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If a company trades while in financial difficulties, at what point does liability arise where the directors know or ought to know that there is no reasonable prospect of avoiding insolvent liquidation. Mark Mullen, barrister at Radcliffe Chambers considers the case of Re Ralls Builders Ltd.
Re Ralls Builders Ltd (in liquidation); Grant and another (Joint Liquidators of Ralls Builders Ltd) v Ralls and others  EWHC 243 (Ch),  All ER (D) 142 (Feb)
The Chancery Division ruled on the joint liquidators’ application for a declaration of wrongful trading that, although the directors of a company in administration ought to have concluded by a certain date that there was no reasonable prospect of the company avoiding insolvent liquidation, continued trading had not caused loss to the company overall or worsened the position of the creditors as a whole. Accordingly, no declaration was made under section 214(1) of the Insolvency Act 1986 (IA 1986), requiring the directors to make any contribution to the assets of the company in respect of any losses said to have been caused to the company during the period of wrongful trading.
This was a wrongful trading claim brought by the joint liquidators of Ralls Builders Limited against its former directors. The company operated in the construction industry and had been profitable to the end of October 2008. In the year to October 2009 it made trading losses as a result of disruption to its business in the winter months and liabilities incurred for defective works carried out by a sub-contractor. The company entered administration on 13 October 2010, moving to liquidation in January 2011. It had continued to trade until entering administration and its liquidators brought proceedings under IA 1986, s 214(1), seeking a declaration that the directors should contribute to the company in respect of losses caused by its continued trading after the point at which they should have realised that it was doomed to insolvent liquidation, together with the costs and expenses of its administration and liquidation.
The first point that the judge had to decide was whether the directors knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation for the purposes of IA 1986, s 214(2). If they knew, or ought to have realised, that the situation was hopeless, and yet continued to trade, then the court had to consider whether it was satisfied that the directors had taken every step that they ought to have taken with a view to minimising the potential loss to creditors.
If the court was so satisfied, a declaration could not be made by reason of IA 1986, s 214(3). If the declaration sought was to be made, the court then had to decide how to quantify the amount of the contribution the directors were to be required to make.
The joint liquidators contended that the directors should have appreciated that the writing was on the wall by July or August 2010 and ceased trading then. However, the company continued to operate thereafter, and incurred further unsecured trading liabilities, although it had reduced its secured obligations and paid some existing creditors. Many of the company’s new unsecured creditors had not been paid on its failure. The liquidators therefore sought a contribution based on the diminution in the net assets of the company or the losses to unsecured creditors sustained during the period of continued trading.
The directors contended that, until they took the decision to enter administration in late September 2010, they did not know, and could not have known, that the position was hopeless. They had a reasonable prospect of securing investment from a wealthy third party and their advisors did not tell them that this was unrealistic or that was inappropriate for them to continue to trade in the meantime. They also relied upon IA 1986, s 214(3) in that continuing to trade enabled the company to complete existing contracts and be paid for them, thus improving the outcome for creditors.
In any event, they contended that there had to be a causal link between the continued trading and an increase in the net deficiency as regards unsecured creditors before they should be ordered to contribute. As the company’s net position had been improved by its continued trading, and the costs and expenses of administration and liquidation would have been incurred in any event, no contribution should be ordered.
The judge, Snowden J, noted that the test under IA 1986, s 214(2) was not whether the company was insolvent, but whether the directors knew, or ought to have concluded, that the company had no reasonable prospect of avoiding insolvent liquidation. This was not to be judged with 20:20 hindsight. He considered that, by the end of August 2010, it should have been apparent that further investment was not going to materialise and the directors should have realised that insolvent liquidation was inevitable. Up to that point, however, the directors had been receiving advice from an expert insolvency practitioner which was to the effect that the company was not trading wrongfully and which did not cast doubt on the likelihood of obtaining further investment.
Having satisfied himself as to IA 1986, s 214(2), the judge went on to consider whether the directors had taken ‘every step’ that they ought to have taken to minimise the potential loss to creditors. He found that they had not. In this case, secured and existing creditors had been paid at the expense of new creditors, and a director who wished to take advantage of the IA 1986, s 214(3) defence had to demonstrate both that the continued trading was intended to reduce the net deficiency of the company and that it was designed appropriately so as to minimise the risk of loss to individual creditors. It was not enough merely to have intended to reduce the net deficiency of the company overall.
Despite that rather disappointing set of findings for the directors, the judge declined to make the declaration sought. The correct approach to determining whether the directors should be required to make a contribution was to ascertain whether the company suffered loss caused by its continued trading. As a starting point the court should look at whether there had been an increase in the company’s net deficiency as regards unsecured creditors. Here, the judge was not satisfied that the continuing trading had caused any material increase in the net deficiency. To the contrary, it had produced a modest improvement. The costs and expenses of administration and liquidation were not caused by the wrongful trading and could not be recovered.
The decision is helpful in stressing that liability will not be imposed merely because a company trades while in financial difficulties. Potential for liability arises at the point that the directors know or ought to know that there is no reasonable prospect of avoiding insolvent liquidation. This is to be determined not simply by looking at the company’s current position but what realistically might be on the horizon. The advice that the directors receive at the time will be of significance in assessing whether they could properly have taken the view that disaster could be averted.
Even then, the court must look at what loss has been caused by trading after the point of no return and will start by looking the effect of that trading on the net deficiency. If there is an increase in the net deficiency, directors will face an uphill struggle to show that they took every step to minimise the risk of loss to individual creditors. The defence afforded by IA 1986, s 214(3) is intended to set a high hurdle for directors and they have to prove that they have taken every step they ought to have taken to minimise loss to creditors individually, including new creditors.
It is essential to get professional advice as soon as possible when a company gets into difficulties. A dispassionate professional will usually be better placed than the directors to identify when a company’s hopes of survival have become unrealistic. The receipt of advice, and adherence to it, will be significant when the court comes to consider when, and whether, the elements of IA 1986, s 214(2) are made out. If those elements are made out, directors cannot simply rely on good intentions if continued trading makes the position of the company worse. Prudent directors should therefore take steps to avoid the risk that an office holder will be able to say that they permitted the company to continue to trade when they ought to have realised that its position was untenable.
Mark Mullen practises in the principal areas of company and insolvency law. He is the joint author of the current edition of Companies Limited by Guarantee, a contributor to Tolley’s Insolvency Law and a Deputy Bankruptcy Registrar.
Interviewed by Kate Beaumont.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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Wrongful trading claims under sections 214 and 246ZB of the Insolvency Act 1986 and the process for bringing the claim
Director's guide to dealing with a company in financial difficulty
Directors and insolvency—roles, powers and duties
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First published on LexisPSL Restructuring and Insolvency
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