Note: since this article was written, the Government has temporarily suspended wrongful trading; click here for more details.
The Government this evening announced strict new curbs on the way we live and work in the UK, in an attempt to curb the spread of COVID-19. With all shops other than supermarkets and pharmacies being forced to close and non-essential workers prevented from going into their place of work, the coronavirus is set to hit company cash flows hard. Businesses in vulnerable sectors (such as hospitality) are likely to face significant cash flow pressure. Despite the promises of Government-backed loans and grants, this may mean some companies which were previously financially stable are now rapidly faced with the looming prospect of insolvency.
Once continued solvency of a business looks doubtful, the focus of the duties of directors - which would normally be to promote the success of the company to the shareholders as a whole - changes. Where the company is likely to become insolvent, the prime duty of the directors will be to act in the best interests of the business' creditors as a whole. Breach of this duty to creditors can lead to the directors of the company having to personally contribute to the debts of the business, disqualification as directors and being obliged to pay back any improper transfers of assets.
The crucial question, then, is identifying at what point a company is (or is likely to become) insolvent.
In determining whether or not a business is insolvent, directors should consider two tests:
- the cash flow test (whether a company is unable to pay its debts as they fall due); and
- the balance sheet test (whether a company's liabilities outweigh its assets).
The cash-flow test looks not just at debts which are currently due, but also with debts falling due in the reasonably near future. A company that satisfies either or both the cash flow and balance sheet tests is deemed to be insolvent
Where the directors of a company conclude, or ought to have known, that the company has no reasonable prospect of avoiding insolvent administration or liquidation, but continue to trade, those directors will be at risk of wrongful trading if the company goes into a formal insolvency process. At that point, the relevant insolvency practitioner can require the directors to personally pay a contribution to amounts owed to creditors by the business.
The test for wrongful trading is both objective and subjective. What the director or former director ought to have known is assessed not only by the knowledge and experience of that particular director, but by reference to the knowledge and experience that a reasonably diligent person in her position may reasonably be expected to have. There is no requirement for her to be dishonest.
The only defence to wrongful trading is that the directors took every step that they ought to have taken to minimise losses to creditors. In practice, this can be a difficult assessment for the directors to make. If the company is on the cusp of receiving funding which will provide a lengthy working capital facility, how long can it continue to trade whilst the investment is being negotiated? If the company is in the process of signing a long-term agreement that will provide multiple years of fixed revenue, can it try to conclude that contract no matter what?
Identifying the point when a director ought to know that there is no reasonable prospect of avoiding insolvency can be extremely difficult in practice. Unlike identifying when a company actually is insolvent, there is no prescribed financial metric that determines when there is no longer a reasonable prospect of trading out of the financial position and avoiding insolvency. Directors are entitled to decide that the business should continue to trade whilst loss-making, in anticipation of future revenue. Accordingly, the courts will take into account what options were available to the directors at the time, and the reasonableness of their belief that such options would rescue the business.
Some recent cases provide examples: in the case of Ralls Builders Limited (in liquidation) , the court concluded that the directors ought to have known six weeks prior to ceasing trading that the company could not have avoided insolvent liquidation. It determined that the "taken every step" defence only applies if steps taken were intended to reduce the overall loss to creditors and that risk of loss to "new" creditors was minimised.
In the unreported 2017 case of Nicholson v Fielding, it was held that the "taken every step" defence would not have succeeded, as the evidence suggested that the steps taken to reduce the losses to creditors were at the expense of HMRC.
Practical tips for avoiding personal liability
- Seek professional advice. Legal and financial advice should be sought by directors of companies in financial difficulties to ensure they fully understand their duties to creditors and to protect themselves against wrongful trading claims. This should be independent of the company's advisors.
- Hold regular (minuted) board meetings. Full board meetings of the company in financial difficulties should be held at least weekly, or even daily. The decisions of the directors should be carefully minuted, particularly if the board are not in unanimous agreement about the path to take.
- Understand the supply chain and review supplier contracts. Directors should understand the operation of the business' supply chain and how disruption to one element may have a consequential impact on the remainder. Directors may also want to take professional advice on the trmination or force majeure elements of their suppliers' agreements.
- Ensure compliance with financial covenants. Directors will need to carefully consider any impact on existing finance arrangements, including the ability to meet repayments and to ensure the company will not breach any covenant tests. The board may need to speak to its lenders to restructure payments or flex covenant testing in the short term while alternate sources of funding or other solutions are explored. Directors should also consider whether they need to open any dialogue with their creditors.
- Obtain up-to-date financial information. Directors should seek robust financial information as they will need to be satisfied that it is reasonable for them to rely on the metrics provided.
Directors of companies under financial pressure must look to strike a balance between two courses of action. On the one hand, if they believe that the company cannot be saved and insolvency is the only path, they must initiate the insolvency process as early as possible to protect creditors (and avoid the risk of personal exposure). On the other hand, they must allow sufficient time to explore all options for the company's survival.
Traditionally, the English courts have allowed directors a fair amount of freedom to navigate their way through this difficult balancing act; we would hope that - especially given the speed at which the current situation is changing - the courts allow directors facing financial pressures due to the coronavirus outbreak the same, if not more, latitude to exercise their discretion.