COVID-19: wrongful trading - practical considerations

As businesses seek to adapt to deal with the financial impact of COVID-19, boards of directors have been faced with the difficult decision of having to file for insolvency or take steps to preserve business continuity and live to fight another day. Understandably directors' duties is a topic that has come keenly into focus with directors wishing to ensure that, whatever steps they take, they do not incur personal liability.

Against the backdrop of evolving Government policy, questions have been asked as to whether there would be a relaxing of the wrongful trading provisions of the Insolvency Act 1986 to protect directors from personal liability in potential 'no win' situations. That answer came, to a degree, in the Government briefing on 28 March in which the Business Secretary Alok Sharma, announced that the Government will make changes to UK insolvency law to allow companies some breathing space and potentially avoid insolvency.

One of the changes that was announced is a temporary suspension of the wrongful trading provisions under s.214 of the Insolvency Act 1986 for a period of 3 months (back dated to 1 March 2020). This announcement will no doubt be of some comfort to directors. Views on this within the insolvency profession are clearly mixed, however, with some being of the view that the legislation as it currently stands remains fit for purpose and affords protection to directors acting reasonably, in particular if they act on the basis of professional advice and in accordance with their fiduciary duties generally. There is, accordingly, a concern that the relaxation of the rules could be open to abuse. Whatever view you take, directors will need guidance on how to proceed.

The devil will, as always, be in the detail so what should directors do in the meantime while we await specifics on the proposed changes? In this blog we summarise the law as it stands and provide some practical considerations for directors seeking guidance.

The law as it stands

As the law currently stands (pending formal implementation of the changes which will be backdated to 1 March 2020) directors may be personally liable for wrongful trading if:

1. A company has gone into insolvent winding up or administration (i.e. a formal insolvency process (administration or liquidation) in which creditors will not be repaid in full).
2. At some time before the commencement of the winding up or administration the directors knew or ought to have concluded (based on both the general knowledge, skill and experience that may reasonably be expected of the directors carrying the same functions as the directors in question and the actual knowledge skill and experience of those directors) that there was no reasonable prospect that the company would avoid going into insolvent winding up or administration (the 'Reasonable Prospect Test').
3. After such time, they failed to take every step they ought to have taken with a view to minimising the potential loss to the company's creditors.

A director found liable for wrongful trading may be ordered to contribute to the company’s assets for the benefit of creditors. The contribution will normally be the amount of the reduction in the company's assets available for creditors arising after the time when the company did not pass the Reasonable Prospects Test.

The protection for directors in deciding to continue to trade even if the Reasonable Prospect Test is failed lies in taking every step to ensure that continuing to trade minimises losses to creditors. There is a wealth of case law on what taking "every step" means and each case will turn on its facts but, in general terms, as long as directors make reasoned decisions which are documented and, where necessary, following professional advice, with the reasonable belief (bearing in mind the subjective and objective tests to be applied) that a particular action will minimise losses to creditors, they will not fall foul of the wrongful trading provisions. 

It is also worth bearing in mind, however, that whilst the need to take "every step" to minimise the loss to creditors only technically arises in a wrongful trading context, such steps should be considered as soon as a company is or is likely to become insolvent to ensure that the directors' wider duties to act in the best interests of creditors are not breached.

Where are we now?

We await specifics as to how the law in this area will be changed. Those changes may well address the concerns that have been raised. For those concerned that these changes will be open to abuse, the Business Secretary has advised that "All of the other checks and balances that help to ensure that directors fulfil their duties properly will remain in force". So what are these checks and balances?

There is no suggestion as yet as to whether there will be a relaxation of other fiduciary duties applicable to directors both under statute and at common law which would otherwise be engaged, in particular, and perhaps most notably, the duty to act in the interests of the company's creditors. This duty is triggered once a company becomes insolvent, and shifts from the duty to act in good faith in the best interests of the company for the benefit of its members. There are also a number of offences under the Insolvency Act 1986 which will likely remain relevant and which are usually investigated alongside wrongful trading including, inter alia, fraudulent trading (i.e. where it appears that a business has been carried on dishonestly with the intent to defraud creditors), transactions defrauding creditors, transactions at an undervalue, preferences and misconduct in the course of winding up.

In short, whilst there may be a relaxation of the rules on wrongful trading, given the clear messaging that directors will still be required to act in good faith and with propriety we expect that any relaxation of the wrongful trading rules will only apply to those directors that have acted reasonably and in accordance with their other fiduciary duties. So what should directors be doing when faced with difficult decisions and should the approach to decision making change?

Practical considerations

Given that the changes will be retrospective, the approach taken by directors to decision making should, we think, remain the same as if the wrongful trading provisions continued to apply. Boards of directors should continue to meet regularly to assess the impact of COVID-19 on their business, establishing steering committees where necessary to consider specific aspects of the business. Formal board meetings should be used to discuss recommendations from the committees and make any decisions which have the potential to impact creditors.

Practical considerations for board meetings, where a company is experiencing financial distress should remain as follows:

• Is the company 'insolvent', whether on:
  • a cash flow basis – i.e. it cannot pay its debts as they fall due; or
  • on a balance sheet basis – i.e. its liabilities exceed its assets.
• If the company is insolvent, is there a reasonable prospect of avoiding an insolvent liquidation or administration? Is there funding available or arrangements that can be agreed with stakeholders which will prevent this? This may require discussions with stakeholders and consideration of the various Government initiatives designed to assist companies when faced with business disruption caused by COVID-19.
• If the company does not have a reasonable prospect of avoiding an insolvent liquidation or an administration, take advice on the steps the directors are considering to ensure they are operating within the lines of the law as it stands and (when formally published) the new relaxed provisions.
• Until the new provisions are set out and the position becomes clear, directors should ensure they are acting in accordance with the other duties imposed on them by law to ensure they can demonstrate that any difficult decisions taken to deal with impact of the virus on business were properly and reasonably taken.

To ensure there is a paper trail evidencing the above have been considered all key business decisions which impact creditors should be taken at duly convened and minuted board meetings.

Conclusion

It remains to be seen how this relaxation of the rules will apply in practice and whether it will extend to other fiduciary directors' duties which would otherwise be engaged. Directors should, accordingly, continue to bear these in mind for now as part of their decision making, particularly insofar as those decisions impact on creditors. As with all changes to law following Government briefings at present, this remains an ever changing landscape so we will provide further updates as the details are clarified.