12 - Voidable transactions and Directors’ Liability in Insolvency Flashcards
(44 cards)
What is the liability of directors of an insolvent company?
They may be held to be personally liable to compensate the company and its creditors if found guilty of one of:
- Fraudulent trading (s 213 / 246Z 1986)
- Wrongful trading ( s 214 / 246Z 1986)
Liquidators and administrators have the power to bring proceedings for compensation against directors personally for this.
Why were the provisions on fraudulent trading enacted?
To prevent abuse of limited liability by those running companies.
They address concerns that directors might:
- Continue trading while the company is in financial difficulty, incurring further debts.
- Cause increased losses to creditors.
Under the Insolvency Act 1986 (IA 1986), the court has powers to impose:
- Criminal sanctions on directors and other liable persons.
- Civil sanctions for fraudulent trading.
Despite these provisions, claims for fraudulent trading are rare due to the high evidential burden of proving intent to defraud creditors.
Who can a claim for fraudulent trading be made by?
A claim can be made by:
- A liquidator (under s 213 IA 1986)
- An administrator (under s 246ZA IA 1986)
- Making an application to court.
The provisions of s 246ZA are aligned with those of s 213 but are adapted for administration.
What is a claim for fraudulent trading, and when can it be made?
A fraudulent trading claim arises when a person is knowingly involved in carrying on a business:
- With intent to defraud creditors, or
- For a fraudulent purpose (s 213/246ZA IA 1986).
Example: Banks may be liable due to their employees’ knowledge of such (Morris v State Bank of India). ‘Any person’ is a wide definition.
Civil liability under these sections requires the guilty party to contribute to the funds available for unsecured creditors.
A corresponding criminal claim exists under s 993 CA 2006 for fraudulent trading, punishable by:
- Imprisonment (up to 10 years), and/or
- Fines.
What constitutes actual dishonesty in fraudulent trading claims?
Actual dishonesty must be proved, assessed by:
- Subjective test: Dishonesty is judged based on what the person knew or believed.
- Blind-eye knowledge: Requires suspicion of facts combined with deliberate avoidance of confirmation.
Definition of fraud (Re Patrick and Lyon Ltd): Real dishonesty involving moral blame as judged by current notions of fair trading among commercial men at the present day.
Two-stage test (Ivey v Genting Casinos):
- Determine the subjective state of knowledge of the accused.
- Assess whether their conduct was objectively dishonest by the standards of ordinary, decent people.
Fraud against even one creditor is sufficient to bring a claim. It is not necessary to show all creditors have been defrauded.
What remedies are available when a person is found to be liable for fraudulent trading?
Civil remedies under s 213/246ZA IA 1986 include:
- Contribution to the company’s assets, compensating creditors for their loss, that the court thinks proper.
- No punitive elements in the contribution amount. The contribution should only reflect and compensate for the loss caused to the creditors.
- Recovered sums held on trust for the general body of unsecured creditors, not for defrauded creditors.
Additional consequences for directors:
- Likely disqualification order under s 10 CDDA 1986.
- Criminal penalties under s 993 CA 2006:
- Imprisonment (up to 10 years), and/or
- Fines.
What is the difference between fraudulent trading and wrongful trading?
Fraudulent trading (s 213/246ZA IA 1986):
- Requires proof of intent to defraud or fraudulent purpose.
- High evidential standard makes claims rare.
Wrongful trading (s 214/246ZB IA 1986):
- Easier to prove and more commonly pursued.
- Focuses on directors continuing trading while aware of insolvency risk, even without fraudulent intent.
Provide a summary of fraudulent trading.
- Claims for fraudulent trading may be brought by a liquidator or an administrator.
- The claim can be brought against any person who is knowingly party to the carrying on of any business of the company with intent to defraud creditors or for any fraudulent purpose, including directors and banks.
- Actual dishonesty must be proven on a subjective basis.
- A person found to be liable can be ordered to make such contribution to the company’s assets as the court thinks proper. There is no punitive element to the remedy however – the contribution should only reflect and compensate for the loss caused to the creditors.
- The court is likely also to make a disqualification order under s 10 CDDA 1986 where a director has been found liable for fraudulent trading
- There is also a criminal claim for fraudulent trading under s 993 CA 2006. The remedies for this are up to 10 years’ imprisonment or fines.
What is the purpose of a claim for wrongful trading?
Wrongful trading was introduced to address negligence in carrying on a business rather than fraud, following criticism of fraudulent trading’s ineffectiveness due to the high threshold for proving it.
A claim for wrongful trading is:
- A civil claim brought by a liquidator (under s 214 IA 1986) or an administrator (under s 246ZB IA 1986).
- There are no criminal provisions for wrongful trading, unlike fraudulent trading, which is both civil and criminal.
Wrongful trading poses a significant risk to directors of companies nearing insolvency, making it critical for lawyers to advise on mitigating such risks.
What is the purpose of wrongful trading provisions under s 214 and s 246ZB?
The purpose is to ensure directors act responsibly when aware (or ought to be aware) that insolvency (by liquidation or administration) is inevitable.
Directors are under a duty to take every possible step to minimise the potential losses to the company creditors.
Courts can order directors to compensate the insolvent estate for losses caused by their conduct, increasing funds for unsecured creditors.
Key features:
- Imposes personal liability on directors, overriding the principle of limited liability.
- No requirement to prove intent or dishonesty, making wrongful trading easier to establish than fraudulent trading.
- It focuses on directors failing to make correct judgments about the company’s financial prospects and not minimising creditor losses.
Who may bring a claim for wrongful trading?
Claims may be brought by:
- Liquidators under s 214(1)
- Administrators under s 246ZB(1)
Administrators and liquidators may assign claims to third parties under the SBEEA 2015, raising funds for the insolvent estate and avoiding litigation risks.
Against whom can a claim for wrongful trading be brought?
Claims can be brought against any person who was a director at the relevant time, including:
- Shadow directors (s 251 CA 2006)
- De facto directors
- Non-executive and executive directors
This claim can only be brought against any person who was knowingly party to the carrying on of the company’s business with intent to defraud creditors.
What are the requirements for liability under limb one of s 214(2) / s 246ZB(2)?
For a director to be liable for wrongful trading, there are two limbs to satisfy. First, the directors must make a proper assessment of the company’s prospects and ability to avoid an insolvency.
Liability arises if:
The court must be satisfied that the company has gone into insolvent liquidation or administration and -
- At some point before the commencement of the winding up or insolvent administration (‘point of no return’),
- The director knew or ought to have concluded that
- There was no reasonable prospect of avoiding insolvency (liquidation/administration).
Note: A company goes into insolvent liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities at the expenses of winding up or administration.
How is insolvency judged for wrongful trading, and when must directors consider limb two?
Insolvency is judged solely on the balance sheet test (s 123 IA 1986), where assets are insufficient to cover debts and expenses.
Directors need to consider limb two only if they know or ought reasonably to know that the company cannot avoid liquidation or administration.
If directors reasonably assess that the company has a chance of avoiding insolvency, limb one is not satisfied, and no further action is required.
However, if they conclude or ought to conclude there is no reasonable prospect of avoiding insolvency, they must proceed to limb two, taking every possible step to minimise losses to creditors.
How does continued trading affect wrongful trading liability?
Liability arises if a director in question:
- Allows the company to continue to trade after knowing or ought to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration.
- The continued trading worsens the company’s financial position.
If the company has not reached the ‘point of no return’, wrongful trading liability does not apply, and there is no need to consider further defences.
What is the ‘every step’ defence under limb 2 of s 214(3) and s 246ZB(3)?
Directors may escape liability if they can satisfy the court that, after knowing insolvency was unavoidable, they took every step with a view to minimise the potential losses to creditors.
Examples of steps include:
- Raising concerns in board meetings.
- Seeking independent financial/legal advice.
- Ensuring up-to-date financial information is available.
- Proposing overhead/liability reductions.
- Avoiding further or increased credit.
- Taking advice on insolvency procedures or creditor negotiations.
What is the ‘reasonably diligent person’ test under s 214(4) and s 246ZB(4)?
This test assesses if directors:
- Knew or ought to have known that there was no reasonable proespect of avoiding an insolvent liquidation or administration (Limb 1).
- Whether the directors then took every reasonable step to minimise the potential loss to the company’s creditors (Limb 2).
Under the test, the facts which a director ought to have known or ascertained, the conclusions which he ought to have reached, the steps which he ought to have taken, are those which would have been known or ascertained, or reached or taken, by a reasonably diligent person having both:
- An objective test: knowledge, skill, and experience reasonably expected of a director in the same role.
- A subjective test: the director’s actual knowledge, skill, and experience.
The court then applies the higher standard of the two.
What advice should directors follow to minimise the risk of wrongful trading liability?
Actions to reduce risks include:
- Hold regular board meetings to review the company’s financial position, with detailed minutes documenting decisions and evidence supporting the company’s ability to avoid insolvency.
- Take professional advice from lawyers, insolvency practitioners, or accountants promptly.
- Ensure up-to-date financial information is available and acted upon at board meetings.
Directors cannot escape liability by resigning; resignation may itself be wrongful if done irresponsibly.
Resignation is only advisable if a director is repeatedly outvoted on decisions and cannot influence change.
What remedies are available for wrongful trading under s 214(1) and s 246ZB(1)?
The court can order directors to contribute to the company’s assets of the company as the court thinks fit. The contribution will increase the assets of the company available for distribution to the general body of unsecured creditors.
Key aspects:
- Contribution Order: The court can order directors to contribute to the company’s assets to increase funds for unsecured creditors.
- Extent of Liability: Determined by the additional asset depletion caused from the ‘point of no return’. Liability is compensatory, not penal.
- Joint and Several Liability: Directors may be held jointly and severally liable, with discretion to apportion liability based on culpability.
- Disqualification Order: The court may disqualify directors under s 10 CDDA 1986.
Why is relief under s 1157 CA 2006 unavailable for wrongful trading?
- While s 1157 allows the court to excuse directors from liability in negligence, breach of duty, or breach of trust if they acted honestly and reasonably, this does not apply to wrongful trading.
- Case example: Re Produce Marketing Consortium Ltd [1989], confirming that s 1157 relief cannot be used in wrongful trading cases.
Provide a summary of wrongful trading.
- Claims for wrongful trading may be brought by a liquidator under s 214 IA 1986 or an administrator under s 246ZB IA 1986.
- The claim can be brought against any person who was at the relevant time a director.
- The court must be satisfied that at some time before the commencement of the winding up or insolvent administration, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation (or insolvent administration); limb one.
- A director may be able to escape liability if they can satisfy the court that, after they first knew or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent administration or liquidation, they took “every step with a view to minimising the potential loss to the company’s creditors” (s 214(3) / 246ZB(3); limb two
- The court applies the reasonably diligent person test under s 214(4) / 246ZB(4) to what the director ought to have known.
- A person found to be liable under s 214 / 246ZB can be ordered to make such contribution to the company’s assets as the court thinks proper and may also be disqualified under s 10 CDDA 1986.
What are voidable transactions, and what is the aim of them during insolvency proceedings?
- Voidable transactions are those challenged by a liquidator or administrator under the IA 1986 within specified statutory periods before a company’s insolvency.
- Their purpose is to restore the company to its position had the transaction not occurred, increasing funds available in the insolvent estate for creditors.
- These provisions, often called ‘clawback’, can reverse transactions or provide financial restitution to be paid into the insolvent estate.
- It is the counterparty to the transaction with the insolvent company (and sometimes its successor in title) that is the target of the clawback provisions, rather than the directors responsible for causing their company to enter into the transaction.
What questions will a liquidator or administrator seeking to challenge a voidable transaction need to ask?
- Did the transaction involve a ‘connected person’ or ‘associate’?
- Did the transaction occur within the ‘relevant time’?
- Was the company insolvent at the time, or did it become insolvent due to the transaction?
- Is there a presumption that shifts the burden of proof to the counterparty?
How are ‘connected persons’ and ‘associates’ defined under the IA 1986?
Connected persons (s.249): Include directors (and shadow directors), their associates, and associates of the company.
Associates of a Director or Company (s.435): Broadly defined to include:
- Spouses, business partners, employees, and close relatives (e.g., siblings, uncles, nieces).
- Trustees linked to the director or company.
- Companies controlled by the director or associated through mutual control by another entity.