Potential Liability of Respective Directors

D & R Recruitment Limited is a company specialising in permanent and temporary recruitment of advertising staff, which has traded since 2005. Daksha and Rachel are directors of the company. The company’s initial trading was funded by loans of £20,000 from each of the two directors. These loans were repaid by the company in February 2009.

Daksha and Rachel noticed a significant downturn in trade in early 2008 and since then have found it difficult to pay the debts of the company. They nonetheless decided to continue to pay themselves large salaries, as both have extravagant lifestyles and have no other source of income.

They did not seek advice about the company’s position but believed that they could trade out of difficulties. Both Daksha and Rachel have accounting qualifications and had produced projections showing an upturn in trade in 2009. This did not occur and a winding-up petition was presented by HMRC in September 2009. The company was wound up compulsorily in December 2009.

At some point prior to the winding-up petition being presented, Daksha and Rachel began trading through a new company, D & R Recruitment (Leicester) Ltd. The company has taken on the old employees of the insolvent company in addition to its own employees. Since it began to trade the new company has been running at a loss.

Consider the potential areas of misconduct and whether the directors actions would impact on them personally.

Introduction

This paper discusses the scenario concerning D & R Recruitment Limited and its directors, Daksha and Rachel. Analysis focuses on the potential liability of the respective directors and possible allegations of misconduct that could be laid against them. In particular, indications of wrongful trading and fraudulent trading are assessed.

It is relevant that D & R Recruitment Limited (“the company”) has traded since 2005 and that it was initially funded by two loans of £20,000 from Daksha and Rachel (the company’s directors) respectively. The company first ran into trading problems in early 2008 and it is noted that despite this position, in which the company found it difficult to pay its debts, Daksha and Rachel continued to take “large salaries” from the company and ensured that their initial loans were repaid in full by February 2009. This suggests a degree of recklessness and culpable irresponsibility for which they may potentially be liable under provisions of the Insolvency Act 1986. Wrongful trading and fraudulent trading must be considered: see e.g. Re Brian D Pierson (Contractors) Ltd [2001] [1] and Re Augustus Barnett and Son Ltd [1986] [2] .

Both directors claim they believed the company could trade out of the position and produced projections indicating an upturn in trade later in 2009. This did not materialise and the company was compulsorily wound up in September 2009 by HMRC (HM Revenue & Customs). It is presumed that the HMRC applied to the court for a winding up order as a creditor of the company (for unpaid taxes) by petition under section 124(1) of the Insolvency Act 1986: see e.g. Taylors Industrial Flooring Ltd v M and H Plant Hire (Manchester) Ltd [1990] [3] .

It is also relevant that Daksha and Rachel persisted in their endeavours despite the failure of the company by incorporating D & R Recruitment (Leicester) Ltd, before the winding up of the old company, which is partly staffed by employees of the old company. The new company is continuing to trade at a loss. This may be viewed as a classic example of the so-called “phoenix syndrome”, whereby directors of a company being wound up establish a very similar business, often with a similar name and attempt to continue to trade [4] : Ad Valorem Factors Ltd v Ricketts [2004] [5] .

Wrongful trading

Section 214 of the Insolvency Act 1986 addresses the issue of wrongful trading [6] . This section provides the court with the power to declare company directors liable to make a contribution to company assets in circumstances where a director knew or should have known that the company had no reasonable prospect of avoiding insolvent liquidation, but failed to take every action that should have been taken in order to minimise and limit as far as possible the potential loss to company creditors: Re Hydrodam (Corby) Ltd [1994] [7]

Section 214(2) provides that a person may be called upon to contribute to the assets of a company where:

“(a) the company has gone into insolvent liquidation,

(b) at some time before the commencement of the winding up of the company, that person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, and

(c) that person was a director of the company at that time”

This section is only applicable once a company has entered liquidation with assets that are not sufficient to meet its debts and liabilities (including the costs of the winding up itself): s214(1), (2)(a) and (6). The situation in the scenario under consideration meets these conditions. It would be for the liquidator of D & R Recruitment Limited to apply to court for a declaration to this effect against Daksha and Rachel (s214(1)) [8] .

The key question is obviously whether the actions of Daksha and Rachel meet the section 214 criteria for the imposition of liability? As stated the two directors continued to draw substantial salaries from the company and made sure that their initial loans were repaid in full by February 2009 despite the fact that the company had encountered difficulties in paying its debts and meeting its obligations continuously from early 2008. Under the definitions of law laid down in section 214 it is necessary to establish that Dakhsa and Rachel:

1. Possessed actual or constructive knowledge that insolvent liquidation was inevitable; and that they

2. Failed to take every step to minimise potential loss to creditors.

Section 214(3) provides that Daksha and Rachel have an obligation to take “every step with a view to minimising the potential loss to the company’s creditors” that they ought to have taken. The Insolvency Act 1986 imposes a test of conduct that incorporates both an objective benchmark of performance and a subjective measure in section 214(4). This statutory standard is a central importance to our analysis and is set out in full below:

“For the purposes of subsections (2) and (3), the facts a director of a company ought to know or ascertain, the conclusions he ought to reach, and the steps he ought to take are those that would be known or ascertained, or reached or taken, by a reasonably diligent person having both –

(a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and

(b) the general knowledge, skill and experience that that director has.”

This dual objective/subjective test has now been adopted as the general standard by which to determine a company director’s duty of skill and care in section 174 of the Companies Act 2006 (partly as a consequence of pressure brought to bear in cases including Norman v Theodore Goddard [1991] [9] , Re D’Jan of London [1994] [10] and Base Metal Trading Ltd v Shamurin [2005] [11] .

The issue that would be addressed by the court is whether Daksha and Rachel in their dealings for and on behalf of the company, should have taken steps other than those that they took in order to minimise and limit the potential loss to creditors? The objective standard imposed by section 214(4)(a) will ensure that Daksha and Rachel are judged against the standard of notional directors equipped with reasonable levels of knowledge, skill and experience carrying out the same functions that Daksha and Rachel carried out themselves. All directors must pass this basic threshold of conduct in order to avoid liability under this provision. The fact that Daksha and Rachel both have accounting qualifications is probably not to their advantage in the context of the subjective standard of performance and diligence imposed by section 214(4)(b), which takes into account the personal qualities of the directors in question and may serve to increase the expected standard of conduct.

Daksha and Rachel produced “projections showing an upturn in trade in 2009″, and further investigation would need to be made into the credibility and basis for these projections. It may be that the court finds these projections to have been technical incredible and baseless, and designed merely to justify the continued trading of the company. Daksha and Rachel did not respond to the crisis faced by the company by taking any action that prejudiced their own financial interests. They continued to pay themselves large salaries and made sure that their own debts had been repaid by February 2009, despite the fact that the company had been finding it “difficult” to pay other debts for at least a year prior to that point in time.

The practice of directors securing full repayment of personal loans prior to corporate insolvency is a very well known ploy and where such occurs within two years of commencement of a winding up it will almost invariably be construed as a ‘preferential payment’ and challenged by the company liquidator [12] . In the case Re Brian D Pierson (Contractors) Ltd [2001] [13] directors ensured that a company repaid loans made by them some six weeks before the company went into insolvent liquidation. It was held that the repayment of the directors’ loans was a preference and the court ordered the directors to repay the money to the company. The broad principle of law, which is directly applicable in the case of Daksha and Rachel, is that company directors are not entitled to exploit their privileged position of control to secure reimbursement of their loans to the company ahead of the claims of other creditors. In Re Brian D Pierson (Contractors) Ltd the court endorsed and applied in even more expansive fashion in Re Conegrade Ltd [2003] [14] . This case involved a loan repayment that was disguised as a property transaction and was more ‘arms length’ than the proximate repayment in Re Brian D Pierson (Contractors) Ltd. However, the court in Re Conegrade Ltd nonetheless unequivocally ruled that the de facto repayment had been preferential and again ordered the directors to refund the money.

It seems most likely that Daksha and Rachel would be ordered to repay their personal loans of £20,000 to the company, or at least that proportion of the loans that was paid back by the company after the company first entered into trading difficulties in early 2008.

The fact that a company is trading while technically insolvent does not necessarily lead to a finding of wrongful trading [15] . Wrongful trading will only be found if there is no ‘reasonable prospect’ of avoiding insolvent liquidation: Secretary of State for Trade and Industry v Taylor [1997] [16] . Consequently it is very hard to assess Daksha and Rachel’s position and potential liability with precision, because such would demand a thorough investigation of the company’s books of account and trading activity over the period in question. Simply put, we cannot tell if there was any substance to the pairs’ stated belief that the company could trade out of its difficulties on the basis of the predicted upturn in trade in 2009.

Once insolvency became a real threat (or inevitability) Daksha and Rachel should have consulted a qualified insolvency practitioner and followed his or her advice in relation to the action that should be taken to minimise potential loss to creditors [17] . The fact that they did not do so, but instead continued to get their own loans repaid and receive their generous salaries, is likely to mitigate strongly against them.

Liability for wrongful trading

The nature and potential extent of the general liability faced by Daksha and Rachel for wrongful trading is outlined in case law. In the case Re Produce Marketing Consortium Ltd (No.2) [1989] [18] it was held that directors should be ordered to contribute to the company’s assets an amount which reflects the depletion of those assets that occurred as a result of the directors’ conduct.

The water was muddied somewhat by Re DKG Contractors Ltd [1990] [19] , where it was held that directors should be held liable to pay the amount of trade debts incurred after the point at which they should have known the company would inevitably enter insolvent liquidation. This policy is however manifestly not in accord with Re Produce Marketing Consortium Ltd (No.2) and in Re Purpoint Ltd [1991] [20] the line taken in Re DKG Contractors Ltd was rejected in favour of a Produce Marketing Consortium-based analysis was the increase in the net liabilities of a company caused by the company continuing to trade after its directors should have been aware that liquidation was inevitable.

On the assumption that the Produce Marketing Consortium approach is adopted Daksha and Rachel could well be exposed to extensive personal liability to contribute to the company’s assets [21] . In addition, section 10 of the Company Directors Disqualification Act 1986 provides that a disqualification order may be made against a director responsible for wrongful trading. Any such disqualification may be for a maximum period of 15 years (section 10(2)).

Fraudulent trading

There is also the possibility that Daksha and Rachel could be investigated for fraudulent trading given the facts revealed in the scenario. This is more serious than wrongful trading, because it requires proof that an individual has knowingly carried on the business of a company with and intent to defraud its creditors (or the creditors of any other person), or for a fraudulent purpose [22] . It is less likely that Daksha and Rachel will be found liable for fraudulent trading than wrongful trading given the additional and specific requirements of fraud, and given that a higher degree of proof will be required [23] .

The relevant statutory provision is to be found in section 213 of the Insolvency Act 1986 and any person found to have conducted fraudulent trading may be declared by a court to be liable to make such contributions as the court thinks proper [24] .

There are other serious consequences that Daksha and Rachel could potentially face. A director responsible for fraudulent trading may be prosecuted for the criminal offence of knowingly being a party to fraudulent trading under section 993 of the Companies Act 2006. This is a so-called ‘either way’ offence which can be tried summarily before the magistrates court (in less serious cases) or on indictment before the Crown Court (in more serious cases). The maximum sentence on indictment is ten years imprisonment and a disqualification order is almost inevitable (section 2 Company Directors Disqualification Act 1986).

Even if a director is not prosecuted for this crime (perhaps due to evidential considerations) he or she is still liable to disqualification under section 10 of the Company Directors Disqualification Act 1986 if found responsible for fraudulent trading and the period is disqualification is likely to be considerably longer than that imposed for wrongful trading given the more serious and contrived nature of the conduct in question. As stated it will be much harder to prove fraudulent trading than wrongful trading given that a specific intent to defraud the creditors of the company (or carry on business for any other fraudulent purpose) would need to be proved against the parties: R v Kemp [1988] [25] and Re Gerald Cooper Chemicals Ltd [1978] [26] .

Specifically, as illustrated by leading case law such as Re Bank of Credit and Commerce International SA (No.14) [2004] [27] it would be necessary to prove that Daksha and Rachel:

1) carried on business with intent to defraud the creditors of the company (or of any person) or for any fraudulent purpose;

and

2) participated knowingly in carrying on the business in that manner;

The concept of fraud was discussed in Welham v Director of Public Prosecutions [1961] [28] as follows:

“It requires a person as its object: that is, defrauding involves doing something to someone. Although in the nature of things it is almost invariably associated with the obtaining of an advantage for the person who commits the fraud, it is the effect upon the person who is the object of the fraud that ultimately determines its meaning.”

This analysis was endorsed in R v Alsop (1977) [29] and R v Grantham [1984] [30] , where fraud was defined as ‘an intention to use deceit to induce a course of conduct in another which puts the other’s economic interests in jeopardy’ [31] .

The “phoenix” company

Section 216 of the Insolvency Act deals with situations similar to that described in the final paragraph of the scenario. Under section 216 directors of an insolvent company are prohibited from becoming directors of a new company with a name so similar to that of the old company that the similarity suggests and association within a period of five years from the original insolvency.

The facts involving Daksha and Rachel point to an infringement of section 216 and this is a criminal offence (triable either way – s.216(4)). It should be noted that this is an offence of strict liability (proof of intent to offend is not required): R v Doring [2003] [32] . The names of the two companies are very similar and certainly sufficiently similar in this context: Commissioners of HMRC v Walsh [2005] [33] . Daksha and Rachel also face a potentially draconian civil penalty for their breach of section 216 of the 1986 Act. They may be made personally responsible for all the debts and liabilities of the new company that are incurred while they are involved in its management: Commissioners of Inland Revenue v Nash [2004] [34] .

In summary

Potentially Daksha and Rachel are liable for wrongful trading and less likely, for fraudulent trading. They may as such be held liable to contribute to the company’s assets an amount which reflects the depletion of those assets that occurred as a result of their conduct. They may also be liable to refund their personal loans repaid by the company in February 2009. They are also liable to be disqualified from acting as a company director for a period of time (which is likely to be longer if fraudulent trading is established). Moreover, if they are found responsible for fraudulent trading they may be prosecuted for the criminal offence detailed above.

As for the ‘phoenix company’, so-called because it has risen from the ashes of the original company, Daksha and Rachel are blatantly in contravention of section 216 of the Insolvency Act 1986. In this regard they may have potentially committed an offence and face criminal penalty and in addition a personal civil liability to meet all the new company’s debts incurred while they are concerned in its management.