The Role of Wrongful Trading Provisions in Insolvency Law - Essay Example

The Role of Wrongful Trading Provisions in Insolvency Law By Introduction Section 214 of the Insolvency Act 1986 seeks to regulate the trading behaviour of directors when companies are experiencing financial difficulties.1 Under Section 214, directors can incur personal liability for the company’s debt should they trade in circumstances where they knew or ought to have known that the company was heading for insolvency.2 The key test under Section 214 relative to determining a director’s liability is whether or not in the circumstances there was no “reasonable prospect that the company would avoid going into insolvent liquidation.”3 For the most part, Section 214 has two main purposes: to protect creditors from incurring additional losses and to so far as possible salvage the company or some part of it as a “going concern”.4 This paper analyses the role of the wrongful trading provision of the Insolvency Act 1986 in insolvency law. In general there are two opposing perspectives relative to the rationale for the insolvency provision. On the one hand it is argued that Section 214 unnecessarily constrains directors’ ability to take appropriate actions to salvage the company in instances where the company is heading for insolvency. It is generally argued that company directors will necessarily take risks when a company is suffering financial difficulties with the hope that the company can be saved from insolvency.5 On the other hand it is argued that it is precisely because directors are compelled to take risks while the company is suffering financial difficulties that Section 214 was enacted.6 Both sides of the argument are examined in this paper. The Wrongful Trading Provision of the Insolvency Act 1986: Background The Cork Report indicates that Section 214 of the Insolvency Act 1986 was necessitated because existing laws regulating fraudulent trading had failed to control risky corporate behaviour in circumstances where the company was experiencing financial difficulties.7 The main purpose of Section 214 is to reduce the risk of loss to creditors who are already confronting the prospect of the company’s assets shrinking to such an extent that it is unlikely that they would recover all of their debts from the company should it go into insolvency.8 Section 214 of the Insolvency Act 1986 provides that “in the course of winding up of a company,” that a director may be liable to contribute to the assets of a company if: ...at some time before the commencement of the winding up of the company, that person (the director) knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation...9 Therefore Section 214 places a duty on directors to closely monitor the company’s financial well-being and to act both competently and responsibly, especially where it appears that the company is heading into insolvency.10 Section 214 goes farther to provide that court will not make a declaration of directors’ liability for wrongful trading if there is satisfactory evidence that the director: ...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.11 Thus the liquidator seeking a Section 214 declaration must provide satisfactory evidence that the director in question did not take steps calculated to reduce or minimize the potential loss to the company’s creditors, but also that the director knew that the company’s insolvency was inevitable. Whether or not the director knew or ought to have known that the company’s insolvency was inevitable is an objective test.12 An instinctive reaction to Section 214 of the 1986 Act is perplexity over what would amount to steps for minimizing the loss to creditors of the company.13Obviously, a director might consider burrowing funds as a means of rescuing the company from eminent insolvency.14 However, Section 214 of the 1986 might consider this kind of action wrongful trading, notwithstanding the fact that it is a step that a competent director might consider as a means of rescuing the company from impending insolvency. Thus it can be argued that Section 214 is a double-edged sword. Wrongful Trading under Insolvency Law in the UK and Asia In a majority of common law countries or countries which have laws originating from the English tradition, there are legislative provisions forbidding fraudulent and wrongful or insolvent trading.15 Singapore’s Companies Act 1967 (as Amended in 2006) contains a wrongful trading provision similar to that of Section 214 of the Insolvency Act 1986. In this regard, Section 339(3) of the Singapore’s Companies Act 1967 provides that when a company is being wound up, any “officer of the company who was knowingly a party to” incurring a debt and at the relevant time, had “no reasonably or probable ground of expectation, after taking into consideration the other liabilities...of the company” when the company was solvent, will be “guilty of an offence”.16 Thus like Section 214 of the Insolvency Act 1987, Section 339(3) of Singapore’s Companies Act imposes a duty on company officers to refrain from incurring company debts in circumstances where there are no reasonable prospects for the company to discharge those debts. In other words there is a duty “not to recklessly incur debts”.17 As in the UK, Singapore requires that its company directors closely and carefully monitor the company’s financial health with a view to minimising losses that have accrued to the company’s creditors where the company is confronting insolvency. The only real difference is that wrongful trading during insolvency in Singapore incurs criminal liability whereas in the UK, the director faces personal liability in respect of the company’s debts. However, once a director is convicted of a criminal offence under Section 339(3) of Singapore’s Companies Act 1967 (as amended), liquidators, as in the UK, may make an application for attaching personal liability to the convicted directors.18 It would therefore appear that it is more difficult to obtain an order for attaching personal liability under Singapore’s company legislation than it would be in the UK. In Singapore, it is necessary to first establish criminal liability before moving ahead with personal liability. In the UK, liquidators are free to move forward with respect to establishing civil liability immediately. This means that in the Singapore that the standard of proof is much higher since criminal liability must be established first. Under civil law the standard of proof is merely to establish the facts on a balance of probabilities whereas in criminal law facts must be proven beyond a reasonable doubt.19 Malaysia’s companies legislation contains a wrongful trading provision very similar to that of Singapore’s and effectively creates a significant barrier to protecting creditors from irresponsible corporate trading where the company is facing insolvency.20 Therefore it is more difficult to obtain an order for personal liability in Singapore and Malaysia than it is in the UK. The rationale for the protection of creditors from the reckless behaviour of directors is found in the ruling of Winkworth v Edward Baron Development Co. Ltd. in which it was ruled that companies have a duty to safeguard the company’s assets in favour of creditors. The court goes on to state that: A duty is owed by the directors to the corporation and to the creditors of the corporation to ensure that the affairs of the corporation are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors.21 According to Anderson, the court’s view of director’s responsibilities toward creditors when a company is facing insolvency informs the basis of Singapore’s insolvent trading law.22 Hong Kong on the other hand has always closely followed the insolvency laws of the UK.23 When the Insolvency Act 1986 was passed in the UK, there were expectations that Hong Kong would pass a similar statutory provision. However, no such enactment took place although Hong Kong’s Law Commission formed a Sub-Committee on Insolvency in 1990. The only measures taken were amendments to Hong Kong’s Bankruptcy Ordinance which were implemented in 1996. The Law Commission’s recommendations now known as the Companies (Amendment) Bill 2000 and Companies (Corporate Rescue) Bill 2001 which make provision for a wrongful trading clause very similar to Section 214 of the Insolvency Act was proposed.24 Neither Bill have been passed and the 2001 Bill was particularly problematic since there has been much opposition to the proposed insolvent trading provision that would permit directions incurring personal liability for company debts accrued once a company was going into insolvency or after the company became insolvent.25 At present the only corporate insolvency statute in Hong Kong exist under Section 166 of the Companies Ordinance which is exactly the same as Section 425 of the UK’s Companies Act 1985.26 Under Section 425 of the UK’s Companies Act 1985, members of a distressed company and creditors could come to a “scheme of arrangements” with the court’s approval and the court would approve the arrangements if they were “fair and reasonable”.27 As Leoung explains, under Hong Kong’s Companies Ordinance, a Scheme of Arrangement permits either the company’s directors, shareholders, creditors or liquidators to apply to “the Court of First Instance” with “an explanatory statement, notices of meeting and forms of proxy” demonstrating the proposal for a Scheme of Arrangement.28 In order for a Scheme of Arrangements favouring the interest of creditors to receive the court’s approval it must be agreed to by 75% of the total creditors of the company.29 Therefore the Hong Kong’s Scheme of Arrangements has an advantage for creditors over the UK’s wrongful trading law in that creditors need not wait for the appointment of a liquidator and can take action early on when the company is suffering from financial difficulties. However, the problem with Hong Kong’s current scheme of Arrangements is the fact that what amounts to financial difficulties is not clearly defined and even so, it is not always possible to know whether or not the company is actually in financial distress. Moreover, as Leoung points out, given the different classes and interests of creditors it will be entirely difficult to obtain a 75% consensus for a Scheme of Arrangements.30 Disadvantages of Wrongful Trading Provisions One of the most controversial aspects of the wrongful trading provision in insolvency proceedings is the fact that is attracts personal liability to directors.31 This has led commentators and academics to speculate that any insolvency provision or any company law provision that effectively threatens a director with personal liability is intimidating and could result in otherwise responsible and competent executives refusing to take on the role of corporate director.32 Daniels argues that when personal liability is assigned to directors for any reason whatsoever, there is always a danger that companies will have difficulties attracting top-notch talent and this cannot be good for companies, shareholders, creditors and the wider class of stakeholders.33 The obvious implications are that companies will be managed by bottom-level talent and as a result confidence in companies will be diminished and obviously companies will have a difficult time finding creditors. Although, there is nothing to indicate that companies are failing to attract top talent to run and manage their affairs, despite wrongful trading provisions, Daniels insist that there is evidence that the threat of personal liability on directors is driving directors out of companies. For example, in British Colombia a statute rendering company directors personal liable for outstanding wages of employees in the event the company became insolvent resulted in 6 directors resigning the moment their company began to suffer financial problems.34 One week later, “the entire board of PWA Corp. resigned en masse from the boards of each of its subsidiaries, including Canadian Airlines Ltd.”35 According to Daniels these latter resignations were also a response to the prospect of personal liabilities for the company’s employee’s wages.36 However, as Keay argues, arguments made against the utility of assigning personal liability to directors on the grounds that it will either cause directors to resign at the first hint of trouble or will discourage talented directors sitting on the board are often short-sighted. For the most part, it is rare that a corporate director who is competent or responsible will feel compelled to resign.37 In addition, contentions that statutory personal liability for directors have not deterred talented directors from accepting or applying for board positions. The reality is, there is no shortage of directors seeking positions within companies.38 In Re Continental Assurance Co of London plc Park J noted in a wrongful trading case, that it is conceivable that if directors were automatically personally liable for the company’s debts when a company was insolvent, it would obviously deter qualified persons joining the board. However, the reality is that only in cases where directors were found to be irresponsible in wrongful trading cases are they usually held liable to contribute to the company’s debts.39 Oesterle argues further that the personal liability assigned to directors under the insolvency statutes including Section 214 of the Insolvency Act 1986 will unnecessarily make directors too risk conscious and therefore overly cautious. Rather than focusing on running the affairs of the company, directors will be too concerned with protecting themselves from the prospect of liability.40 This cannot be a bad thing under the wrongful trading provisions since directors can escape liability by taking steps to minimize the losses accrued to creditors. Thus a careful and responsible director need only ensure that he is aware of the company’s financial health, as he or she should be, and that unnecessary risks are not taken when the company’s financial health cannot support unnecessary risk-taking. Thus in safeguarding against incurring liability, the director should be acting responsibly and competently. Oesterle also argues that courts lack the business acumen to adequately evaluate directors’ conduct under the wrongful trading provisions of insolvency law. According Oesterle, there is always a danger that paid experts and lawyers will only make the job of the courts more difficult. Moreover, it is always possible that the courts will come down on the side of the wronged creditor and against the director who was running the company when it went into insolvency.41 The courts however, have shown a tendency to evaluate the conduct and responsibility of directors fairly and reasonably. For example, Re Purpoint Ltd Vinelott, J. ruled that although it was doubtful that a reasonable director would have allowed the company to trade in circumstances where assets were mostly subjected to loans and cash capital was absent, there was still reason to doubt that the director ought to have known that the company’s insolvency was imminent.42 It was also held in Re Brian D. Pierson (Contractors) Ltd. that in cases of wrongful trading under the laws of insolvency it was necessary to assess the director’s liability realistically and by reference to what is reasonably expected of a business person. In doing so, it must be considered that directors are not as cautious as other professionals such as attorneys and accountants.43 In other words, the court was of the opinion that in applying wrongful trading provisions of the insolvency law, it was necessary to acknowledge the fact that directors do not operate risk free. Thus liability will not be attached merely because the director took some risks. Directors by the nature of the businesses they run must be expected to take some risks. The reality is that courts have demonstrated not only an ability to carefully consider the facts and circumstances of each case, but have demonstrated an ability to fairly assess the behaviour of directors in wrongful trading claims under the insolvency laws. In doing so, courts have demonstrated an unwillingness to simply “second guess” the business decisions of directors.44 At the end of the day, a “responsible” and “conscientious” director will not have to fear the prospect of personal liability under the insolvency law.45 Therefore, if the purpose of the wrongful trading law is to protect creditors from the irresponsible and excessively risky conduct of directors, it also has the added ability to ensure that directors act responsibly and that the keep themselves duly informed of the company’s financial health and that they make business decisions accordingly. As Park J. noted in Re Continental Assurance Co of London plc, directors who have usually confronted personal liability under the wrongful trading provision of the insolvency law have been those who have turned a blind eye: ...to the reality of the company’s position, and carried on trading long after it should have been obvious to them that the company was insolvent and that there was no way out for it. In those cases the directors had been irresponsible, and had not made any genuine attempt to grapple with the company’s real position.46 Keay also points out that a number of observers and scholars argue that the wrongful trading provision of the insolvency laws is unnecessary as creditors have a number of other mechanisms under the law of contract to protect themselves from bad loans.47 The fact is, creditors can negotiate for favourable protection in their contracts with companies. It has also been argued that creditors are free to take out insurance against losses associated with unsatisfied loans and credit facilities.48 While these are valid arguments, there are creditors who are not on equal standing with the companies to which they extend credit. In many cases a creditor is a mere supplier of equipment or goods on a payment plan. Therefore these suppliers will not have the wherewithal to negotiate terms of a contract. As Keay noted, the smaller class of creditors are usually not in a position to obtain insurance coverage.49 Moreover, the main purpose of the wrongful trading law is to temper the reckless and irresponsible behaviour of company directors at a time when the company is suffering financial difficulties and insolvency is inevitable. As previously noted the high standard of proof for fraudulent trading was inadequate to safeguard against instances in which directors acted recklessly and quite often incompetently. Advantages of the Wrongful Trading Provisions The most obvious advantage of the wrongful trading provisions of insolvency law is that it provides creditors with a much needed layer of protection. Creditors have always had a number of rights against debtors under statutory law. However, protection against the conduct of debtors has always been very limited.50 According to Schulte, the purpose of Section 214 of the Insolvency Act 1986 was to “minimise the abuse of limited liability by company officers”.51 Previously, “an honest director could not be liable for a company’s debt despite reckless, unreasonably and cavalier business practices.” 52 Under the fraudulent trading provisions it was very difficult to substantiate a claim that directors had been dishonest in squandering what was left of the company’s assets. Moreover, the courts had established a “strict standard of proof for fraudulent trading” and for the most part, a number of suspicious cases would never get to court.53 Therefore one of the most celebrated advantages of the wrongful trading provisions is that it lowers the standard of proof and places directors under a more acceptable duty of care and ascertains that the behaviour complained of does not have to be fraudulent. According to Schulte: Section 214 measures a director’s conduct against a minimum standard of commercial morality and competence.54 This is very important, because while large creditors such as banks and other financial institutions have the wherewithal to protect themselves by negotiating contract terms and for demanding guarantees, the smaller creditor does not have these resources. The smaller creditor is usually at the mercy of the company directors. For example Jain’s study of the “equilibrium lending arrangement” demonstrates that larger institutional creditors have the wherewithal to negotiate terms of a credit contract that will guide the behaviour of corporate executives while smaller creditors are often forced to leave the corporate executives with autonomy over their investment.55 It therefore follows that the wrongful trading provision is entirely necessary for protecting the interest of smaller creditors who are especially vulnerable to the irresponsible trading of corporate directors when companies are on the brink of insolvency or when the company is already insolvent. Aside from protecting vulnerable creditors, the wrongful trading provision has another advantage: the protection and promotion of commercial morality. According to the Cork Report, the purpose of wrongful trading law is to “support the maintenance of commercial morality” and to establish and enforce higher standards in corporate responsibility.56 Regardless, as Keay notes, establishing and enforcing commercial morality is a particularly elusive goal since it is difficult to define and even more difficult to enforce.57 Regardless, the general feeling is that the shifting liability from shareholders to directors at a time when the company is in trouble draws attention to the duty of directors. Arguably, when a company is in financial trouble, it is directors that are looked to for making decisions to rescue the company, particularly since they failed to prevent the company’s pending demise. Moreover, as noted in Re Oasis Merchandising Services Ltd there is a public element to wrongful trading under the insolvency law.58 For example when a director is found liable for wrongful trading within the meaning of Section 214 of the Insolvency Act 1986, that director is liable to be disqualified as a director under S. 10 of the Company Directors’ Disqualification Act 1986.59 In this regard, a director’s disqualification is typically permitted on the grounds that the director committed an act in breach of commercial morality.60 In the final analysis, the wrongful trading provision of section 214 of the Insolvency Act 1986 serves a wider purpose than merely protecting the interest of creditors, especially the smaller and more vulnerable creditor. The wrongful trading provision of the insolvency law is intended to protect and promote the commercial integrity of corporations and to promote public confidence in the business community. Perhaps more importantly, the greatest perceived advantage is that corporate directors will act more responsibly during insolvency or where companies are on the brink of insolvency with view to salvaging whatever assets remain with the company for the benefit of not only the creditors but for the business environment as a whole. Conclusion The wrongful trading provisions of the insolvency laws have been for the most part criticized as unnecessary and harmful to companies. It has been argued that shifting liability from shareholders to corporate directors is unduly harsh and will harm corporations in terms of attracting talent and keeping talent. However, these fears have not come to fruition and are not supported by empirical evidence. The purpose of the wrongful trading provisions and its role in insolvency law has been demonstrated by the courts. In general the courts have only directed that corporate directors act responsibly and closely monitor the financial health of the companies they manage. Bibliography Textbooks Anderson, Helen. Directors’ Personal Liability for Corporate Fault: A Comparative Analysis. (The Netherlands: Kluwer Law International, 2008). Blazey-Ayoub, P.J. Conomos, J.W. and Dorris, I. Concise Evidence Law. (Sydney, Australia: The Federation Press, 1996). Charkham, Jonathan andSimpson, Anne. Fair Shares: The Future of Shareholder Power and Responsibility. (Oxford, UK: Oxford University Press, 1999). Finch, Vanessa. Corporate Insolvency Law: Perspectives and Principles. (Cambridge, UK: Cambridge University Press, 2002). Oesterle, Dale, A. ‘Corporate Directors’ Personal Liability for “Insolvent Trading” in Australia, “Reckless Trading” in New Zealand and “Wrongful Trading” in England: A Recipe for Timid Directors, Hamstrung Controlling Shareholders and Skittish Lenders’. In Ian M. Ramsay, Company Directors’ Liability for Insolvent Trading, (Melbourne, Australia: CCH Australia Limited and Centre for Corporate Law and Security, 2000), 19-42. Westbrook, Jay Lawrence. A Global View of Business Insolvency Systems, (Washington, D.C.: The International Bank for Reconstruction and Development/The World Bank, 2010). Yeo, Victor; Lee, Joyce; Hanraham, Pamela; Ramsay, Ian and Stapledon, Geof. Commercial Applications of Company Law in Singapore. (Singapore: CCH Asia Pte Limited, 2008). Journal Articles Bachner, Thomas. ‘Wrongful Trading Before the English High Court Re Continental Assurance Company of London Plc, (Singer v Beckett)’. (2004) 5 European Business Organization Law Review, 195-200. Chu, Tina and Young, Angus. ‘Legislative Proposals to Codify Directors’ Liability for Insolvent Trading in Hong Kong: A 10-Year Journey.’ (2010) 18(3) Insolvency Law Journal, 158-168. Daniels, Ronald, J. ‘Must Boards Go Overboard? An Economic Analysis of the Effects of Burgeoning Statutory Liability on the Role of Directors in Corporate Governance.’ (1994) 24 Canadian Business Law Journal, 229-258. Davies, Paul. ‘Directors’ Creditor-Regarding Duties in Respect of Trading Decisions Taken in the Vicinity of Insolvency’. (March 2006) 7(1) European Business Organization Law Review, 301-337. Horrigan, Bryan. ‘Duties and Liabilities – Where Are We Now and Where are We Going in the UK, Broader Commonwealth, and Internationally?’ (January 2012)13(2) International Journal of Business and Social Science, 21-45. Keay, Andrew and Murray, Michael. ‘Making Company Directors Liable: A Comparative Analysis of Wrongful Trading in the United Kingdom and Insolvent Trading in Australia’. (2005) 14 International Insolvency Review, 27-55. Keay, Andrew. ‘Wrongful Trading and the Liability of Company Directors: A Theoretical Perspective.’ (September 2005) 25(3) Legal Studies, 431-461. Keay, Andrew. ‘The Insolvency Factor in the Avoidance of Antecedent Transaction in Corporate Liquidations.’ (1995) 21 Monash University Law Review, 305-333. Leung, Yohah, Ka Lok. ‘Corporate Rescue in Hong Kong- The Way Ahead.’ (2010) 3(1) KHU Global Business Law Review, 1-27. Mokal, Rizwaan, J. ‘An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives and the Creditors’ Bargain.’ (June 2000) 59(2) The Cambridge Law Journal, 335-369. Jain, Neelam.‘Monitoring Costs and Trade Credit.’ (Spring 2001) 41(1) The Quarterly Review of Economics and Finance, 89-110. Schulte, Richard. ‘Wrongful Trading: An Impotent Remedy?’ (1996) 4(2) Journal of Financial Crime, 38-46. Schwarcz, Steven, L. ‘Rethinking A Corporation’s Obligations to Creditors’. (1996) 17 Cardozo Law Review, 647-689. Smart, Philip and Booth, Charles, D. ‘Reforming Corporate Rescue Procedures in Hong Kong.’ (December 2001)1(2) Journal of Corporate Law Studies, 485-499. Varallo Gregory, V. and Finkelstein, Jesse, A. ‘Fiduciary Obligations of Directors of the Financially Troubled Company.’ (November 1992) 48(1) The Business Lawyer, 239-255. Official Papers Insolvency Law Review Committee, ‘Insolvency Law and Practice’ (1982) Cmnd 858, HMSO. Cases Re Continental Assurance Co of London plc [2001] BPIR 773. Re Dawson Print Group Ltd (1987) 3 B.C.C. 322. Re Oasis Merchandising Services Ltd[1994] BCC 911. Re Produce Marketing Consortium Ltd (No 2) [1989] 5 BCC 569. Re Purpoint Ltd [1991] BCLC 491. Re Sherborne Associates Ltd. [1995] BCC 40. Rubin v Gunner & Anor [2004] EWHC 316. Winkworth v Edward Baron Development Co. Ltd. [1986] 1 WLR 1512. Statutes Companies Act 1967 (Singapore) (as amended). Company Directors’ Disqualification Act 1986. Insolvency Act 1986. Read More