Corporate Insolvency II

Question 1

Liability of directors

Answer 1

When a company becomes insolvent, the directors need to be extremely careful in how they act, since they may be held to be personally liable to compensate the company and its creditors if found guilty of one of the following:

• Misfeasance (s 212 IA 1986)
• Fraudulent trading (s 213 / 246ZA IA 1986)
• Wrongful trading (s 214 / 246ZB IA 1986)

Question 2

Misfeasance – s 212 IA 1986

Answer 2

• Directors of a company owe duties to the company under s 171 – 178 CA 2006. Breach of any such duties is generally actionable by the company
• On a winding up, typically it will be the liquidator, not the company, who will bring an action against the directors under s 212 IA 1986 for any breaches of duty
• the court may order that person to compensate the company in respect of money or property misapplied as a result of the misfeasance.

Question 3

Who may bring a claim for misfeasance?

Answer 3

Under s 212(3) IA 1986 claim may be brought by:​
A liquidator (not an administrator);​
The Official Receiver; or​
Any creditor or contributory.

Question 4

Who is the burden of proof on for misfeasance?

Answer 4

The burden of proof is on the claimants to establish misfeasance on the part of the director or other defendant, it is not for the defendant to justify their conduct (Mullarkey v Broad)

Question 5

Against whom may a claim be brought?

Answer 5

Under s 212(1) a claim in misfeasance may be brought against:

• Any person who is or has been an officer of the company
• Any others who acted in the promotion, formation or management of the company
• A liquidator or administrative receiver (a claim for misfeasance can also be brought against an administrator under Schedule B1 to the IA 1986)

Question 6

Misfeasance by a liquidator: Re Centralcrest Engineering Co Ltd

Answer 6

The Inland Revenue brought proceedings against a liquidator under s 212. The liquidator had allowed the company to continue to trade for 27 months after it had gone into compulsory liquidation, resulting in £73,230 being owed to the IR. The court held that there were two elements to the misfeasance: firstly, allowing the company to trade without the sanction of the court or liquidation committee and secondly allowing the company to trade when it was apparent that the assets should have been realised.

Question 7

What amounts to misfeasance?

Answer 7

• covers the whole spectrum of directors’ duties
• Misapplication of any money or assets of the company
• Breach of a statutory provision or a duty, for example:
• Unlawful loans to a director;
• A director entering into a contract with his own company and failing to notify the board (s 177 CA 2006);
• Failing to seek prior general meeting approval where a director has entered into a substantial property transaction (s 190 CA 2006)
• A director failing to act within his powers (s 171 CA 2006)
• Directors responsible for transactions at an undervalue as provided in s 238 or preferences as provided in s 239 may thereby commit a misfeasance
• Breach of the duty to exercise reasonable care, skill and diligence, ie negligence (s 174 CA 2006)

Question 8

Remedies for misfeasance

Answer 8

• The court will examine the conduct of the director/other person against whom the claim for misfeasance has been brought and make an order for repayment, restoration or contribution to the company’s assets or such other order as it thinks fit.
• The director may claim relief under s 1157 (where the court is satisfied that the director acted honestly and reasonably and, having regard to all the circumstances of the case, ought fairly to be excused).
• A finding of misfeasance is also a relevant factor to which a court shall have regard when considering whether to make a disqualification order against a director for unfitness under s 6 Company Directors Disqualification Act 1986.

Question 9

Ratification for misfeasance

Answer 9

• Ratification by the shareholders under s 239 CA 2006 can usually absolve the directors from personal liability for breach of duty. Ratification at a time when the company is solvent should therefore preclude misfeasance proceedings.
• However, when a company is facing the prospect of insolvency, case law has established that the duties of directors shift towards the company’s creditors and away from the members as a whole.
• Consequently, it is not possible for the shareholders to ratify what amounts to a breach of directors’ duties at a time when the company’s fortunes have declined to such an extent that there is a reasonable prospect that the company will go into an insolvent liquidation or administration.

Question 10

Wrongful trading

Answer 10

• the concept of wrongful trading was introduced in order to establish liability for directors who carry on business negligently rather than fraudulently.
• A civil claim for wrongful trading can be brought against a director by a liquidator under s 214 or an administrator under s 246ZB IA 1986.
• Wrongful trading is now the major risk run by the directors of a company trading on the brink of insolvency.

Question 11

Wrongful trading - purpose

Answer 11

• The purpose of s 214 and 246ZB is to ensure that when directors become aware (or ought to become aware) that an insolvent liquidation (or insolvent administration, as the case may be) is inevitable, they are under a duty to take every step possible to minimise the potential losses to the company’s creditors.
• If they fail to do this, the court can, under s 214 and 246ZB, order the directors to contribute to the insolvent estate by way of compensation for the losses
• Wrongful trading liability therefore imposes personal liability on directors and marks a very important exception to the principle of limited liability under which those who run a company cannot be liable for its unpaid debts.
• no requirement to show intent or dishonesty, it is easier for a liquidator or administrator to prove wrongful trading than it is fraudulent trading.

Question 12

Who may bring a claim? - s 214(1) / 246ZB(1)

Answer 12

A claim for wrongful trading may be brought by:
Liquidators under s 214(1), and
Administrators under 246ZB(1).
- Administrators and liquidators can also now (under the SBEEA 2015) assign wrongful trading claims to a third party as a way of raising funds for the insolvent estate and thereby, avoid the risk of litigation.

Question 13

Against whom may a claim be brought?

Answer 13

• A claim may be brought against any person who was at the relevant time a director.
• This includes shadow directors as defined in s 251 CA 2006, de facto and non-executive directors - Re Hydrodam (Corby) Ltd

Question 14

Requirements for liability – s 214(2) / 246ZB(2)

Answer 14

the court must be satisfied that the company has gone into insolvent liquidation and:

• at some time before the commencement of the winding up or insolvent administration ( the ‘point of no return’)
• 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).
• a company goes into insolvent liquidation (or as the case may be, an insolvent administration) at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of winding up or administration (s 214(6) / 246ZB(6)).
• Insolvency for wrongful trading purposes is therefore judged solely on the “balance sheet test” and not on the “cash flow test”

Question 15

Wrongful trading - Continued trading

Answer 15

It must be proven that the director in question allowed the company to continue to trade during the period in which they knew or ought to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration and that the continued trading made the company’s position worse (Re Continental Assurance Co of London plc)

• Re Produce Marketing Consortium: the time at which the directors ought to have realised that there was no reasonable prospect of the company avoiding insolvent liquidation was the latest possible date on which the annual accounts for that year ought to have been delivered.
• The fact that the directors had not seen the accounts was irrelevant since s 214(4) required them to be judged not only on the facts actually known to them but on the fact that they should have known

Question 16

The ‘every step’ defence - s 214(3) / 246ZB(3)

Answer 16

Assuming the company has reached the point of no return, 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 (ie from the ‘point of no return’ onwards), they took every step with a view to minimising the potential loss.

Question 17

Examples of evidence that may be supportive of establishing the every step defence

Answer 17

Voicing concerns at regular board meetings;
Seeking independent financial and legal advice;
Ensuring adequate, up-to-date financial information is available;
Suggesting reductions in overheads/liabilities;
Not incurring further credit; and
Consulting a lawyer and/or an insolvency practitioner for advice

Question 18

The ‘reasonably diligent person’ test – s 214(4) / 246ZB(4)

Answer 18

• The court applies the ‘reasonably diligent person’ test in order to determine whether:
• a liquidator or administrator has established that a director ought to have concluded that there was no reasonable prospect of avoiding an insolvent liquidation or administration (the s 214(2) / 246ZB(2) liability), and
• whether the director then took every step to minimise the potential loss to the company’s creditors (the s 214(3) / 246ZB(3) defence).
• Under that test, the facts which a director ought to have known or ascertained, the conclusions which he ought to have reached and 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:
• the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by the director (objective test)
• the actual knowledge, skill and experience of that particular director (a subjective test).
• the court applies the higher of the two standards.

Question 19

Advice to directors

Answer 19

• Directors should hold board meetings regularly to review the company’s financial position
• They should write up minutes of each meeting so there is a written record on which the directors can later rely to justify why decisions were taken
• A director cannot escape liability by simply resigning without previously taking every step with a view to minimising the potential loss to the company’s creditors, since a claim for wrongful trading can be brought against any person who was a director at the relevant time
• The best course of action for a company is to seek professional advice as soon as possible
• but the absence of warnings from advisers does not relieve directors of the responsibility to review the company’s position critically

Question 20

Remedies for wrongful trading

Answer 20

• If a director is found to be liable for wrongful trading, the court can order that director to make such contribution to the assets of the company as the court thinks fit.
• The court has a wide discretion. It will ordinarily be based on the additional depletion of the company’s assets caused by the directors’ conduct from the date that the directors ought to have concluded that the company could not have avoided an insolvent administration or liquidation
• An order by the court for a director to contribute to the company’s assets under s 214 / 246ZB is compensatory and not penal in nature.
• the court has a discretion to apportion liability between directors based on their culpability by ordering the more culpable directors to pay more than the less culpable ones.
• the court also has a discretion to make a disqualification order against them under s 10 CDDA 1986.

Question 21

No relief under s 1157

Answer 21

• not available in wrongful trading proceedings (Re Produce Marketing Consortium Ltd)

Question 22

Fraudulent trading

Answer 22

• A claim for fraudulent trading under s 213 / 246ZA IA 1986 can be brought against:
• any person (s 213(2) and s 246ZA(2))
• who is knowingly party to the carrying on of any business of the company
• with intent to defraud creditors or for any fraudulent purpose (s 213(1) and s 246ZA(1)).
• Sections 213 (in liquidation) and 246Z (in administration) IA 1986 impose a civil liability to contribute to the funds available to the general body of unsecured creditors suffering loss caused by the carrying on of the company’s business with intent to defraud.
• There is also a corresponding criminal claim for fraudulent trading under s 993 CA 2006.
• The claim may be brought by a liquidator under s 213 or an administrator under s 246ZA, although court approval is required.

Question 23

Fraudulent trading - Actual dishonesty

Answer 23

• Actual dishonesty must be proven
• Dishonesty is assessed on a subjective not objective basis ie what the particular person knew or believed.
• Knowledge includes blind-eye knowledge, which requires a suspicion of the relevant facts together with a deliberate decision to avoid confirming that they did exist (Morris v State Bank of India)
• The meaning of fraud for the purposes of s 213 has been defined as requiring “real dishonesty involving, according to current notions of fair trading among commercial men at the present day, real moral blame.”
• Not necessary for all the creditors to have been defrauded, just one.

Question 24

Fraudulent trading vs wrongful trading

Answer 24

• In practice, a very high standard of proof is required for a successful claim in fraudulent trading
• claims for fraudulent trading are rare and claims for wrongful trading under s 214 / 246ZB IA 1986 are more often brought against directors.

Question 25

Voidable transactions

Answer 25

The IA 1986 gives both a liquidator and an administrator the ability to challenge certain transactions that have taken place within specified statutory periods prior to the insolvency of a company. These are known as ‘voidable’ or ‘antecedent’ transactions.

The aim of a challenge is to restore the company to the same position it would have been in had the transaction not taken place and thereby, increase the funds available.

Question 26

Questions to ask for voidable transactions

Answer 26

• Did the transaction involve a ‘connected person’ or ‘associate’?
• Did the transaction take place within the ‘relevant time’?
• Was the company insolvent at the time of the transaction or did it become insolvent as a result of the transaction?
• Is there a presumption available which shifts the burden of proof from the liquidator/administrator to the other party?

Question 27

Transactions by a company at an undervalue (TUV) – s 238 IA 1986

Answer 27

• The provisions under s 238 concern loss of value from a company, whether through gifts or a significant inequality in consideration, to the company’s detriment at a time when it is “insolvent”
• Insolvency means ‘inability to pay debts’ under s 123 ie the company is insolvent on either the cash flow or balance sheet basis.
• Note that “insolvency” has a wider definition for voidable transaction purposes than it has for wrongful trading purposes (in the latter case, “insolvency” is restricted to balance sheet insolvency only).
• A claim may be brought under s 238(1) by:
  A liquidator, or
  An administrator.

Question 28

TUV: Granting security / payment of a dividend

Answer 28

• It was generally thought that the granting of security by a company cannot amount to a transaction at an undervalue on the basis that the security does not itself deplete the assets of the company or diminish their value
• However, in Hill v Spread Trustee Company Limited, it was found that the granting of security for no consideration (or for consideration significantly less than the value of the charge) can be challenged as a transaction at an undervalue.
• Similar uncertainty existed around whether a dividend, lawfully paid, could amount to a transaction at an undervalue. The case of BTI 2014 LLC v Sequana SA & others suggests that a dividend can be attacked as a transaction at an undervalue.

Question 29

TUV: What is a transaction at an undervalue?

Answer 29

A transaction at an undervalue is either:

(1) A gift; or
(2) A transaction for a consideration the value of which, in money or money’s worth, is significantly less in value than the consideration provided by the company.
- This involves a comparison in monetary terms between what the company gave away and what it received under the transaction. The comparison to be made is aimed at establishing if there has been an inequality of exchange adverse to the company under the transaction. A simple example would be where a company sells an asset worth £10,000 but only received £5,000 in payment.

Question 30

TUV: When and how can the transaction be avoided?

Answer 30

The court may set aside a transaction as a transaction at an undervalue if:

(a) The company made a gift or otherwise entered into a transaction for a consideration, the value of which in money or money’s worth is significantly less in value than the consideration provided by the company.
(b) It took place within the ‘relevant time’ (s 238(2)) - in the two years preceding the onset of insolvency (s 240(1)(a)), which is the commencement of the relevant insolvency procedure
(c) It is proved by the applicant that the company was insolvent at the time of the transaction or became so as a result of it (s 240(2)).

Question 31

TUV: Defence

Answer 31

Even if all of the requirements set out above are satisfied, no order will be made to set aside the transaction if the court is satisfied that:
The company entered into the transaction in good faith and for the purpose of carrying on its business;
At the time there were reasonable grounds for believing that the transaction would benefit the company.

Question 32

TUV: Sanctions

Answer 32

• The court has a discretion to make such order as it thinks fit to restore the position as if the company had not entered into the transaction (s 238(3)).
• Any such order should not prejudice a subsequent purchaser from the party which transacted at an undervalue with (or received a preference from) the company, provided they were acting ‘in good faith and for value’ (s 241(2)).
• However, under s 241(2A) there is a rebuttable presumption that an acquisition by a subsequent purchaser was not in good faith where the subsequent purchaser either:
• Had notice of the relevant surrounding circumstances
• Was connected with or was an associate of either the company or the party which transacted at an undervalue with (or received a preference from) the company. the burden of proof shifts to the subsequent purchaser to show good faith.

Question 33

Transactions defrauding creditors (TDC) - s 423 IA 1986

Answer 33

• Claims under s 423 do not necessarily relate to insolvency – these claims may also be brought by a victim of the transaction in question where the company is solvent.
• The requirements for the claim are:
• There has been a transaction at an undervalue and
• The intention or purpose of the transaction was to put assets beyond the reach of creditors of the company or otherwise prejudice their interests
• this transaction may be avoided under s 423(3). This even includes future creditors who were unknown at the time of the transaction.
• Insolvency practitioners may prefer to bring claims under s 238 (TUV) than under s 423.
• The reason is that, under s 238, it need not be proved that the purpose of the transaction was to put the assets beyond the reach of creditors or otherwise prejudice them.

Question 34

TDC: Who may claim

Answer 34

An application to the court to set aside the transaction can be made by any of the following (s 424):
A liquidator or an administrator;
A supervisor of a voluntary arrangement; or
A victim of the transaction in question.

Question 35

TDC: sanctions

Answer 35

• There is no ‘relevant time’ or period within which the transaction must have taken place. However, generally speaking, the more recent the transaction, the more likely it is that the applicant will be able to show the necessary intent.
• The court may make such order as it thinks fit to restore the position to what it would have been but for the transaction in question (s 423(2))
• The main advantage of a claim under s 423 is that it does not face the risk of becoming time-barred in the same way as a claim under s 238.

Question 36

Preferences by a company – s 239 IA 1986

Answer 36

• The purpose of s 239 is to prevent a creditor obtaining an improper advantage over other creditors of a company at a time when that company is insolvent.
• A claim may be brought under s 239(1) by:
  A liquidator, or
  An administrator.
• A company gives a preference to a person if:
  That person is a creditor of the company (or a surety or guarantor of any of the company’s debts or liabilities); and
  The company does anything or allows anything to be done which has the effect of putting that person in a better position in the event of the company going into insolvent liquidation than he/she would otherwise have been in.
• An example of a preference would be paying an unsecured creditor in priority to other creditors.

Question 37

When can a preference be avoided?

Answer 37

• It was given within the ‘relevant time’ (s 239(2)) - in the 6 months preceding the ‘onset of insolvency’ (s 240(1)(b)), being the commencement of the relevant insolvency procedure (s 240(3)).
• The relevant time is extended to 2 years for preferences to connected persons and associates (s 240(1)(a)).
• It is proved that the company was insolvent (on either a cash flow or balance sheet basis) at the time of the transaction or became so as a result of it (s 240(2)).
• It is proved that the company was ‘influenced … by a desire’ to prefer the creditor (s 239(5)). This is a subjective test. The company must have positively wished to put the party in a better position

Question 38

Preferences: Connected persons

Answer 38

• If the preference is given to a connected person or associate, there is a rebuttable presumption that the company was influenced by the desire to prefer the creditor (s 239(6)).
• a person is connected with a company if—
  (a) he is a director or shadow director of the company or an associate of such a director or shadow director, or
  (b) he is an associate of the company,
• see section 435 Insolvency Act for further definition of ‘an associate of the company’

Question 39

Preferences: Defence

Answer 39

an absence of the desire to prefer required by s 239(5).

• not necessary to prove an intention to prefer (which is objective), but a desire to prefer (which is subjective).
• Re MC Bacon Ltd: the security could not be challenged as a preference because the directors, in granting the security, had not been influenced by a desire to prefer the bank, but only by the desire to continue trading and to avoid the calling in of the company’s overdraft

Question 40

Preferences: Sanctions

Answer 40

• The court has a discretion to make an order to restore the position as if the company had not given the preference (s 239(3)).

Question 41

When can floating charges be avoided?

Answer 41

• The floating charge must have been created within the ‘relevant time’. The relevant time is 12 months preceding the onset of insolvency, ie the commencement of administration or liquidation (s 245(2) and 245(3)(b)).
• The relevant time is extended to 2 years in the case of a floating charge granted to a connected person (s 245(3)(a))
• Unless the floating charge was granted to a ‘connected person’ or an ‘associate’ (in which case there is no insolvency requirement), it must be proved that the company was insolvent (on either a cash-flow or balance sheet basis) at the time of the floating charge’s creation or became insolvent in consequence of the transaction

Question 42

When are new floating charges valid?

Answer 42

Even if the above requirements are met, a floating charge will be valid to the extent that ‘new money’ or other fresh consideration (which can include goods or services) is provided to the company (or existing debts of the company are extinguished) in return for the grant of the floating charge on or after its creation (s 245(2)).

Question 43

Avoidance of floating charges

Answer 43

• Where a floating charge is void under s 245, only the security (and its advantage to a floating charge creditor in the order of priority) is void and not the debt itself.
• a floating charge is also void against a liquidator, administrator and other creditors if it is not duly registered with Companies House under s 859H CA 2006.
• a floating charge granted to a creditor may also be voidable as a transaction at an undervalue or a preference under s 238 and 239.