Wrongful Trading and Fraudulent Trading

The basic principle underlying the concept of wrongful trading can be summarised in the simple phrase, ‘If you are in a hole, stop digging’, while the concept of fraudulent trading covers the more serious ‘intent to defraud.’ This article discusses these risks to directors and how to deal with them.

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What Are Wrongful Trading and Fraudulent Trading And When Do They Apply? Wrongful trading occurs when a company’s directors continue to trade beyond the point where they:

knew or ought to have concluded that;

there was no reasonable prospect of avoiding an insolvent liquidation; and

did not take every step with a view to minimising the potential loss to creditors that they ought to have taken.

Under these circumstances a Liquidator can bring an action against one or more of the directors for an order that they make a personal contribution to the loss suffered by creditors as a result.

Only the Liquidator in an insolvent liquidation (either a Creditors’ Voluntary Liquidation or a Compulsory Liquidation) can bring this type of action, so the procedure is not available in other circumstances such as an Administration or a Company Voluntary Arrangement.

Fraudulent trading occurs where the directors deliberately carry on trade with the intention of defrauding creditors and is intended to cover those cases where there is actual dishonesty involved. It is a more serious offence than wrongful trading and can lead to more severe penalties including imprisonment.

As the standard of proof involved in a fraudulent trading case is therefore of the criminal type, beyond reasonable doubt, rather than the civil test required in wrongful trading cases, on the balance of probabilities, few such actions are brought by Liquidators.

Who Can be Liable For Wrongful Trading?

An action can be brought against not only the formal directors of the business as registered at Companies House, but also against de facto directors, people acting as directors without actually being appointed, and shadow directors, people on who’s instructions the directors are accustomed to act. There is a generally an exemption for professionals who are giving advice to the company in their professional capacity but this line is potentially easy to cross.

How Are The Tests For Wrongful Trading Applied?

The wrongful trading test is based on the facts that the director knew or ought to have known and the conclusions that should have been drawn from these.

Telling what a director knew may be a simple issue of fact but how is what ought a director to know or concluded be judged? The law applies two tests, firstly being those a reasonably diligent person with the skill and experience reasonably expected of a director and the second being those of the skills and experienced they actually hold. So there is both a general minimum standard to which directors will be held, while those with specialist skills may be held to a higher one.

When looking at a potential wrongful trading action the liquidator will attempt to establish the point at which the business became insolvent. This may be as simple as looking at the company’s accounts to see the point where it had net liabilities, or it may involve looking at key signs that may suggest this was the case such as failure to file accounts, failing to operate VAT or PAYE schemes correctly and failing to pay VAT or PAYE/NIC when due, or the granting of County Court Judgements against the company.

Contrary to many misconceptions directors do not have to cease trading if a company is insolvent and indeed if the directors genuinely believe that they will trade out of the position and recover the situation for creditors, then continuing to trade is the correct thing to do.

The important point to be conscious of is that once the business is insolvent then the directors’ duties change from running the business in the interests of the shareholders to running the business in the interests of its creditors. So for example if continuing to trade think very carefully about how you can make purchases from your suppliers without worsening their position.

How Can You Protect Yourself From The Risk of a Wrongful Trading Action?

The obvious protection against an action is demonstrate that you acted reasonably as a director on the basis of the information that you had or could reasonably be expected to discover; not least because to bring a wrongful trading action a Liquidator will usually needs no engage a no win, no fee lawyers to act. So one step towards a successful defence is showing them will be tough case to win.

The key five steps you should take as a matter of course as directors are to:

hold regular formal board meetings to discuss the business’s performance and position, and increase the frequency if circumstances require it;

keep up to date and accurate financial records and review financial reports and forecasts at your board meetings;

take and keep safely minutes of these board meetings and any other relevant discussions;

keep all decisions made under regular review; and

if you have any concerns about the business’s viability you should seek and follow appropriate professional advice.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and as these can have serious implications you should always seek appropriate professional advice on your own particular circumstances before taking any action.