Establishing the requirements of a wrongful trading claim—Brooks v Armstrong; Re Robin Hood Centre plc (in liquidation)

When should directors conclude that a company has no reasonable prospect of avoiding going into insolvent liquidation? Chloe Poskitt, a solicitor, and Dominic Offord, a partner and head of commercial litigation and insolvency, at Browne Jacobson LLP, discuss the implications of the decision in Re Robin Hood Centre plc (in liquidation).

Original news

Brooks and another v Armstrong and another; Re Robin Hood Centre plc (in liquidation) [2015] EWHC 2289 (Ch), [2015] All ER (D) 45 (Aug)

The applicants, in their capacity as liquidators of Robin Hood Centre plc (the company) issued an application under sections 212 and 214 of the Insolvency Act 1986 (IA 1986) against the respondent directors for misfeasance and wrongful trading. The High Court held that, among other things, the respondents knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation following certain events—such as a letter from HMRC confirming a VAT liability and an increase in the rent and service charge. At that point, the directors should have taken steps to minimise the losses to the creditors as a whole. The directors were ordered to pay compensation calculated by a deficiency comparison based on the difference between the date of a hypothetical liquidation and the actual date of liquidation.

What was the background to the application?

The application was brought by the company’s liquidators against the directors under IA 1986, s 214 for contribution by the directors to the assets of the company in respect of wrongful trading and for an order for compensation under IA 1986, s 212 for breach of duty.

The liquidators claimed that there were a number of events which the meant that the directors knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation. The events were:

• the year-end accounts for 2005 and 2006

• the receipt of professional advice in October 2006 about a large VAT liability, in respect of which the directors had sought a review

• the year-end accounts for January 2007, which showed a loss and did not include the VAT liability or an increase in rent expected from a pending rent review

• a letter from HMRC on 3 May 2007 stating that the VAT liability had been confirmed on review

What were the legal issues that the Registrar had to decide in this application?

The principal legal issues which the Registrar addressed were:

• whether the directors had wrongfully traded—which involves essentially three elements under IA 1986, s 214(2):
  • the company went into insolvent liquidation at a time when its assets were insufficient for the payment of its debts, liabilities and the expenses of the winding up (the insolvency element)
  • at some point before the commencement of the winding up, that person knew or ought to have concluded there was no reasonable prospect that the company would avoid going into insolvent liquidation (the knowledge element)
  • that the person was a director (including shadow director) of the company at that time

• which party had the burden of proof in relation to the defence under IA 1986, s 214(3) that every step was taken to minimise the losses to the creditors and whether the directors had actually taken those steps

• whether one of the directors should be judged by a higher standard than a ’reasonable director’ given his experience

The other issues that were also considered were the interpretation of company financial statements for the purpose of knowledge and the calculation of compensation.

What were the main legal arguments put forward?

The main arguments submitted by the liquidators were that, in applying the Eurosail test (whether a company has sufficient assets to meet all of its liabilities—BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc [2013] UKSC 28, [2013] All ER (D) 107 (May)), the company was balance sheet insolvent and that the knowledge element was satisfied as the financial statements showed a trading loss for the previous 12 financial years. The liquidators relied upon these events as key when assessing the extent of the directors’ knowledge.

The directors alleged that they took all reasonable steps by:

• trading to the end of January 2009

• taking steps to sell the business

• obtaining professional advice

• keeping creditors informed of the position

The VAT liability was subject to an appeal and the increase in the rent was only relevant to their knowledge at the end of January 2009, when steps were taken to place the company into creditors’ voluntary liquidation.

What did the Registrar decide, and why?

The Registrar found that IA 1986, s 214 did not require proof of insolvency at the date of knowledge. However, the liquidators did have to prove knowledge at some time before the commencement of the winding-up, rather than at a particular date. Knowledge should not be approached with hindsight and the fact that a decision proved to be wrong did not amount to failing to act as a reasonable director. While one of the directors had more experience as a director, it was in the retail field and did not lead to a higher standard being applied.

Therefore, following the VAT advice in October 2006, the directors had been entitled to investigate what to do rather than be criticised for acting too precipitously. However, acting reasonably and with the general knowledge, skill and experience reasonably expected, the directors knew or ought to have known by January 2007 that:

• the company could not afford, and therefore make, a time-to-pay arrangement with HMRC, and

• the company had no reasonable prospect of avoiding insolvent liquidation

The Registrar found that once it had been established that a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, the onus was on the director to establish that he had taken every step to minimise the potential loss (see Re Idessa (UK) Ltd (in liquidation) [2011] EWHC 804 (Ch), [2011] All ER (D) 129 (May)).

The Registrar applied the reasonably diligent director test under IA 1986, s 214(4) and found that when balancing the adverse consequences of liquidation against the potential benefits of trading meant that the directors had taken the right steps by continuing to trade from February 2007. However, circumstances changed following receipt of the letter from HMRC on 3 May 2007 confirming the VAT liability. Further, it was (or ought to have been) foreseeable that the company would be unable to make the next rent payment.

The requirement for the directors to take every step to minimise loss was loss to the body of creditors as a whole. Therefore, as the directors had paid the trade creditors, but not the VAT and rent liabilities, such a requirement was not met as it merely increased the liabilities to creditors as a class.

The Registrar finally held that the discretion to order compensation under IA 1986, s 214 was unfettered and its purpose was to compensate and not to act as a penalty. There had to be more than a ’but for’ nexus between the wrongful trading and the loss and that the compensation based on the difference between a hypothetical liquidation on 3 May 2007 and the actual liquidation should take account of the impact of continuing to trade. Such facts included that the continued trading did not cause the VAT liability but it did increase the interest and penalties plus the debt to the landlord, it benefitted trade creditors and reduced the bank overdraft. Further, the directors had not taken the decision to continue trading for dishonest reasons.

To what extent is this judgment helpful in clarifying the law in this area?

Successful cases for wrongful trading resulting in a compensatory award are few and far between. This case is useful as it contains a detailed analysis of how the courts approach the different elements of a wrongful trading claim. In particular, it clarifies that the burden of proof in a establishing a defence under IA 1986, s 214(3) that every step were taken to minimise the losses lies with the director.

What practical lessons can those advising take away from the case?

This case highlights the need for directors to tread carefully when a company is on the brink of insolvency. Directors should ensure that they have up to date financial information and seek to address and, if necessary, revise plans in light of changes in the company’s circumstances.

It is not sufficient to solely rely on professional advice to highlight possible options because, as stated by Registrar Jones:

That does not relieve them of their ability and obligation to take “every” step when reaching their decisions based upon the financial position which was or ought to have been known to them."

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Further Reading

If you are a LexisPSL subscriber, click the link below for further information:

A summary procedure under section 212 of the Insolvency Act 1986 and the process for bringing a misfeasance claim

Wrongful trading and the process for bringing the claim

Ways in which an IP can fund litigation/investigations where there are no assets in the estate

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First published on LexisPSL Restructuring and Insolvency