Directors concerned about insolvency must be aware of wrongful trading, fraudulent trading and their consequences. Failure to understand or act on these concepts can have severe consequences for your business, your reputation and even your personal life.
The Insolvency Act of 1986 introduced wrongful trading to build on the notion of fraudulent trading. It’s a much more common offence, as it's not a criminal act and often done unwittingly.
To prepare you if your company enters insolvency, we’ll explore both wrongful and fraudulent trading and explain how they work.
It should be noted that due to the Coronavirus pandemic, emergency legislation has been enacted that allows some relaxing in the rules surrounding wrongful trading. The idea is that directors will not be held personally liable if they continued to trade when the situation was so unclear going forward. However since this legislation has been enacted there have been lots of forms of support in loans etc. If this money is being used to prop up an already failing business and it is reasonable to see that the money will run out then it could be construed that the directors are trading wrongfully. Similarly, how directors use any loan funds received by the company also needs careful consideration. Directors are now coming under scrutiny, and sometimes even attack, because of misrepresentations in loan applications, or misuse of the funds once received.
The relevant section below;
Suspension of liability for wrongful trading: Great Britain
(1) In determining for the purposes of section 214 or 246ZB of the Insolvency Act 1986 (liability of director for wrongful trading) the contribution (if any) to a company’s assets that it is proper for a person to make, 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.
(2) In this section the “relevant period” is the period which—
(a) begins with 1 March 2020, and
(b) ends with 31st March 2021.
There are of course exceptions as some companies have not been adversly affected by the pandemic so
What is wrongful trading?
Wrongful trading or 'trading irresponsibly' is a civil offence and is covered by section 214 of the Insolvency Act 1986
According to the 1986 Act, it occurs when company directors have continued to trade when:
- “They knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation”
- They did not take “every step with a view to minimising the potential loss to the company’s creditors”
Essentially, directors must be found to have acted reasonably and responsibly in the time preceding the company’s insolvency to avoid wrongful trading proceedings. They must always have put creditors' interests first, and not worked for their own benefit.
If directors are found guilty of wrongful trading, they can be held personally liable for the company’s debts from the point they knew the company was insolvent.
In some cases, they can also be disqualified from being a director, fined or even imprisoned.
What Actions Constitute Wrongful Trading?
The liquidator, who must be an insolvency practitioner, determines if wrongful trading has occurred. This occurs during their mandatory assessment of the director’s conduct. There is a six-year limitation period, so you will not be charged after this time has passed.
Here are some examples of behaviour or actions they’ll look for:
- Not filing annual returns at Companies House
- Failing to file annual or audited accounts at Companies House
- Not operating the PAYE scheme correctly, failing to pay PAYE and NIC when due and building up arrears
- Failing to operate the VAT scheme correctly and building up arrears
- Taking excessive salaries that the company cannot afford
- Repaying a director loan made to the company while other creditors were not paid
- Trading while insolvent
- Taking credit from suppliers when there was ‘no reasonable prospect’ of paying the creditor on time
- Wilfully piling up debt
- Taking deposits from customers when you know the product or service will not be delivered.
You will be at risk of being accused of wrongful trading if you have engaged in any of the above. To avoid this, you must always act in the creditors' best interest. This even means prioritising their payments over personal and bank guarantees.
It’s important to note that wrongful trading can only apply in terminal insolvency.
Put simply, this means it can only apply when the business is no longer viable. It will only begin after formal insolvency proceedings, such as liquidation or administration.
However, if there is no insolvency event and you still partake in suspicious behaviour, be very careful. Keep records of all actions concerning these points, as well as of board and shareholder meetings. This may protect you in the future.
What can you do?
Consult insolvency experts and try to act pre-emptively if you are concerned about wrongful trading. You could also try:
- Time to Pay arrangements
- Company Voluntary Arrangements
- Creditors Voluntary Liquidation
There are many options available, all of which could help demonstrate you acted reasonably and appropriately for the situation. It's best to try these, as you cannot be charged with wrongful trading until your business has ceased to trade (usually through voluntary or compulsory liquidation).
What is fraudulent trading?
Fraudulent trading is a criminal offence, therefore much more serious than wrongful trading.
The main difference between the two is intent. Directors who take part in fraudulent trading have a clear intent to deceive and defraud their creditors and customers.
However, the Insolvency Service must prove intent, so a thorough investigation will take place.
Directors are most likely to be charged with fraudulent trading if they have tried to maximise money coming in prior to liquidation.
The liquidator will report findings of wrongful trading first, then accuse the director of fraudulent trading if required.
The punishments (although similar to wrongful trading) are more severe. You may be:
- Held personally liable for a larger proportion of the company's debts
- Given a longer disqualification
- Fined more for your actions
- Sent to prison - this is much more likely for fraudulent trading
Both wrongful trading and fraudulent trading can have a severe impact on your professional and personal life, so should be avoided at all costs.
Categories: Implications for Directors
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Please note that the guide includes updates due to Covid-19 For instance there have been some changes to insolvency legislation that limits creditors actions and relaxes rules regarding wrongful trading. A new 20 day moratorium for distressed businesses has also been introduced.