Wrongful trading or misfeasance? Claims against directors

Claims against Directors – Wrongful trading or misfeasance?

On 8^th February, Frettens’ resident insolvency guru, Malcolm Niekirk, delivered one of his popular coffee break briefings to over 100 insolvency practitioners and solicitors.

These coffee break briefings are delivered monthly and are completely free to attend. You can sign up for Malcolm’s newsletter and receive your invitations to future briefings here.

Wrongful trading and misfeasance resources

If you have already attended the webinar and would like to download the accompanying slides, you can do so here.

You can watch the full presentation here – it’s about half an hour long.

Wrongful trading and misfeasance

This article summarises the key points covered, including (quick links):

• The problems with wrongful trading
• What you need to prove for wrongful trading claims
• Companies Act misfeasance claims and what you need to prove
• Other uses for misfeasance claims
• Wrongful trading and disqualification orders

What do liquidators need to prove in a wrongful trading claim?

There are three elements that you need to prove as a liquidator or administrator for a wrongful trading claim:

1. A tipping point
2. Lack of skill or knowledge from a director
3. Financial loss

What is a tipping point in insolvency?

This is a particular moment in time where the director knew that the company was not going to avoid an insolvent liquidation or administration.

What is a ‘lack of skill or knowledge’ in wrongful trading?

A lack of knowledge or skill is demonstrated by showing that a reasonable director (with this director’s skill, knowledge and experience) should have been able to realise that the company was about to go over the tipping point.

Proving financial loss in wrongful trading claims

Liquidators or administrators must show what a reasonable director would have done differently or sooner, and how this action would have softened the damage or financial loss.

How can a director defend a wrongful trading claim?

A director can defend a wrongful trading claim even if a liquidator proves the three criteria, by proving they did all that they could to minimise the creditors’ losses.

It is worth noting here that if a liquidator proves financial loss, then it would be extremely difficult for a director to prove they did all they could to prevent it. The two points are almost mutually exclusive.

Temporary relaxation of wrongful trading legislation

As a result of the COVID pandemic, there is a temporary relaxation of the wrongful trading legislation.  It started in March 2020 and is due to end on 30^th April 2021, though the legislation is flexible, so this date may change.  it is actually made up of two periods, set under two different pieces of legislation, with a gap of nearly two months between them (in October and November 2020).

These restrictions apply to claims under the Insolvency Act, but not necessarily to those under different legislation. They do help the directors of financial services businesses.

Conditions of the wrongful trading relaxation

The court is to assume that the person is not responsible

• for any worsening of the financial position
• of the company or its creditors
• that occurs during the relevant period…

The relaxation does not apply:

• To any other claims or duties;
• To financial services businesses (see the lists in schedule ZA1 IA’86).

Problems with proving wrongful trading

Proving the trigger date

There are three stages to this part, all of which need to be proven. There are obvious issues and complications with all of these.

Malcolm speaks about these issues in detail in the briefing, which you can watch here (this section starts at around 7 minutes).

1. Proof of the company’s financial condition on any given date.
2. Proving that meant insolvency was inevitable.
3. Proving that a particular director should have realised that.

• With expert forensic evidence - too complicated?
• Without expert evidence - insufficient evidence?

Proving loss

With expert forensic evidence - risk of confusion over what is evidence for:

• Trigger date
• Loss

As a result of these relaxations and changes, wrongful trading, for now, is not a route that liquidators and administrators can realistically consider.

Misfeasance as an alternative to wrongful trading

As wrongful trading is difficult to prove at the best of times, and now subject to these extra relaxations, it is worth considering misfeasance as an alternative when claiming against a director.

If a director is believed to have been trading whilst insolvent and it was not reasonable to do so, then this could be a more suitable process.

What is misfeasance?

Misfeasance is wrongful action taken by a director, with reference to their duties as a director.

Is a director personally liable for losses if guilty of misfeasance?

If a director is found to be guilty of misfeasance, then they can be made personally liable for losses to shareholders or creditors, and can be made to pay compensation to the company as a result.

What are the duties of directors?

These are set out in the Companies Act 2006 ss171-177. The main duties of directors relevant for claims of misfeasance are outlined as follows:

Directors must:

• Act constitutionally
• Promote the success of the company (for its members / creditors)
• Use independent judgement
• Use reasonable skill, care and diligence
• Manage conflicts of interest
• Not be corrupt

This applies to named directors, shadow directors and de facto directors.

Misfeasance: Directors’ duty to act in good faith

Section 172 is perhaps the most useful definition of those duties.

Under s172, a director’s duty is to:

• Act in good faith
• As they consider likely to promote the success of the company
• For its members’ benefit
• (Or, in some cases, for its creditors’ benefit)
• And in doing so, think about:
  • Long term consequences of decisions;
  • Employees, suppliers, customers, the community and environments;
  • Reputation;
• Treat shareholders fairly

The key points here for misfeasance claims is to promote the success of the company and acting in good faith.

Do you have to prove that liquidation was inevitable in a misfeasance claim?

As a liquidator or administrator, you do not need to prove that liquidation was inevitable at any specific moment in order to prove misfeasance.

You can examine decisions made after certain points, referencing accounts, and ask a director to explain how those decisions were made in good faith.

Take the example of a business which had a negative net worth for nearly two years with further losses on the deficiency account before liquidation started.  A liquidator could ask what decisions were made in good faith to promote the success of the company after the date of the last accounts.

Malcolm talks through an example on the recording, at around eleven minutes.

Misfeasance vs Wrongful Trading

We can see why misfeasance may be an easier claim to prove and bring to court that wrongful trading, especially in the current environment. I will now take a look at some of the common scenarios.

Transactions at an undervalue

To claim under the Insolvency Act (for a transaction at an undervalue), a liquidator would need to prove that a transaction was financially disadvantageous, that the company was technically insolvent, and that it was relatively recent (for example in the last two years, or six months before the appointment of an IP, depending on any connection with the other party).

Under the Companies Act (misfeasance), an administrator does not need to prove the insolvency element. An undervalue transaction is simply not promoting the success of the company and the company is entitled to be compensated (for the loss to either the shareholders or creditors). There is also no time limit (other than the normal ones for bringing legal proceedings) and a director can be personally liable, even if they were not the beneficiary of their actions.

Preferences

The following are all very British reasons to bring a claim under the Insolvency Act (for preferring a creditor). Essentially a director here has to be shown to have given preferential treatment to certain creditors.  These are the basic elements for a claim:

• Queue jumping
• Bad faith
• The Company was technically insolvent
• As formal insolvency approached

Under the Companies Act (misfeasance), these points do not need to be proven in the same way. Instead, you are entitled to ask how decisions promoted the success of the company and for the director to explain how they were taken in good faith.

With misfeasance claims, the director needs to prove they were acting in good faith where there is an obvious connection between them and the beneficiary.

As with transactions at an undervalue, a misfeasance claim can be easier to prove and subject to less restrictions than a preference claim.

Malcolm discusses this in further detail around 18 minutes on the recording.

Relief for misfeasance compensation

The court can mitigate damages that a director has to pay in terms of compensation if they believe the director was honest, acted reasonably and it is fair to let them off, however a director has to PROVE that they were both honest and reasonable in their actions.

Wrongful trading and seeking a disqualification Order

If a liquidator wins a wrongful or fraudulent trading claim against a director, then the court has an automatic right to disqualify the director with the Order it makes.

A disqualification can be up to the full term of fifteen years.

A liquidator does not NEED to request this, the court is entitled to do so on its own under section 10 of the Company Directors Disqualification Act 1986.

Section 10 can therefore be a handy negotiating tool for liquidators and administrators when dealing with rogue traders and negotiating an out of court settlement.

Misfeasance and wrongful trading: Our insolvency guru’s summary

Advantages in bringing a misfeasance claim over a wrongful trading claim

The main advantages of bringing a misfeasance claim against a director are that it can be easier to prove and not subject to the same current restrictions.

Whilst undervalue transactions and preference claims are slightly more nuanced, you can actually pursue the director personally for compensation for loss suffered by the company.

The two are, however, not mutually exclusive alternatives to one another, and a liquidator could consider s172 (Breach of duty) as something to add to any letter when asking a director to explain their actions.

Legal advice on misfeasance and wrongful trading

If you are an insolvency practitioner and would like to discuss any issues surrounding misfeasance and wrongful trading, please don’t hesitate to get in touch with Frettens’ Insolvency Guru, Malcolm Niekirk.

If you haven’t already, be sure to register for Malcolm’s newsletter to receive up-to-date information and insights in insolvency law, and invitations to his monthly ‘coffee break briefings’.