Insolvency Law: Wrongful and Fraudulent Trading - Essay Example

?INSOLVENCY LAW: WRONGFUL AND FRAUDULENT TRADING By INSOLVENCY LAW: WRONGFUL AND FRAUDULENT TRADING IntroductionDirectors’ duties arising under the Insolvency Act 1986 are best described as an extension of directors’ ordinary duties. Insolvency or pending insolvency exposes directors to an expanded standard of care and broadens the range of possible claimants from shareholders to creditors.1 Although the duties of directors toward creditors of financially distressed companies are decidedly well-documented and codified, there are significant aspects of that duty that are decidedly unclear.2 Among the many cited ambiguities of the relevant directors’ duties, determining whether or not a director breached his/her duties by acting fraudulently or wrongfully pursuant to Sections 213 and 214 of the Insolvency Act 1986 or merely acted incompetently. This paper analyzes the problems attending the ambiguity implicit in the duties and liabilities relative to fraudulent and wrongful trading pursuant to the Insolvency Act 1986. Fraudulent Trading Statutory provisions establishing liability for fraudulent trading employ words like “knowingly”3 and “unfit”.4 The use of these terms of reference in respect of the expanded duties of directors when a company is distressed speaks to liability and a standard of conduct. Obvious questions arise as to whether a corporate director’s standard of knowledge and skill will automatically determine that he was competent and thus dishonest. The test itself is unclear and has been interpreted by the courts in such a way as to suggest that in determining the whether or not the director acted in good faith within the parameters of what is expected of a skilled and knowledgeable director is both subjective and objective.5 Before analyzing the test relative to establishing fraudulent trading and thus a breach of the directors’ duty toward creditors of financially distressed companies, it is necessary to examine the enabling statutes. Section 213 of the Insolvency Act 1986 provides a civil remedy for fraudulent trading. Specifically, Section 213 (1) provides that while a company is “winding up”, “it appears that any business of the company has been” conducted for the purpose of defrauding creditors or “for any fraudulent purpose, Section 213(2) applies.6 Section 213(2) provides that the court may make a declaration pursuant to an application by a liquidator that “any persons knowingly parties to the carrying on of the business” pursuant to Section 213(1) “are liable to make contributions (if any) to the company’s assets as the courts thinks proper”.7 Section 993 of the Companies Act 2006 creates a criminal offence in the case of fraudulent trading calculated to defraud creditors when a company is either insolvent or on the brink of insolvency. Upon conviction, the offender is liable to up to ten years imprisonment and/or a fine.8 Section 6 of the Disqualification of Directors Act 1986 also permits the court to make a disqualification order in respect of a director of a company that became insolvent if his/her conduct was such that it “makes him unfit to be concerned in the management of a company”.9 It is clear that the purpose of these statutory provisions is to guard against illicit trading in circumstances where limited liability prevents company creditors recovering debts from a company that is financially distressed. Thus any director or corporate executive trading “as usual” will likely cause creditors’ irreparable harm.10 Thus laws establishing liability either criminally or civilly are intended to prevent dishonest as opposed to incompetent trading. The word knowingly suggest that fraudulent trading laws are intended to protect creditors and suggest that consciously accruing debts when it is reasonable to assume that the company cannot pay its debts is fraudulent. It is therefore reasonable to assume that the test for determining whether or not a director or executive is acting fraudulent requires specific dishonesty that is separate and apart from his or her competency. The emphasis on competency is captured by Lord Templeman in Winkworth v Edward Baron Development Co. Ltd. who said: A duty is owed by directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited to the prejudice of the creditors.11 The duty described by Lord Templeman is not only broad and requires the director act with specific skill and competency, but also does not articulate deliberate dishonesty on the part of the director. It can thus be concluded here that the director who is incompetent to ensure that the company’s affairs are properly administered is nonetheless dishonest. In this regard, the test is an objective one and assumes that all directors who do not administer the affairs of the company so that the company’s assets are dissipated are doing so knowingly and therefore competently and dishonestly. It was held in Re: Patrick & Lyon Ltd. that fraudulent trading is characterized as “actual dishonesty according to current notions of fair trading”.12 It can thus be assumed that fraudulent trading is an objective test since the trading must be dishonest by reference to a wider understanding of what amounts to fair trading rather than what the director or guilty party understands as fair trading. Even so, the courts continue to blur the line between competency and dishonesty by describing fraudulent trading in dual terms: objectively and subjectively. For instance in R v Grantham the court held that an individual managing a company’s affairs and secures credit for that company knowing that the funds cannot be repaid, is guilty of acting with a specific intent to defraud creditors.13 Thus in this case the offender must have knowledge that the funds borrowed cannot be repaid and thus suggests that a director may act in good faith thinking that the borrowed funds may rescue the company from financial distress. Yet, the objective nature of the test as articulated in Re: Patrick & Lyon Ltd does not allow for a subjective consideration of what was operating on the director’s mind when he/she obtained credit for a financially distressed company. It was further held in Re: William C. Leitch Bros. Ltd that a director acts dishonestly when he obtains credit or conducts a business transaction when he knows that the debt created thereby will very likely never be repaid.14 Again it was held in Re: L. Todd (Swanscombe) Ltd. that there must be a finding that the director acted dishonestly and not unreasonably.15 Thus it is difficult to satisfy a court that a director had the necessary knowledge and thus the necessary intent to defraud. Given that dishonesty must be distinguished from competency and reasonable business standards, it is easy to understand why a previously mandated jury trial would have had unsatisfactory results. Even with the abrogation of jury trials on matters of fraud, a judge still has to be satisfied that the director acted dishonestly and not merely unreasonably. Thus establishing dishonesty and therefore fraudulent trading is difficult. The difficulty with establishing fraudulent trading was illustrated by Morphitis v Bernasconi. In this case, it was held that a single transaction alone could not establish fraudulent trading pursuant to Section 213 of the Insolvency Act 1986. In addition, there must be some connection between the fraudulent transaction and the loss incurred. 16 It is even more difficult to attribute knowledge on the part of an employee who acts fraudulently to that of the company. In Morris v Bank of India it was determined that in applying Section 213 of the Insolvency Act 1986 to situations where a company may be vicariously liable for the fraudulent acts of an employee the court will have to consider whether or not the employee had the requisite agency to bind the company and whether or not the company managers knew or ought to have known of the employee’s fraudulent conduct.17 In the final analysis, fraudulent trading is difficult to prove as the lines between competency and dishonesty are blurred. It is difficult for any tribunal of fact to determine by virtue of the burden and standard of proof pursuant to criminal and civil liability whether or not the defendant acted dishonestly or unreasonably or incompetently. This explains why actions are seldom brought in fraudulent trading.18 Wrongful trading appears to present a more viable option for creditors who suffer losses by the illicit trading of directors when companies are financially distressed. Wrongful Trading Any business transaction that is fraudulent is conceivably fraudulent. Thus it makes sense that if an aggrieved creditor wants to increase his or her chances of success against a company in liquidation or on the brink of insolvency they may wish to pursue an action under Section 214 of the Insolvency Act 1986. Section 214 of the Insolvency Act 1986 provides that a liquidator in respect of an insolvent company may apply to the court for a declaration that a director make “such contribution (if any) to the company’s assets as the courts thinks proper”.19 The application can be made in respect of a de facto director20 as well as in respect of a deceased director by taking action against the deceased director’s estate.21 The declaration however is subject to certain requirements that once again raise the spectre of determining dishonesty and competency. First Section 214 specifically requires that the director “knew or ought to have concluded” prior to the winding up process “that there was no reasonable prospect that the company would avoid going into insolvent liquidation.”22 Thus knowledge and by extension competency is a prerequisite for determining dishonesty. Moreover, Section 214 of the Insolvency Act 1986 goes on to provide that the court will refuse a declaration on the application of the liquidator if the court is satisfied that the director in question: ...took every step with a view to minimising the potential loss to the company’s creditors as (assuming him to have known that there was no reasonable prospect that the company would avoid going into solvent liquidation) he ought to have taken.23 It therefore follows that the liquidator must prove to the satisfaction of the court that the director not only took steps to minimize the creditor’s loss, but that he/she also knew that the company was definitely insolvent. In other words, if the director did not know that the company had not hopes of escaping liquidation he/she would not be under a duty to minimize the potential loss to the creditor and by implication could trade or gamble away the creditor’s assets. Again, the lines between knowledge/competency and dishonestly are entirely tenuous so that an incompetent or unknowing director might gamble away the creditor’s assets without incurring liability under Section 214 of the Insolvency Act 1986. Whether or not a director has the requisite knowledge is defined by Section 214. Pursuant to Section 214, a director is deemed to have the knowledge that a director ought to have and should make decisions according to that general expectation. It is inferred that the directors have “the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director” and “the general knowledge, skill and experience that the director has”.24 Arguably, it will generally be assumed by virtue of this objective test, that an incompetent director is dishonest when he does not reach conclusions or make business decisions in a manner consistent with the criteria set forth in Section 214 of the Insolvency Act 1986. The court made it clear in Rubin v Gunner and Another that a reasonable director was an objective test. For instance directors were entitled to believe that a benefactor’s intentions to provide funding to save a company from liquidation were genuine. This belief was supported by documents provided that implied that the benefactor had the means to provide the funds. However as time passed and certain promises were repeatedly reneged upon, any reasonable director would not have given the benefactor the benefit of the doubt and would have reasonably concluded that the benefactor was not going to rescue the company. Thus the directors were guilty of wrongful trading.25 Again, there is no allowance for the particular competence or skills of the directors involved. The test for competence and skill are widely and generally applied so that an incompetent director is automatically assumed to be dishonest and not careless or prone to taking risks. Conclusion Both wrongful and fraudulent trading exposes directors, de facto or shadow directors to enormous liability in the context of financially distressed companies. Unfortunately, this is a time where company directors are suffering significant stress where they may seek to attempt to salvage the company for the benefit of shareholders and company employees and for themselves. However, the law mandates that they become singularly focused on the interests of creditors. The justification for this approach is based on the notion that the shareholders have lost whatever stake they had in the company and all that remains is the interests of creditors. However, conventional wisdom dictates that looking after the company’s best interest is also for the benefit of the creditors. Be that as it may, the common law and statute both make it virtually impossible for the director to seek reasonable avenues for saving the company. The test for dishonesty is constructed so that wrongful and/or fraudulent trading is either difficult to prove or may only be defended if the director succeeds in salvaging the company by taking risks with the creditors’ assets. In the final analysis, the director’s own personal knowledge and skills are not taken into account so that any director who fails to salvage the company is not merely incompetent, but is dishonest and guilty of fraudulent or wrongful trading. Since fraudulent trading specifically requires proof of intent to defraud, wrongful trading is the typical route that liquidators take. Bibliography Companies Act 2006. Disqualification of Directors Act 1986. Insolvency Act 1986. McKenzie-Skene, D.W. (2007). “Directors’ Duty to Creditors of a Financially Distressed Company: A Perspective From Across the Pond.” Journal of Business & Technology Law, Vol. 1(2): 499-528. Morris v Bank of India (2005) EWCA Civ 693 Morphitis v Bernasconi [2003] EWCA Civ 289. Preetha, S. (April-June 2011) “The Fraudulent Trading Offence: Need for a Relook”. NUJS Law Review, 232-249. Re Hydordan (Corby) Ltd. [1994] 2 BCLC 180. Re: L. Todd (Swanscombe) Ltd. [1990] BCC 125. Re: Patrick & Lyon Ltd. [1933] 1 Ch. 786. Re Sherborne Associates Ltd. [1995] BCC 40. R v Grantham[1984] 3 All ER 166. Re: William C. Leitch Bros. Ltd [1932] 2 Ch. 71. Rubin v Gunner & Anor [2004] EWHC 316. Sealy, L. and Worthington, S. (2007). Cases and Materials in Company Law. Oxford, UK: Oxford University Press. Winkworth v Edward Baron Development Co. Ltd. [1987] 1 All ER 114. Read More