Remedies Available to Liquidators

Abstract

The brief will investigate the remedies available to liquidators under the Insolvency Act 1986 in the event of a false statement by a director and wrongful trading by directors. The brief will discuss the requirements for Section 211 and 214 and 239 of the Act and conclude that the directors will in all probability be liable under Section 211 but that it is not a clear cut case that the liquidator will succeed under Section 214. The brief will conclude that the court will in all probability also set the transaction aside in terms of Section 239 of the Act as it will increase the available funds for the unsecured creditors. The brief will also discuss sales under value and conclude that further investigation will be required to establish this issue. The brief will shortly refer to disqualification of directors and conclude that the directors may be disqualified.

Issues

When it was clear that the company was in financial difficulties, the directors decided against obtaining professional advice as to the financial viability of the company. Did their lack of doing so bring about any liability for them?

Secondly the directors misled the creditors by informing them that they are expecting a large payment shortly which will be utilised to repay the debts due to the creditors. The result of their misleading conduct was to induce the creditors to extend the credit limit of the company. Are they liable for such misleading conduct?

The directors further sold two Mercedes cars to Dipak’s wife and used the proceeds to clear the overdraft facility with the bank. Dipak has provided his house as security for the overdraft and thereby also removed his own liability to the bank. Is the sale of the cars to Dipak’s wife a sale under value or a preference?

Types of Duties

Directors owe three types of duties to the company. The first is to act within his or her powers; secondly a director owes a duty of care and skill and lastly fiduciary duties of a kind that is similar to those owed by an agent to his or her principal. The last mentioned is embodied in different forms the duty of loyalty. [1]

The size and business of the particular company and the experience or skills that the director holds him or herself out to possess will all determine the nature of the duty. [2]

Insolvency Act

The Insolvency Act 1986 [3] provides for malpractice, penalties and investigations and prosecutions of companies and officers of companies.

Section 211

Section 211 of the Insolvency Act provides:

“(1) When a company is being wound up, whether by the court or voluntarily, any person, being a past or present officer of the company—

(a) commits an offence if he makes any false representation or commits any other fraud for the purpose of obtaining the consent of the company’s creditors or any of them to an agreement with reference to the company’s affairs or to the winding up, and

(b) is deemed to have committed that offence if, prior to the winding up, he has made any false representation, or committed any other fraud, for that purpose.

(2) For purposes of this section, “officer” includes a shadow director.

(3) A person guilty of an offence under this section is liable to imprisonment or a fine, or both.”

The directors made a false representation to the creditors. They informed the creditors that they are expecting a large amount of money and will repay the company’s debts. This was clearly untrue. Section 211(1)(a) requires that the statement must be made to the creditors with the purpose of obtaining their consent in relation to the company’s affairs. The directors made the false representation to induce the creditors to wait for payment.

Section 211 (1)(b) creates the assumption that the offence will be deemed to have been committed if a false statement has been made prior to winding up. The onus of proving that the statement was not made for such a purpose rests on the directors. Once the false statement has been proved in court, the directors must show that they did not make the statement to obtain any agreement from the creditors.

The statement is false and it was made to ensure that the creditors give them more time and also to extend the company’s credit. The penalties that they face are imprisonment or a fine of both. [4]

The punishment for a contravention of Section 211 depends on the mode of prosecution. If the prosecution is by way of indictment the punishment is a maximum of 7 years imprisonment or a fine or both and in the event of summary proceedings the punishment is 6 months or statutory maximum or both.

It is clear that the legislature view this type of offence in a serious light and both directors face significant criminal consequences.

Section 214 [5]

Section 214 deals with wrongful trading by a company. The section provides that if in the course of winding up of the company it appears that at some time before the commencement of winding up the director of the company knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, it will amount to wrongful trading.

The section provides for an objective test to determine whether the director ought to have come to the conclusion that the company was not going to be able to avoid insolvency. Section 214(3) provides that the court will not make a declaration under this section if it is satisfied that the person took every step he or she ought to have taken with the view to minimise the potential loss to the creditors. [6]

The objective test is set out in section 214(4) and provides for the reasonable diligent person having the knowledge that could reasonably be expected from a person who carries out the same duties that the director is carrying out and having the general knowledge skill and experience of that director.

Section 215 provides that the court can give directions as the court deems fit for giving effect to such a declaration. [7]

Problems with Section 214

The wrongful trading section of the Insolvency Act has proven to be a disappointment as the impact that it had is low. [8] The section itself does not use the words wrongful trading but gives a description of what will be wrongful trading and should be called irresponsible trading. [9]

Tolmie suggests that the main issues in hearing matters under Section 214 is when the directors should have realised that insolvent liquidation was inevitable. [10]

Section 214 has been introduced in order to require directors to take some action to stop their companies from sliding into insolvency by ensuring that the directors monitor their companies’ health more rigorously. It has been designed to address the situation where the directors can see that the company is in difficulty but do nothing about it.

The insertion of section 214 into the Act was pursuant to the Cork Report’s finding that the existing fraudulent trading provisions were insufficient to curb directors who run up losses when the company is in deep financial difficulty. [11]

Judicial approaches have also not added to the efficacy of the provision. There exists confusion about the role and purpose of the Law. The Cork Report envisioned that civil liability for wrongful trading will balance the requirement of encouraging the growth of companies with the discouragement of irresponsibility. [12]

One of the problems with prosecuting a claim under Section 214 is the lack of funding. Of 92,500 corporate insolvencies in England and Wales only 4 wrongful trading actions reached the court. [13] Liquidators have become hesitant to institute such claims since the finding in Bacon [14] that a liquidator would incur personal liability for costs in an unsuccessful action and directors also often do not have sufficient assets.

Judicial approach to Section 214

The balancing requirement has allowed judges to adopt different approaches to wrongful trading and led to a degree of uncertainty. [15]

In Produce Marketing Consortium Knox J held that the provisions of Section 214 are more compensatory than penal. The court further held that the directors will be deemed to have the information which should have been available and acquiescing in the delay of their auditors is no defence. [16]

A director who is not a financial director of a plc is not required to have the technical accounting expertise of professional accountants but they will be expected to ensure that the management accounts provide a reasonably accurate picture of the company’s financial position. [17] The information that the director should have obtained depends on whether or not there were warning signs, such as pressure from creditors, which may indicate a particular need to monitor the company’s solvency. [18] The facts in DKG were such that the directors should have introduced financial control.

In Brian [19] the court held that the test to apply is the reasonably prudent business person who will be less likely to be as cautious as lawyers and accountants but unwarranted optimism with no realistic factual basis is unacceptable. In Brian the director refused to face the facts and had persistently ignored the negative facts. The wife who was a non executive director signed documents on advice of her husband. She had no active role in the management of the company but the court held that she was liable under Section 214 of the Act.

Other judges differ from Knox J’s opinion by holding that the provision is not so much a civil remedy to raise standards of directors and to compensate creditors but a way to punish directors whose actions are deemed to be immoral. [20]

The courts have also held that it is incumbent upon the directors to obtain timely financial statements that are required under the Companies Act 2006. In both DKG [21] and Purpoint [22] the court held that the financial information was insufficient.

The courts distinguish between cases where the director is fully aware of the financial situation and the possibility and consequences of insolvent trading and considered the position carefully before deciding to trade on and those where the directors made no real attempt to address the issue. The fact that the directors chose to trade on and it later proved to be a mistake should not give rise to liability when the directors have carefully considered the situation. [23] The courts have also held that hindsight should be avoided. [24]

The provision of Section 214(3) requires that the directors minimise the losses to creditors. Resignation is not such a course and it has been held that the only realistic option is some form of insolvency. It may not only be prudent for a director to seek advice but a necessity. [25]

The judgements of the courts require that the liquidator must elect a particular date at which to establish that the directors should have realised the inevitability of insolvency. [26] The court has discretion as to what compensation it deems fit to order against the director and may take into account the degree of culpability of the director. [27]

The directors may well be liable under Section 214 of the Insolvency Act. They knew that the company was in financial difficulties and considered taking professional advice. The fact that they decided not to does not place them in the category of directors who considered the consequences carefully since they did not have the advantage of any advice. In the circumstances of the facts a reasonable business person would have sought such advice and considered it carefully. The directors fall under the category of directors who did not take any real steps to address the issue.

Preference & Sale under Value

Section 238 allows the court to set aside a transaction that was entered into by the company at under value. [28]

Section 239 of the Insolvency Act deals with the position where the company has given a preference to someone who is a guarantor or surety of a creditor. [29] The requirement is that the company must have intended to give a preference to a surety or guarantor of a creditor of the company. Once again Section 239(6) creates the presumption that the preference was influenced by a desire to produce the effect that the person who is benefitted should be benefitted.

The directors sold the Mercedes’ to Dipak’s wife for £20,000.00. The facts do not disclose whether the sale was for value or not. The court may therefore decide not to set it aside on the basis that it was sold for under value. The liquidator will have to investigate the transaction more closely to determine the value of the cars.

However, the payment made to the bank had the effect of discharging Dipak’s guarantee to the bank and therefore provided an advantage to Dipak and may fall foul of Section 239 of the Act.

The main hurdle to instituting proceedings in terms of section 239 is also related to the lack of funding. [30] There have been calls to allow liquidators to assign shares in the fruits of such action provided that they do not relinquish control of the claim. An example of such a method will be to allow commercial companies to purchase the claim and pursue it themselves and thereby funding it too. [31] Milman and Parry concluded that the courts should reconsider its hostility to litigation ‘trafficking’.

Re Hawkes Hill Publishing Co Ltd [32]

The facts in this case are very similar to the facts of the scenario under discussion. The company was incorporated with the goal of publishing a bi-monthly free golfing magazine which would generate income by selling advertising space. The initial funding came from a small business bank loan which was guaranteed by both the director and the secretary to a maximum of £20,000.00.

The company had problems early on as it had to pay for publishing before the advertising income came in. Apart from this the company also did not appreciate its VAT obligations. Golf clubs were also finding it difficult financially at the same time as a result of adverse weather conditions.

By the end of the first year the accounts disclosed that the company made a loss. The director cut costs by dismissing some sales staff and the director and secretary forwent salaries. The company also started publishing a second free magazine for job advertisements and as this one was published weekly the prospects of funding looked good. However the company still did not prosper and the directors started searching for someone to either fund the business or to buy it. After all but one of the interested parties withdrew from negotiations to buy the business it was eventually sold for £20,000.00 to the remaining bidder. The court was satisfied that the sale was at fair value.

One of the provisos of the contract was that the secretary who was knowledgeable about advertising be appointed by the new company at a salary of £40,000.00 per annum. The secretary was deemed to be a director as she was so involved that she was constituted as a de facto director. The secretary’s position with the company was almost immediately terminated.

The money from the sale was paid into the bank account to reduce the indebtedness of the company to the bank. This in effect also reduced the guaranteed amounts but did not completely clear the debt.

The liquidator brought proceedings against the director and the secretary for wrongful trading under Section 214 of the Insolvency Act and a claim under Section 239 of the Act for giving a preference to both of them when the bank was paid.

Lewison J held that the liquidator’s claims must be dismissed. In the claim under Section 214, the court held that the liquidator failed to show that the directors had no reasonable grounds to believe that the company will succeed.

The court stressed that hindsight in judging such cases is not always fair and that companies often struggle in the early phases of business. The forward booking for advertisements looked good. Although the parties also gave director disqualification undertakings the court held that directors often give such undertakings when they are under pressure and they are not able to defend the court proceedings due to a lack of funds.

The court held that the payment to the bank also did not constitute a preference as the bank was a secured creditor and would have received the full proceeds upon liquidation. The fact that the bank could recover under the security meant that it would have reduced the guarantors’ liability by at least the amount that the bank recovered.

As the secretary was immediately dismissed, she also did not enjoy any benefit from the sale of the business. The court said that there must be preference in fact and since the bank would have been the same off and the other creditors still unsecured, the preference was not a preference in fact. This dictum was undisputed as it was already held that that is the position by the House of Lords. [33]

In the facts under discussion the directors also reduced the liability of the company to the bank and therefore cleared the overdraft to the bank completely. In these circumstances the court may well find that there has been a preference. The facts do not disclose whether the bank was a secured creditor. For the sake of the discussion I will assume that it is not. If the transaction is therefore set aside an additional amount of £20,000.00 will be available to the unsecured creditors.

Disqualification of Directors

The directors can also be declared disqualified directors by the court. If the court makes such a finding the directors will be disqualified from acting as such for a period of time. [34]

Conclusion

The Insolvency Act 1986 does not assist the creditors of insolvent companies as much as it was initially hoped. In the facts under discussion the contravention of Section 211 of the Act is probably the biggest risk that the directors face.

The court may also find that the preferred transaction be set aside and the money be repaid to the company. This will not dramatically affect the directors except that Dipak will have to honour the guarantee or lose his house.

Lastly, the provisions of Section 214 may not be available to the liquidator as the courts are very hesitant to make adverse findings under this section.

Books

Finch V., Corporate Insolvency Law: Perspectives and Principles (2002) Cambridge University Press

Goode R., Principles of Corporate Insolvency Law (2005) Sweet & Maxwell

Tolmie F. M., Corporate and Personal Insolvency Law (2003) Cavendish Publishing

Cases

Daniels v Anderson (1995) 16 A.C.S.R. 607

Lewis v Hyde [1990] BCC 78

Produce Marketing Consortium Limited [1989] 5 BCC 569

Re Brian D Pierson [2001] 1 BCLC 275

Re Continental Assurance of London plc [2001] BPIR 733

Re DKG Contractors Ltd [1990] BCC 903

Re Hawkes Hill Publishing Co Ltd (2007) 151 S.J.L.B. 743 (Ch D)

Re MC Bacon (No2) [1990] BCLC 607

Re Purpoint Ltd [1991] BCC 121

Re Sherborne Associates Ltd [1995] BCC