Suspension of Liability for Wrongful Trading – A Cause for Comfort or Concern?

31 March 2020

Suspension of Liability for Wrongful Trading – A Cause for Comfort or Concern?

The Business Secretary, Alok Sharma, on Saturday 28 March announced a Government proposal to introduce a series of measures to give companies ‘breathing space’ in the current Covid-19 pandemic. The aim is to both allow affected businesses to keep trading whilst they explore options for rescue, and to remove the threat of personal liability of directors if they continue to trade beyond a point where the company cannot avoid an insolvent liquidation or administration.

The measures in the announcement include enabling AGMs to be held flexibly and in compliance with recent guidelines on social distancing (e.g. by telephone with proxy voting or online) and the introduction of legislation proposed in 2018 which will give distressed companies a monitored moratorium whilst seeking investment, rescue or restructure; prohibit certain essential suppliers from enforcing termination clauses or seeking ransom payments; and provide for a new form of restructuring plan to enable companies and creditors to agree a scheme of restructuring.

Of the measures proposed, however, the announcement which has garnered the most attention is the proposal to temporarily suspend the operation of the wrongful trading provisions of the Insolvency Act 1986 (“IA 1986”) with effect from 1 March 2020. Under s.214 IA 1986, a Court may declare that a director of a company is liable to make a contribution to a company’s assets where the company has gone into insolvent liquidation, and at some time prior to the commencement of the winding up, the director knew or ought to have concluded that there was no reasonable prospect of avoiding an insolvent administration or liquidation. However, no order can be made if the Court is satisfied that the director took every step to try to minimise the potential loss to the company’s creditors that he or she ought to have taken.

The intention behind this relaxation of the wrongful trading rules is relatively obvious. The current pandemic has very quickly caused significant trading and, particularly, cash-flow problems for countless businesses, many of which would otherwise have been trading profitably. The speed and effect of the measures imposed to curtail the pandemic, and their unknown duration, means that it would be very difficult in reality for directors to make fully informed decisions about what steps they ought to be taking (or not) to try to sustain their companies, and whether or not there is light at the end of the tunnel. In addition, Government measures recently introduced to provide financial support to companies affected by the pandemic have not had time to work. With the threat of wrongful trading hanging over their heads, many directors would feel they have no choice but to cease trading and place their companies into an insolvency process. The Government has, however, already announced that it would not let sustainable businesses fail as a result of the pandemic, and the suspension of s.214 IA 1986 is clearly designed to give directors reassurance to try to ensure businesses keep running. It is also likely to appeal to voters who are concerned that the effect of the Government’s advice and restrictions might cause unnecessary damage to business.

There are, however, several other points to note about this step:

  1. There will be a debate about whether the suspension is really needed. If a director takes every step they ought to have done to minimise losses, then no liability can arise. One difficulty, of course, is what ‘every step’ means and part of the benefit of the suspension of the wrongful trading provisions is that the answer to this does not have to be found. However, perfection is not required in these circumstances and there is certainly room for argument that in the current circumstances, a Court would be slow to conclude (bearing in mind the joint objective and subjective knowledge tests in s.214(4) IA 1986) either that a director knew or ought to have concluded that an insolvent administration or liquidation was inevitable, or that they failed to take every step to minimise losses that they ought to have done.
  2. Whilst removal of the threat of liability for wrongful trading will protect directors from liability, it does not affect whether the company is insolvent or manages to avoid an insolvency process. If a company does avoid such a process, then s.214 IA 1986 would not have applied to the director in any event. If a company does end up in an insolvent administration or liquidation, then it is perfectly conceivable that this will simply be at a later stage, with greater liabilities, than would otherwise have been the case because the director was prepared to risk continuing to trade for longer.
  3. Although the details of the proposed legislation are not known, it appears the exemption will apply to all companies, and not merely those directly affected by Covid-19. That raises the prospect that the relaxation of the wrongful trading provisions will allow unscrupulous directors of companies which are not affected by the pandemic, or which would inevitably have become insolvent, to avoid personal liability for wrongful trading.
  4. There may well be a risk that with removal of personal liability for wrongful trading, directors are encouraged to think that they can run their companies without regard to their duties or other aspects of company and insolvency legislation. To do so would be a grave error. In particular:
    1. Directors continue to owe their fiduciary and non-fiduciary duties to the company, and, where the company is insolvent or of doubtful solvency, to the company’s creditors. The misfeasance provisions of the IA 1986 will still apply where a company enters liquidation. The issues caused by the current pandemic are likely only to have heightened the risk to the company and its business, which means directors should be more alert than ever to ensure they are acting in the interests of the company or its creditors. Decisions should be carefully justified and recorded, and advice should be taken from professionals where necessary.
    2. Fraudulent trading provisions (s.213 IA 1986) continue to apply.
    3. The provisions of the IA 1986 relating to antecedent transactions will continue to apply. Arguably, the present financial climate means there will be a greater risk of such transactions occurring, and greater examination of them after insolvency. For example, where a company is under financial pressure, and particularly where HMRC has deferred its requirements for payment of tax, there will be an increased temptation on directors to discharged connected debts first and then to trade using cash which would otherwise have been paid over to HMRC for VAT.
    4. Similarly, directors, and particularly director shareholders, may be tempted to continue to pay dividends on the strength of the company’s most recent statutory accounts (for a period prior to the commencement of the current financial crisis). It may be a breach of duty for them to do so, irrespective of whether Part 23 of the Companies Act 2006 is satisfied, where the financial position of the company has changed such as to render it contrary to its (or its creditors’) interests to make the distribution.
    5. Directors’ disqualification provisions continue to apply, and any director who acts in a manner which makes him unfit to be concerned in the management of a company may be subject to disqualification proceedings.
  5. Then there is a risk that this measure will backfire and undermine creditor and supplier confidence. The breathing space afforded by the relaxation will no doubt be abused by a minority of directors but the change in the law could lead to scepticism about the credit-worthiness of perfectly viable companies. This is serious risk in the current climate in which companies are looking at ways to preserve their cash – none more so than the airlines who have been looking for excuses not to refund, or delay refunding, airfares. Law reforms introduced in haste often have unintended consequences.

Thus, although the suspension of liability under s.214 IA 1986 will be welcomed by many directors, and was no doubt a sensible political move, there remain many issues to be navigated in these difficult times. Indeed, now more than ever directors will need to think very carefully the decisions they make to ensure they are acting in the best interests of the company or its creditors. Insolvency practitioners and lawyers advising directors, or who find themselves dealing with the aftermath of an insolvency, will need to be alert to all the points above and no doubt many others.

This article was written by Steven Thompson QC and Hugh Miall.