High Court: up to directors to prove they took 'every step' to minimise potential loss to creditors

Out-Law News | 07 Aug 2015 | 5:11 pm | 4 min. read

It is up to the directors of an insolvent company to prove that they took "every step" to minimise the potential loss to creditors as soon as they knew that the company could not reasonably avoid liquidation, the High Court has confirmed.

Mr Registrar Jones had been asked to rule on the correct construction of a UK insolvency law provision governing the circumstances in which a director could be ordered to make a contribution towards an insolvent company's assets (67-page / 510KB PDF). The leading insolvency law textbook, Sealy & Milman's 'Annotated Guide to the Insolvency Legislation', argues that it is up to the liquidator to prove that the director failed to take every step he ought to have taken.

The judge said that Sealy & Milman's interpretation of the provision was "not the natural construction of the words used and it does not make sense to require the [liquidator] to prove the director took 'every step'".

"Second, if parliament has intended the burden of proof to be upon the [liquidator], it would have expressly provided that a declaration would not be made unless (or only if) the [liquidator] satisfied the court that 'every step' etcetera had not been taken. Third, it is more logical to place such a burden upon the [directors] in circumstances where they have been trading knowing there was no reasonable prospect of avoiding insolvent liquidation," he said.

"Finally, the relevant facts will be known to the [directors] and it is therefore right and appropriate to them to justify continued trading in those circumstances," he said.

"This judgment increases the pressure on directors, and gives liquidators an easier ride in proving wrongful trading claims," said insolvency law expert Nick Pike of Pinsent Masons, the law firm behind Out-Law.com. "We can expect an increased focus on director behaviour in similar cases in future."

Section 214 of the 1986 Insolvency Act deals with wrongful trading, and allows a liquidator to apply to court for a declaration that a director or former director must make "such contribution ... to the company's assets as the court thinks proper" if that person "knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation". It is a defence if that person can satisfy the court that he or she "took every step with a view to minimising the potential loss to the company's creditors ... as he ought to have taken".

Here, the joint liquidators of an insolvent company that ran a Robin Hood-themed tourist attraction in Nottinghamshire had asked the court to order that company's former directors contribute to the company's assets and pay compensation for breaches of their directors' duties. The liquidators claimed that the directors had wrongfully traded in breach of section 214 following certain events, including: the year-end accounts for 2005 and 2006; the receipt of professional advice in October 2006 about a large VAT liability; and the rent increase expected from a pending rent review. The company entered liquidation on 6 February 2009.

The judge disagreed with the liquidators as to the date on which the directors' knowledge could be established. For example, they were entitled to fully investigate the VAT issue before deciding on a course of action, and the law did not require them to immediately cease trading. However, by May 2007 it had become apparent that the company would be unable to meet its quarterly rent and service charge payment the next month. At this point they were under a duty to "re-assess" whether to liquidate or to continue to trade, the judge said.

"There is no evidence of the directors addressing the change in circumstances by producing a new business plan, budget and cash flow for either 3 May or 29 August 2007," he said. "Instead they appear to have relied upon continued trading."

"The fact that trade creditors were paid cannot mask the fact that the liabilities of the creditors as a class were increasing. The requirement to take 'every step' ... needed the directors to aim to minimise loss for all not just for some ... The directors, on whom the burden of proof lies, have not adequately addressed this issue within their evidence and did not address it at the time," he said.

It made no difference that none of the financial and business advisers consulted by the directors during this period advised them to take action, the judge said.

Civil fraud and asset recovery expert Alan Sheeley of Pinsent Masons said that the judge's reasoning could also apply in cases where a director did not investigate suspicious circumstances which might impact on the balance sheet.

"Frauds impact a company's balance sheet and cash flow significantly which can result in a company becoming insolvent," he said. "My experience is that the whistle blower who reports a suspicion of fraud usually uncovers a much bigger problem, which can sometimes lead to the company's insolvency. If a director fails to implement fraud prevention policies or worse, fails to follow those polices and investigate frauds, then they will need to consider how they will justify their actions or failings to creditors, via the liquidator, to avoid being personally liable should the company become insolvent at a later date."

"All directors know that they owe a duty to act in the best interests of the company by way of statutory and common law obligations. With this in mind, directors will find it extremely hard to justify inaction or a laissez-faire attitude to investigating frauds if it ultimately leads to the company's insolvency. This case does provide directors with a defence, though: as long as they act reasonably and investigate frauds as and when they arise and act appropriately then they will avoid any potential personal liability to creditors," he said.

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