*Stop press (9 January 2017) – liquidators have applied for permission to appeal the decision*
How important is it for an insolvency office-holder to quantify the increase in the net deficiency to creditors in support of a wrongful trading claim? Chloe Poskitt and Emma Taylor, both associates at Browne Jacobson, review the appeal decision in Brooks v Armstrong.
Brooks and another (Joint Liquidators of Robin Hood Centre plc in liquidation) v Armstrong and another  EWHC 2893 (Ch),  All ER (D) 117 (Nov)
The Chancery Division allowed, in part, a cross-appeal by the directors of a company in creditors’ voluntary liquidation against an order that they were jointly and severally liable to pay compensation of £35,000 for wrongful trading. The directors had argued that the process by which the registrar had calculated the compensation payable by them had been unfair. The court held that the liquidators had failed, in the earlier proceedings, to advance and establish a properly formulated case that there had been any increase in net deficiency of the company during the period of wrongful trading, and that, on the approach adopted and facts found by the registrar, there had been no such increase. Accordingly, it held that the registrar should not have ordered any payment by the directors to the liquidators, under section 214(a) of the Insolvency Act 1986 (IA 1986).
What are the practical implications that those advising can take away from this appeal?
This appeal judgment serves as a useful reminder—hot on the heels of Re Ralls Builders Ltd  EWHC 243 (Ch),  All ER (D) 142 (Feb)—of the risk of a pyrrhic victory when pursuing wrongful trading actions if claims are not properly particularised by quantifying the increase in net deficiency and any additional losses properly attributable to a wrongful decision to continue trading. The benefits of obtaining expert evidence to substantiate such losses should also not be overlooked.
What was the background to the appeal?
The liquidators of Robin Hood Centre plc issued an application seeking the sum of £701,000 from the directors of the company for misfeasance and wrongful trading.
The liquidators had alleged various dates (the most likely being 9 October 2006) on which they claimed the directors knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation (the Knowledge Condition).
Registrar Jones found that the directors had the requisite knowledge at 31 January 2007 but that they had not been wrong to continue trading, at least until 3 May 2007, because, up to that point, they had been taking steps to minimise further losses to the company’s creditors (the Minimising Loss Defence).
The directors were ordered to pay compensation calculated at £35,000 by reference to a deficiency comparison between the date of a hypothetical liquidation on 3 May 2007 and the actual date of liquidation on 6 February 2009.
For further reading on Registrar Jones’ first instance decision, see blog post: Establishing the requirements of a wrongful trading claim.
The liquidators appealed and the directors cross-appealed.
What were the issues before the deputy judge?
The liquidators sought to challenge Registrar Jones’:
- methodology for assessing the amount of compensation awarded
- assessment that the Knowledge Condition was not met as at 9 October 2006, and
- decision that the directors should be relieved from liability between 31 January 2007 and 3 May 2007 based on the Minimising Loss Defence
At the same time, the directors sought to challenge Registrar Jones’ conclusion that wrongful trading had occurred at all and, if it had, as to the amount of compensation to be paid.
What were the main legal arguments put forward?
The liquidators’ main grounds of appeal
- the registrar should have quantified the maximum loss, to which the directors were liable to contribute, as all unpaid debts incurred after the date on which it was alleged the company should have stopped trading (following the decisions in Re Purpoint Ltd  BCLC 491 and Re Kudos Business Solutions Ltd; Earp v Stevenson  EWHC 1436 (Ch),  All ER (D) 51 (Jun)) and that he was entitled to follow that approach because some of the company’s financial records were missing
- Mr Armstrong (one of the two respondent directors) should have been judged to a higher standard when assessing the knowledge a director should have had because of his experience as a director of various other companies
- the company’s historic profitability up to 9 October 2006 should not have been taken into account when considering the directors’ assessment of whether the company could avoid insolvent liquidation at that time since that profit was based on the company continuing to operate a VAT scheme that was no longer acceptable to HMRC
- the registrar had erred in law and fact by ignoring the effects of depreciation on the company’s principal physical asset on a balance sheet assessment of its likelihood of avoiding insolvent liquidation because it could still be used to generate profit on a cash flow basis but allowing for the effects of depreciation to justify the company’s continued trading and reliance on the Minimising Loss Defence
- the registrar erred in the exercise of his discretion and/or had taken into account an irrelevant consideration and/or erred in law in holding that a perceived lack of any dishonesty on the part of the directors meant that the registrar was entitled to reduce the quantum of compensation payable by 50%
The directors’ grounds of appeal
- the registrar unfairly and inappropriately had regard to events after 3 May 2007 when deciding if the Knowledge Condition was satisfied, and the Minimising Loss Defence not made out, as at that date. They argued that the liquidators were limited to trying to establish the satisfaction of the Knowledge Condition at one of the pleaded dates and that it was not permissible to consider events at other later dates (Re Sherborne Associates Ltd  BCC 40)
- the approach taken by the registrar to calculate the compensation payable was unfair and inappropriate because he had adopted an approach of his own making, which he had not deployed at the hearing and on which the directors did not have a fair chance to adduce evidence or make submissions
What did the deputy judge decide, and why?
The liquidators’ grounds of appeal
Calculating compensation under IA 1986, s 214
The deputy judge refused to follow the approach in Re Purpoint and Re Kudos Business Solutions on the basis that, despite the missing financial information, it was still possible to perform ‘increase in net deficiency’ calculations. The liquidators had been able to do so albeit that the registrar had considered their calculations to be deficient. The facts were distinguishable from Re Purpoint and Re Kudos Business Solutions in that the directors had not failed to keep records contemporaneously (they had clearly done so as they had been regularly audited). The issue was simply that certain records had not been collected by the liquidators. The liquidators argued that the directors had breached their duty to produce the company’s papers and were responsible for their absence. However, given the lapse of time and other relevant factors, the registrar declined to decide that issue.
The standard of care expected when assessing a directors’ knowledge
The registrar had applied the correct test when assessing Mr Armstrong’s conduct and was entitled to take into account the features he had when assessing the director’s knowledge as at 9 October 2006. It was significant that the registrar had seen and assessed for himself how the witnesses (including Mr Armstrong) had performed under cross-examination and that nothing had been presented on appeal to suggest that Mr Armstrong’s other experience should be grafted upon the standard of the reasonably diligent person so far as relevant to the specific issues which faced the company on 9 October 2006.
Relevant factors when assessing a directors’ knowledge and conduct
Challenges to the company’s supposed profitability had not been raised at trial and it was by no means certain that if changes had had to be made to the VAT scheme that that would have precluded the company from continuing to generate a profit. The registrar had properly relied on a full range of considerations to reach his conclusions including that the directors ought to be ‘entitled to time to investigate what to do rather than to be criticised for acting too quickly’, that there were ‘many potential avenues to investigate’ and that an immediate liquidation would not have benefitted the company’s creditors in any event.
The effect of depreciation on the Minimising Loss Defence
The deputy judge was satisfied that no inconsistency existed between finding that the assets of the company would have realised little or nothing on a sale within a liquidation and that the assets could still continue to generate positive cash flow within the business while it was still operating. It was also relevant that the negative effect of the assets’ depreciation had already occurred by 31 January 2007 and was not worsened through continued use.
The issue of the directors’ honesty was only one of a number of factors referred to by the registrar and which he was entitled to consider as part of his balancing exercise when assessing the level of compensation to be paid by them.
The directors’ grounds of appeal
When assessing the Knowledge Condition, the registrar was entitled to draw inferences based on the evidence presented to him and the deputy judge was satisfied that the registrar had done so without the use of hindsight.
The deputy judge was persuaded that, whilst motivated by the right reasons, the registrar had erred in applying an analysis which had not been advanced by either party and which had not been the subject of submissions at the hearing. Had the registrar’s analysis been considered at the hearing the directors would have been entitled to raise legitimate objections to it, either on the basis that there was insufficient evidence on relevant issues, or because, if the analysis was followed through to a proper conclusion, there would have been no compensation payable.
To what extent is the judgment helpful in clarifying the law in this area?
This case highlights the complexities and difficulties of bringing a wrongful trading action and quantifying the losses for which directors could be made liable. It also provides useful guidance on the limited circumstances when it will be permissible to depart from the practice of calculating the ‘increase in net deficiency’ necessary to establish the losses caused by delaying an unavoidable insolvent liquidation.
- Court: Chancery Division
- Judge: Mr David Foxton QC sitting as a deputy judge of the High Court
- Date of judgment: 15 November 2016
Interviewed by Stephen Leslie.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
If you are a LexisPSL Subscriber, click the link below for further information:
First published on LexisPSL Restructuring and Insolvency