act 1986. This makes it an offence for a company director to continue to trade if they know their business is trading while insolvent - that it is unable to pay its debts as they fall due. In wrongful trading, there is no intent to defraud the company’s creditors. It is merely a case of poor judgement or the failure of the directors to carry out their responsibilities.
Fraudulent trading, however, takes place when directors knowingly carry on business affairs with no intention of paying debts. This offence is often more difficult to prove given the burden of proof.
The recent announcement demonstrates the government’s desire to support proper functioning of businesses during this time. When effective, the new legislation will help businesses continue as normal by maintaining employment where possible and providing them with the opportunity to secure emergency loans to see them through the pandemic. The relaxation on wrongful trading rules is designed to reduce directors’ concerns with regard to personal liability. However, the government made it clear that existing laws for fraudulent trading and the threat of director disqualification do remain in force as a deterrent against director misconduct. Directors, therefore, have to ensure they meet their responsibilities.
Notwithstanding the relaxation of the wrongful trading rules, directors must continue to act in accordance with their fiduciary duties and those codified in the Companies Act 2006. Those that do not, expose themselves to the risk of personal liability and criminal sanctions.
When a company is insolvent or at risk of being insolvent, the directors’ duties switch. The requirement is for directors to take decisions for the benefit of the company’s creditors, rather than the shareholders.
Directors, if not properly advised, may expose themselves to the following risks:
Directors should, therefore, consider appointing legal and financial expert advisers to support the company early on, when they believe there may be a risk of insolvency, to ensure contingency plans are in place. Advisers can assist in identifying areas of risk where directors could potentially be in breach of their duties. They can also provide guidance to help directors navigate themselves through circumstances that many may not have previously experienced.
In the current climate, the financial position of the company can change daily. Boards should, therefore, be encouraged to meet as frequently as is reasonable in the circumstances (even daily via video conferencing) to consider whether the company is able to continue to be capable of paying its debts as they fall due. While access to the UK government’s emergency loans may be appealing, directors should be cautious about incurring further indebtedness (including trade credit) and should consider whether their actions are in the best interests of creditors as a whole.
If the company is unable to avoid an insolvency, board minutes will provide evidence to an insolvency practitioner about whether the directors acted appropriately regarding their duties and any actions they took that were supposed to be in the best interests of the company’s creditors. It is, therefore, essential to keep a comprehensive set of minutes for all board meetings.
Directors should try to avoid situations in which they have or may have an interest that may conflict with that of the company. Boards should, therefore, consider the company's corporate governance and ensure there is sufficient independence on the board. Directors who act on the boards of different companies within the group must consider the position of each company independently of the other companies. One company within the group may be insolvent while other companies within that group remain solvent. But directors should still consider whether any actions are in the best interests of each group company (and its creditors) separately.
The board should not enter into any transactions at an undervalue unless the board believes in good faith that the transaction would benefit the company. In such cases, the basis of that belief should be fully documented. The board should also not take any action with the intention of putting a creditor in a preferential position, unless absolutely necessary due to creditor duress. If such a course of action is taken, the reasons behind this should also be fully documented.
The government’s announcement that it is suspending wrongful trading laws will have been welcomed by many company directors. During this period when business is suffering and anxieties are high, it will provide some comfort to those who will be juggling the looming prospect of insolvency of their business with potential criminal sanctions if they get it wrong. However, as outlined above, despite this government support in these challenging times, directors still have to be aware of their duties and what they will be required to adhere to; particularly when the practicalities of the relaxation are not yet fully known.
This article was also featured on Lexology.com.
Nicola is known for her fraud, civil recovery, arbitration and business crime expertise, her experience of leading the largest financial disputes and multinational investigations and her skills in devising preventative measures and conducting internal investigations for corporates.