There is often confusion between the three terms in this heading, but there are distinct differences between each:
Wrongful trading is when a company has entered into insolvent liquidation and prior to the commencement of the winding-up the directors knew or ought to have known that there was no reasonable prospect that the company would avoid insolvent liquidation.
Wrongful trading is a civil offence, so directors found guilty can be held personally liable for the company’s debts. They may also face disqualification as a director for a period of up to 15 years.
Directors have a defence if they can demonstrate that they took every step to minimise the potential loss to creditors.
If we look at a typical example where a company has one remaining building project to complete. It will take approximately 1 month to finish and cost £30,000 in labour, materials and overheads. Once complete, a final payment of £100,000 will be paid to the company by a reputable customer. The company stands to make a £70,000 net profit.
There are no other jobs in the pipeline and the directors know that the company cannot pay all of its liabilities, which currently total £200,000.
The directors wish to complete the project. In this situation, it is important that the directors produce sufficient supporting cash-flows and file notes to demonstrate their reasoning to continue to trade. The ‘new’ £30,000 creditors will have to be serviced in the normal terms of business. The historic £200,000 of liabilities is to be ring-fenced until the project is complete, following which the company will be required to be placed into an insolvency procedure and the funds distributed pro-rata between the historic creditors.
In the above simple example, it is clear that the decision to continue to trade should produce a benefit for the creditors. If, for some reason beyond the directors’ control, the profit did not materialise, the directors have mitigated the risk of a claim for wrongful trading. This is subject to the Court being satisfied of the directors’ decision making.
Directors should work closely with their accountant and Licenced Insolvency Practitioner to hand hold them through these steps and plan an exit route.
As opposed to wrongful trading where the directors ‘ought to have known’, there is a subtle difference in fraudulent trading where there has been intent to defraud creditors. It is not only limited to directors but can be brought against professional advisors and anyone who can be shown to have been involved in intentionally deceiving and defrauding creditors.
In the case of Walker (Liquidator of Jade Corporate Group of Companies Limited) v Mark Holt , it was decided that the company’s accountant be ordered to contribute to the company’s assets ‘as a result of their knowledge of the fraudulent trades being undertaken by the company’ even though they were not physically involved.
Fraudulent trading is a criminal offence which means that it punishable by fines and/or imprisonment, depending on the severity. However, it is often hard to prove ‘intent to defraud’ because of the burden of proof.
An example of fraudulent trading would be selling tickets to a festival which is never going to be held.
Under the Insolvency Act 1986, there are two clear definitions of insolvency; firstly, a company cannot pay its debts as and when they fall due; and secondly, its liabilities exceed its assets.
There are thousands of companies which continue to trade with a balance sheet that shows a negative figure at the bottom of its accounts, or have missed a payment due to a temporary cash-flow issue. It does not mean that those companies have to cease to trade tomorrow, or I, as a Licenced Insolvency Practitioner, would be working very long days and weekends to keep up with all the work.
The issue which faces those directors and companies is that of ‘temporary financial difficulty’. If we look back at the above example in the discussion on wrongful trading, the company could not continue to trade past the completion of the project due to insufficient future work. Let’s assume that the company is in a similar scenario financially, but has future viable work in the pipeline. Cash-flows are produced and within 6 months the company’s balance sheet is looking much healthier and creditors are being paid on time. Based on the forecast, the company will return to solvency and thus the risk of wrongful/fraudulent trading is mitigated.
However, in situations such as that above, I would still urge directors to produce detailed file notes and compare actual figures against their estimated cash-flows to ensure that they are still on track. If at any time the figures are looking materially different, directors should consider seeking professional advice to review the risks.
If you are a director or have a client who is worried about the financial status of your company or wish to discuss any of the issues in this article, please contact Jon Mitchell on 01392 288555 or email firstname.lastname@example.org
Jon Mitchell is a Licenced Insolvency Practitioner at Thomas Westcott Business Recovery LLP and highly experienced in business rescue, restructuring and insolvency solutions.
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