This case centres on Section 214 of The Insolvency Act 1986 which deals with making directors (and shadow directors) personally liable for wrongful trading. The Judge in this case clearly sets out the position that many Companies show a balance sheet deficit from time to time, but nevertheless have a real prospect of trading out of that position. The negative balance sheet position detailed above is held by the Judge to be very different from the position where the directors knew or ought to have concluded there was no reasonable prospect of avoiding insolvent liquidation. He goes on to say that the fact that a company is insolvent and carries on trading does not automatically mean that a director will be liable for wrongful trading if the company fails to survive. In short, if you can show that you have a rational belief, supported by credible evidence (ideally in writing), that the sun will come out again, you can carry on trying to turn the business around.
It was also stated that if a director took every step he ought to have taken, with a view to minimising losses, he avoided liability under Section 214(1), even if he didn’t succeed in his objective of rescuing the business.
It is clear that that directors, must be able to show that not only was continued trading designed to reduce the net deficiency, but also that it was designed to minimise the risk of loss to individual creditors.
Directors therefore need to be ensuring that if trading continues, consideration is given to whether existing creditors are being paid at the expense of new creditors. If it looks as though that will happen it is vital to seek independent professional advice about your position. And for that advice to be put in writing.
This Ralls case is particularly useful because it summarises almost all previous cases on wrongful trading and although, ultimately, the court refused to make a declaration requiring the directors to make a contribution to the company assets in respect of losses caused, there was criticism of their conduct. That criticism makes useful reading and it was at its harshest in relation to a failure to spot the point of no return.
In Ralls, the Court decided on the basis of evidence provided, that the directors ought to have concluded there was no reasonable prospect of the Company avoiding insolvent liquidation when it became clear that the businessman who was promising to inject a large, and vital sum of money was not actually going to put in the cash.
The directors argued that right until the end the bank was not putting pressure on them and that the summer trading was going quite well. BUT they had to admit that if they didn’t get in the large cash injection the company would have to go into a formal process. They were guilty of wrongful trading from the day when it should have been obvious to them that promises of money were not going to be honoured.
The arguments about what, if any contribution they should pay to the creditors in this particular case focused on the net deficiency for the Company, the dates when this occurred, and also the level of extra losses which could be attributed to the Company going into liquidation (which could not be laid at the directors’ door). Arguments were put forward about new credit being obtained during the period after the directors should have realised the Company could not avoid insolvent liquidation and the Company going into a formal insolvency process. While the court criticised the directors for their actions relating to new credit being obtained, the case was decided by reference to what was the net deficiency of the Company and whether it was increased between the date they should have pulled the plug and the actual date of death.
The court criticised the low calibre of expert information provided at the trial, which saw experts unable to agree whether the continued activity made the creditors’ position worse, improved the overall position or whether the position stayed the same! As there was no definite quantifiable loss for the period between the date the directors ought to have concluded the Company could not avoid insolvent liquidation and the death of the Company i.e. a loss attributable to their wrongful trading, no order could be made against the directors for a contribution. They were rather fortunate.
It is evident that while in this particular case the Directors were not required to make a contribution to the assets of the Company, the bigger picture that all turnaround practitioners acting as directors need to be aware of is:
- Being balance sheet insolvent is wholly different in law from the company being in a position where it cannot avoid insolvent liquidation or insolvent administration.
- That in the event of being unable to avoid insolvent liquidation (or administration) and continued trading, directors will be expected to show that they have taken all steps to minimise losses AND that they have designed their plan to minimise risk to creditors and have considered the position regarding new creditors AND that they recorded their decisions and have taken expert independent advice.
- Failure to consider all of these points, and to document matters adequately will leave directors open to attack under Section 214 and another recent case called Brooks v. Armstrong (2015) holds that the onus is on the directors to show that they did take the right steps, rather than on the liquidator to show that they didn’t.