Definition of Wrongful Trading
Wrongful trading is not defined by fraud, that is the job of the Fraud act 2006. Trading while insolvent describes wrongful trading.
Negative net assets in the balance sheet represents balance sheet insolvency, negative net current assets (working capital); cashflow insolvency.
It is the responsibility of the directors and senior officers of the company (shadow directors) to ensure that creditors are paid on time. A company with negative working capital would be unable to do that from its own resources.
If the company folds, the insolvency act takes over from the Companies Act. An early consequence is that directors are likely to lose their protection under limited liability.
Responsibilities of Directors
As a director or senior company officer, you are expected to be aware of the financial condition of the business. This is best illustrated by sec. 214 (2b) of the the Insolvency act that states:
"…at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation."
Note the words "...ought to have concluded".
What is Insolvency
There can be no argument that a company has become insolvent if by the end of its financial year net assets / equity are in deficit but what really matters is the point at which insolvency occurred and what if anything was done about it.
The balance sheet is key. If net assets or net current assets fall into deficit, action must be taken to ensure the business will have access to enough cash to continue to pay its way until solvency has been restored.
Contribution Orders under Wrongful Trading
A liquidator who is of the opinion that there is a case to answer in respect of wrongful trading can apply to a court for an order requiring individual directors of the company to make financial contributions towards the creditors of the company.
The scale of contributions are decided by the court and depending on perceived culpability will range from the nominal to substantial. Persons who have not been appointed as directors but who are regarded by the court as having acted as such (shadow directors) can also be ordered to make contributions.
Wrongful Trading and Financing.
A company with negative working capital can still argue that it is not insolvent if it has sufficient external financing to enable it to continue to meet its liabilities.
Working capital is defined by net current assets; i.e. Current assets (cash convertable within a year) less liabilities payable within a year. Because bank overdrafts are repayable on demand, they are always recognised as a current liability and therefore always a charge against working capital.
The links below will take you to important working (interactive) examples showing hiow this can be done using Figurewizard.
How is it that Tesco directors have been charged with wrongful trading despite Tesco not having gone out of business?
The three Tesco directors are charged with false accounting (companies act) and fraud by abuse of position (fraud act 2006) not wrongful trading.
It does not take Tesco going bust (highly unlikely) to trigger these actions against directors. It is worth noting that where breaches of the Companies act are concerned it is not only directors or shadow directors who can be called to account but also employees who have knowingly participated in such breaches. That can especially be the case in instances of fraudulent trading.
How does wrongful trading apply to a director who has resigned before a company became insolvent? Would that absolve them for any compensation claims and if not how long before insolvency would they need their resignation to take effect to avoid liability?
A director who can demonstrate that they resigned because they knew the company was heading for insolvency but had been unsuccessful in persuading the directors to do the right thing should be in the clear - "Demonstrate" being the operative word however. There are no specified time limits.
I don't have a problem with directors allowing a company to run up debts knowing that it's likely to go bust having to contribute to out of pocket creditors. My question is though how in a legal sense are directors meant to square their responsibility towards the company and its creditors at the same time? I would have thought that the two interests would be incompatible.
Yes directors are charged with a responsibility towards the company at all times but from the point where the directors either knew or, in the opinion of the court "ought to have known" that insolvency was unavoidable, responsibility towards the company's creditors takes over and trading should cease. If other directors disagree with that then resignation with correspondence to support a recommendation that trading should have ceased becomes very important.
I see that the administrators of BHS (FRP) are reported to be looking to recover millions in fees paid to Grant Thornton (accountants) and Olswang (lawyers) who were engaged in what passed for due diligence prior to the business being flogged off to Chappell for a pound. Can they do this? I thought that sec. 214 of the insolvency act only applied to directors and others acting as directors of the company, not its advisers.
Prosecuting claims against advisers where third party losses are involved is notoriously difficult but Phillip Green looks to be a far easier target.
In 2004 Green paid himself a dividend of £220 million despite the fact that BHS net current assets were £56 million. Thus by this direct action, Green rendered a perfectly good, solvent company insolvent and more importantly put its staff pension scheme at risk. It is greatly to be hoped that he will pay an appropriate price for this.