Insolvency update – changes to wrongful trading

Insight

01.04.2020

On 28 March the Business Secretary, Alok Sharma, announced proposed changes to the UK insolvency laws in order to address the unique circumstances arising from the Coronavirus pandemic. This note has been finalised on 1 April 2020 and reflects our understanding at this time.

The details of the legislation are still awaited, so we are currently in an unusual period where we know some retrospective changes are proposed but they are not yet in effect, but the principal changes are:

A temporary suspension of the law making directors liable for wrongful trading for a period of three months commencing 1 March 2020 for all companies (not limited to those directly affected by coronavirus related issues); and
The introduction of a new form of moratorium from creditors in addition to the current administration provisions.

The new form of moratorium appears to be based on proposals that were mooted in 2018 and appear to have similarities to the US Chapter 11 process. Details are awaited and it is too early to speculate on how this may benefit businesses in addition to the current moratorium offered by administration.

This note therefore focuses on the proposed changes to wrongful trading and comments on the possible purpose of these changes and how they interact with those provisions that appear to be remaining in place.

At the heart of the current dilemma is that at present the government is encouraging businesses to trade through the current economic environment, access new funding and continue to employ staff at our near current levels. The wrongful trading provisions arguably act as an opposing force, encouraging in some circumstances boards to take a different approach, and take every step to minimise the loss to creditors, with the risk of personal liability for boards if they don’t act in this manner.

Putting it bluntly, some boards could find themselves facing personal liability if they act in a manner being encouraged by the government. This is clearly inherently unjust and inefficient and these changes would seem to seek to address this dichotomy.

In headline terms, our current thinking based on the limited information available to date is:

This change should help businesses in financial difficulties where there is significant uncertainty regarding the businesses’ financial future.
In particular it might aid such companies considering whether to bridge their cashflow by borrowing additional sums and accessing the furloughing scheme.
It will not however change the importance of taking advice and carefully considering how the business should deploy any borrowed monies.
It is unlikely to benefit those businesses where insolvency is highly probable or certain.

A further question we have is how this suspension will be unwound, as this has the potential to create a cliff edge where businesses that have operated on the amended basis find they need to again comply. This is another reason why we suggest that boards continue to apply to same rigorous processes, which will enable them to re-adjust again in due course.

What is wrongful trading?

If a board is unable to conclude that a company has a reasonable prospect of avoiding an insolvent liquidation then they then have to take every step to minimise the potential loss to creditors. If they do not then they risk personal liability if that worsens the position of creditors. The response is often for such companies to enter an insolvency process.

What is not changing

It is worth noting that it appears that, other than the suspension of wrongful trading provisions, other legislation applicable to companies experiencing financial difficulties appears to be remaining in place. These include:

Fraudulent trading
Directors disqualification provisions
Misfeasance and the general duty to act in the interests of creditors
Preference
Transaction at an undervalue.

So why change wrongful trading?

There are three good reasons for these changes:

Inherent uncertainty

Part of the purpose of the wrongful trading provisions is to encourage boards to look forward and model the company’s performance, based on information currently available, in order to be able to conclude whether the business has a reasonable prospect of avoiding insolvency. This assumes in part that accurate financial information is available to the board in order make an objectively reasonable assessment and to justify their conclusion. The provisions then place pressure on a board to act where there is no such reasonable prospect – often with the consequence that the company will enter an insolvency process.

The difficulty is that we are currently in uncharted territory and it is extremely difficult to model with any accuracy how the current situation may continue and what this means for the economy during 2020 and beyond. This therefore makes it difficult for a board to positively conclude, based on objectively verifiable information, that the company has a reasonable prospect of avoiding insolvency. Faced with personal liability boards operating in this information vacuum may be encouraged by the wrongful trading provisions to cease trading and enter insolvency.

There is a risk therefore that the combination of a lack of certainty which allows a board to positively conclude that there is a reasonable prospect plus the risk of personal liability could cause otherwise viable businesses to cease trading.

Strain on cashflow

The economic impact of the Coronavirus pandemic has a unique signature, as for many businesses it has caused a sudden and dramatic reduction in revenue.

The current strain placed on cash flow means that many businesses now need to consider increased borrowing. This includes the lending schemes the government has put in place for both large and smaller businesses.

The wrongful trading provisions could arguably act as a brake, dissuading companies from accessing additional borrowing. This is because where there is no reasonable prospect, directors can be held personally liable if they worsen the position of creditors and in a normal economic environment this encourages companies to take steps to minimise assuming new liabilities.

By removing this potential impediment it would seem the government is attempting to make it easier for boards of companies in a marginal financial position to access bridging loans which may enable the business to trade through their current cash flow position to a point where the business environment stabilises.

Employees

The fact that wrongful trading can encourage companies to reduce their liabilities could also affect the ability of companies to maintain their current number of employees.

Generally speaking companies experiencing financial difficulties are encouraged to reduce their liabilities, and this could include the number of staff the employ. In particular, whilst the government’s employment retention schemes have included a contribution towards the costs of continuing to employ staff they do still require the company to make some payments to the staff which are furloughed and who cannot work for the business during this period. Arguably therefore the message to business to maintain employment contradicts the wrongful trading provisions and the suspension of these provisions could help businesses which are in financial difficulties but wish to take advantage of furloughing staff who currently are not required.

This is reflected in the reaction from business so far, with British Chamber of Commerce Head of Economics, Suren Thiru saying that “it is right that the rules on wrongful trading are temporarily suspended to ensure that directors are not penalised for doing all they can to save companies and jobs during this turbulent period”.

What this means for boards

As well as being aware of the changes to wrongful trading and the rationale for this it is equally important to be aware of the insolvency provisions that it seems will continue to operate (again these are current thoughts based on information available on 1 April).

The interaction between the suspension of wrongful trading provisions and the continuation of existing provisions is complex and it will only be possible to reach conclusions once we have sight of the draft legislation but our present view could be summarised in five statements:

A board should continue to take professional advice.
Boards should continue to place the interests of creditors first.
It remains a good discipline for the board to continue to consider if there is a reasonable prospect of avoiding insolvency – even if a view is taken depending on the conclusion in light of these changes.
It does not affect how a company should apply the funds (so for example businesses still have to avoid preferring creditors) and the requirement to put the interests of creditors first.
These changes do not assist businesses that know they are unable to avoid insolvency.

In particular it is worth highlighting that whilst a company facing uncertainty may now decide to continue trading and borrow additional sums, the board still needs to carefully consider how to then apply those funds. The normal rules on preference apply and the board will need to carefully consider how it applies those funds, which creditors and suppliers are paid and be mindful about protecting the interests of creditors as a whole.

The current position is inherently fluid, and it is important to note that this summary does not constitute legal advice and each matter needs to be analysed on its own merits.

We look forward to seeing what further information is made available this week and will provide an update once this is made available.

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If you require further information about anything covered in this briefing, please contact David Fletcher or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.