Commercial Law Coursework

“At some time before commencement, the person knew, or ought to have concluded, that there was no reasonable prospect of the company not going into insolvent liquidation”

s.214(2)(b) Insolvency Act 1986

The standard test for this knowledge would be that the director would be judged, according to s.214(4)(a) and (b), as a reasonably diligent person having both “the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by a director in relation to the company” and with view to the “general knowledge, skill and experience that the director has”. This legislation is perhaps most clearly shown in Re Sherbourne Associates, when three men set up and managed an advertising agency without any relevant qualifications or industry experience, yet they were presumed to hold knowledge comparable to experienced and qualified directors in the same field.

Ben has claimed that Maxis continued to trade for the four months prior to his application despite Maxis’ being insolvent. Could this constitute wrongful trading?

Section 214(3) shows that a director can excuse himself from liability if he ‘took every step with a view to minimising the potential loss to the company’s creditors as (assuming him to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation) he ought to have taken”.

Section 727 of the Companies Act 1985, which gives the courts discretionary power to relieve directors of liability, does not apply in cases of ‘wrongful trading’. Re Hydrodam (Corby) established that shadow directors are not exempt from liability either.

Re Produce Market Consortium is perhaps the leading authority in cases of ‘wrongful trading’. In this instance the liquidator’s application before the court to have the two indicted directors contribute to the assets of the company was successful, with the directors contributing £75,000 on the basis that they continued trading despite the company’s auditors forewarning them of serious financial difficulties. The court reasoned that consideration should be given “ not only to what was actually there, but that given reasonable diligence and an appropriate level of general knowledge, skill and experience, what was ascertainable” and not just the “documentary material available at the given time”.

A company can, however, “trade out of difficulties” despite being technically insolvent and the “Rainbow test”, incepted into the common law in Re White & Osmond, where “there is nothing to say that directors……..are not entitled to incur credit to get them over the bad time”, a test endorsed by Re Sherbourne Associates.

The courts, therefore, must consider whether the director knew, or ought to have known, that there was no reasonable prospect of the company not going into insolvent liquidation and, if so, whether he took every step that he should be reasonably considered to take with a view to minimising the potential loss to creditors.

If the court declares that the directors are liable then they will have to contribute and could also face disqualification from holding the office of director.

There are varying methods of deciding upon an appropriate level of contribution that the director makes to the companies liabilities (if the courts decide that he should). The judges in Re Marketing considered the reduction in the company’s assets due to the conduct of the director whereas the formula used in Re Purpoint was the increase in net liabilities after insolvent liquidation became inevitable to the reasonable person of the required general knowledge, skills and experience. In the most recent case reported on this topic, Rubin v Gunner, the Companies Court delegated the decision on an appropriate contribution to an inquiry. Directors found guilty of wrongful trading could also be further penalised under s.215(4), with the courts having the power to determine that any debts owed by the company to the director “rank in priority after all other debts owed by the company and after interest on those debts”.

Any director found liable can also, by statute, be disqualified from being a director for a period of up to 15 years.

If the liquidator feels that this wrongful trading was performed with the intention of committing fraud he can raise a civil action, with the possibility of a criminal case being brought. Actual deceit, on the more stringent ‘beyond reasonable doubt’ criminal test, has to be proved for the prosecution to be successful under the criminal charge of fraudulent trading, an offence under s.458 CA’85. This crime carries a maximum custodial sentence of 7 years and possible disqualification as a director.

The liquidator could apply for the directors to be disqualified from taking “part in the promotion, formation or management of a company” as they are directors of an insolvent company and it would be up to the courts to decide whether the director was unfit. He cannot, however, apply for them to be prohibited from such a specific business sphere or any geographical restriction – R v Ward demonstrates that disqualification cannot be limited to a particular class of companies.

The CCDA’86 conveys the duty of disqualifying directors of insolvent companies to the courts (should they be unfit), with the period of disqualification being between 2 and 15 years. This unfitness is decided by a  range of factors, with Re Lo-Line, suggesting most erroneous acts or omissions would not be sufficient, but in insolvency cases they have particular regard to the extent of the director’s responsibility for the company becoming insolvent and their failure to perform services or deliver goods which creditors have paid for.

Though the courts may find the defendant unfit, they can take into account whether he has reformed when fixing the disqualification period (though constrained by 2 year minimum).

Disqualification is not seen by the legal community as a punitive measure, with LJ Dillon, in Re Sevenoaks, saying “it is beyond dispute that the purpose of s.6 is to protect the public”.

The implications, therefore, for the directors of an insolvent company can be very severe. Should they be proved to be culpable in wrongful trading then, as well as a disqualification, they could also have to contribute to the company’s assets. If the liquidator pushes for the directors to be prohibited from trading in the same area and business then they could also be disqualified as unfit by the courts for anywhere between 2 and 15 years. As both statute and case-law show, the consequences of managing an insolvent company are very serious.

Appendix A

Grounds for compulsorily winding up (s.122 IA’86)

A company may be wound up by the court on a petition where:

a) A special resolution has been made by the company

b) A public company has been registered for more than a year and has not been issued with a s.117 certificate under the Companies Act 1985 (requirement for minimum issued share capital of £50,000 of which 25% must be paid up)

c) The company is an old public company

d) The company has not commenced business within a year of incorporation or has suspended business for a year

e) The number of members has fallen below two (except in the case of a single member private company)

f) The company is unable to pay its debts

g) It is just and equitable that the company should be wound up

h) The High Court of Session is satisfied that a creditor’s security in a floating charge is at risk

Application for Winding up

A petition for a winding up order in Scotland may be presented by:

1) The company itself

2) The directors

3) Any creditor or creditors

4) A contributory or contributories

5) Any combination of the above parties

6) A receiver

7) An administrator

8) The supervisor of a company voluntary agreement (CVA)

In addition the Secretary of State may present a petition where the company is registered as a public company but does not have a s.117 certificate.

Appendix B

The powers of a Liquidator include:

(Schedule 4, Insolvency Act 1986, Part I)

1. Power to pay any creditor in full
2. Power to make compromises or arrangements with creditors
3. Power to compromise calls, debts or claims of the company and any questions relating to the company’s assets or the winding up

(Part II)

1. Power to bring or defend any legal proceedings on behalf of the company
2. Power to carry on the business of the company as far as is necessary for its beneficial winding up

(Part III)

1. Power to sell the company’s property by public roup or private bargain
2. Power to take part in insolvency proceedings on behalf of the company
3. Power to borrow money on security of the company’s assets
4. Power to do everything necessary for obtaining payment of money due from a contributory
5. Power to do everything necessary to carry out tasks which the liquidator cannot do himself
6. Power to do everything necessary for winding up the company’s affairs and distributing its assets

Appendix C

Factors determining ‘unfitness’

These matters include:

1. Any misfeasance or breach of a fiduciary or other duty by the director in relation to the company (sch.1 para.1)
2. Any misapplication or retention by the director of, or any conduct by the director giving rise to an obligation to account for, any money or other property of the company (sch.1 para.2)
3. The extent of the directors responsibility for any failure by the company to comply with various accounting and publicity requirements of CA 1985 (CDDA 1986, sch.1 paras 4 and 5)

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