Case law on wrongful trading has developed significantly over the past two years, with the cases of Ralls Builders and Brooks increasing judicial consideration of the conduct of directors in the period preceding an insolvency.

The judgment of the appeal and cross-appeal in Brooks was handed down in late 2016. It provides an essential update on the factors a court must assess in determining the basis on which directors may be compelled to personally contribute to the company for their own wrongful trading actions. It also serves as a warning to liquidators to ensure the basis of the compensation sought is very clearly and correctly prepared.

Background

In October 2015, we published an update on the case of Brooks and another v Armstrong and another [2015] EWHC 2289 (Ch), also known as the ‘Robin Hood’ case. A link to our previous post is available here.

The liquidators and the directors appealed the above judgment before David Foxton QC, sitting as a Deputy Judge of the High Court (citation [2016] EWHC 2893 (Ch)).

In summary, the first instance hearing before Mr Registrar Jones considered in detail whether the directors of Robin Hood Centre plc (the Company) were liable to contribute to the assets of the Company’s insolvent estate as a result of wrongful trading (i.e. continuing to trade after the point at which the directors knew, or ought to have known, that the Company could not avoid insolvent liquidation). It was held that the directors had not acted as reasonably diligent directors and had failed to establish the statutory defence to wrongful trading. Consequently, the directors were held to be jointly and severally liable to pay a minimum contribution of £35,000 to the estate of the Company.

The appeal hearing, heard on 18-20 October 2016, considered appeals from (i) the liquidators and (ii) the directors, by way of cross-appeal. Each of the areas appealed included a number of grounds.

The liquidators’ grounds of appeal

The liquidators challenged the date on which the Registrar deemed the starting point for wrongful trading, the Registrar’s conclusion as to the amount of compensation to be paid by the directors, and the fact that the Registrar made no order as to costs.

The directors’ grounds of appeal

The directors also challenged the dates on which the Registrar concluded that wrongful trading had occurred, and the amount of compensation they were ordered to pay.

The judgment of David Foxton QC

The appeal covered various grounds for each of the arguments summarised above. The Judge considered several factors and a great deal of case law in making his judgment:

The liquidators’ argument regarding the date on which wrongful trading commenced  (i.e. the point from which the directors could not have reasonably concluded that the Company could avoid insolvent liquidation)

The Judge rejected the liquidators’ argument that the wrong test had been applied in assessing the conduct of one of the directors, Mr Armstrong. The liquidators argued that a higher standard of conduct should be applied, given Mr Armstrong was a director of a number of other companies, including some much larger than the Company.

The Judge rejected this contention and held that Mr Armstrong was indeed experienced, but that such experience was in a different field and that the proposed higher standards did not ‘fit his cloth’. It was argued that the directors could not reasonably have proceeded to trade on the basis of making a profit without taking into account HMRC’s position as to the VAT scheme (regarding the ticketing system). This ground was rejected, on the basis of the Registrar’s wider considerations as to the conduct of the directors, including that an immediate liquidation would in any event have left very little, if anything, for creditors. Therefore, the decision to continue to trade had only limited likelihood of further prejudice to the Company’s creditors.

The directors’ argument regarding the finding of wrongful trading

The directors argued that the Registrar had unfairly and inappropriately taken into account certain factors, including a failure to take into account an element of rent which was paid, references to a rent review, a hardship letter and the January 2008 accounts.

The contention was that these considerations required an element of hindsight. The Judge held that the consideration of the rent (and the rent review) had been relevant as the directors ought to have appreciated at the time that the outcome of the rent review would likely be an increase in rent.

He further held that the Registrar had been entitled to draw an inference about the interplay between the hardship letter and the accounts, because the position the Company recognised in the January 2008 accounts could, in the absence of a suggestion that there had been a change in circumstances, not be argued to be different to the position per the May 2007 hardship letter.

It was held that the Registrar was entitled to infer that the deterioration shown in the accounts would have manifested itself to some extent in May 2007, particularly given the directors had regard to the monthly management accounts produced in the interim period.

The arguments regarding the amount of compensation awarded

The liquidators argued that the court should quantify the maximum loss caused by wrongful trading as “all unpaid debts incurred after the date on which it was alleged the Company should have stopped trading” (following Re Continental Assurance). At first instance, the Registrar held that this was “wrong and wholly unrealistic”, taking into account certain assumptions made and the liquidation values ascribed by the liquidators to the assets.

The Registrar assessed the increase in the Company’s net deficiency from the point on which trading should have ceased and, following Re Continental Assurance, adjusted this downwards by reference to the ‘nexus’ requirement of a connection between the Company’s loss and the directors’ conduct, and having regard to discretionary considerations. The Registrar concluded that the increase in net deficiency was £78,500 and the directors were liable to contribute around 50 per cent of this: £35,000.

The liquidators challenged the 50 per cent reduction, which the Judge noted was open to criticism as it mixed issues (such as his finding that the directors had not been dishonest and had hoped to benefit the local tourist trade).

The Judge concluded that the liquidators had failed to establish that the wrongful trading had resulted in an increase in the Company’s net deficiency and that the Registrar had applied a flawed analysis as to the net deficiency, but was entitled to take into account that the directors had acted honestly.

The directors, in their cross-appeal, submitted that the calculation was unfair and inappropriate, adopting an approach of the Registrar’s devising, which was not deployed at the hearing and on which the directors (and indeed the liquidators) had not had an opportunity to present evidence or otherwise challenge the Registrar’s finding. The Judge had sympathy for the Registrar’s position, but held that the directors’ appeal in this regard should succeed on the basis that the Registrar’s analysis was not such that the directors could not have raised any legitimate objection at the hearing. For example, the directors were given no opportunity to object to the rate of discounting which would have applied to the rent.

The Judge held that the Registrar should not have ordered any payment by the directors to the liquidators because (i) the liquidators had failed to present a properly formulated case that there had been an increase in net deficiency during the period of wrongful trading and (ii) on the Registrar’s approach, there had been no such increase.

Summary

The Judge allowed the directors’ appeal against the award that they were liable to pay compensation of £35,000, because he found that the liquidators had not established that the directors had caused any increase in the Company’ net deficiency.

The Judge adjourned the hearing to address costs and consequential issues.

Comment

The area of wrongful trading has come under considerable judicial consideration in recent years, including the Ralls Builders case and the above-referenced hearing and appeal. It is clear that the courts are reluctant to order directors to make contributions to the insolvent company’s estate in the absence of clear wrongdoing. The calculation of net deficiency will always depend on the specific circumstances of the case but should, pursuant to Brooks, be carefully considered and evidenced to ensure the court has the benefit of a clear assessment on which the parties may adduce evidence and, where appropriate, object.

When facing financial difficulty, directors should always take (at least) reasonable steps to protect the company and should have regard to the interests of creditors (rather than the interests of shareholders) from the point at which they cannot reasonably conclude that the company can avoid insolvent liquidation. Steps that can assist with this include:

1. closely monitoring the company’s financial and trading position, together with careful scrutiny of regularly produced financial reports and forecasts
2. taking appropriate legal and/or financial advice
3. considering all options available to the company in the light of its current, or reasonably foreseeable circumstances.

Client Alert 2017-043