Understanding ‘wrongful trading’ and how to reduce your risk

18th May 2023
As the impact of the pandemic recedes, we are advising a significant number of companies who are seeing profitability return but are weighed down by the government-guaranteed loans and arrears to HMRC, which they were advised to take on during the pandemic. The question we are often asked is:

“Am I okay to carry on trading? As I do not want to be personally liable if the company enters insolvency.”

The starting point is that, unless you have given a personal guarantee to a creditor, by trading through a limited liability company, the directors are not liable for the company’s debts in the event of failure, but this can be challenged.

There are two tests of insolvency:

  • Balance sheet: Does the company have more liabilities than assets?
  • The cash flow test: Can the company pay its creditors as and when they fall due?

A company can fail both tests, and its directors are not necessarily guilty of wrongful trading. However, there are big warning signs, and directors should take the appropriate advice from their solicitors or a licensed insolvency practitioner. Taking the advice alone is a tick in the right box.

When does wrongful trading occur?

Wrongful trading occurs when a company’s directors have continued to trade when they should have concluded that insolvent liquidation was inevitable. If the deficit to creditors worsens, then the court may order the directors to contribute to the company’s assets.

Directors can therefore reduce their risk by continually assessing the position – producing forecasts indicating there is a way forward and liquidation is not inevitable. Accordingly, key decisions should be minuted, and the position should be reassessed regularly, as well as on the occurrence of significant events. By taking the appropriate advice, directors can obtain an independent opinion on whether their actions are reasonable, which could be critical in any rebuttal of wrongful trading.

How does this relate to insolvency?

When a company goes into insolvent liquidation, the appointed liquidator has a duty to the company’s creditors to assess the reasonableness of the directors’ actions. If issues are found (and the liquidator may raise them many months after the company has ceased trading), at which point the directors will no longer have access to the company’s records. However, the liquidator will have little knowledge of the company’s affairs prior to liquidation, and so if the directors can provide regular board minutes demonstrating that they were aware of their duties and why it was reasonable to carry on, this is a sound basis for a defence.

If there are no minutes or evidence of such considerations, the courts may conclude that the directors were not acting reasonably. The fact that the evidence exists may well prevent any further action.

The cautionary tale of Ralls Builders

In the case of Ralls Builders Limited, the directors were pursued for wrongful trading. The company suffered a business closure and when reopening suffered further losses until recovering to small profits. Overall, the creditor position had improved, but some individual creditors became worse off. The judge did not make an order for payment against the directors as it was held that it was conceivable that continued trading had not worsened the creditors’ positions. The judge also considered the extent to which the directors had sought professional advice at an early stage, and it was considered reasonable for the directors to rely on the advice sought.

How can we at KRE help?

If you have concerns, we are happy to meet and advise, and that’s generally without obligation or cost. We guide the directors to what they should specifically be considering and how to record their decisions. If a more in-depth review is required, such as reviewing forecasts, then a fixed fee would be agreed. In addition, we will be there to advise as events change, usually without further charge.

If you think that we can help reduce the risk then please contact one of our three licensed insolvency practitioners for an initial, informal conversation.

Paul Ellison              07967 471211 / [email protected]
Robert Keyes           07500 933 022 / [email protected]
David Taylor             07855 231 103 / [email protected]