Judgment was handed down last week on the substantial directors' duties and wrongful trading claims brought against former directors of various BHS companies1. The liquidators of those companies were successful in arguing that the directors were liable for wrongful trading (albeit at the latest date of six possible dates argued) and were also successful in bringing the first ever claim for "misfeasance trading"2. Whilst the judgment is very fact specific, it is an interesting analysis of so-called "insolvency-deepening" activity and shareholder value extraction. Moreover, it is a salient reminder to directors of their duties where they are operating in the zone of insolvency.
In this article, we outline some of the claims brought by the liquidators and suggest some key takeaways for directors where a business is facing distress.
Wrongful trading
The law
A director (or former director) may be guilty of wrongful trading if at some point before the commencement of the winding up of the company or its entry into administration, they knew, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into insolvent liquidation or insolvent administration3. In such circumstances, a Court can order that director to contribute towards restoring a shortfall in the company's assets.
When determining this, the Court will hold the directors to an objective standard of the general knowledge, skill and experience reasonably expected of a person carrying out that director's functions (a "notional director"). The Court will also overlay any additional knowledge, skill and experience of the specific director, potentially having the effect of holding that director to a higher standard than the notional director.
Application in the BHS claim
Given the nature of a wrongful trading claim, it was necessary for the joint liquidators to establish that the directors knew or ought to have known that there was no reasonable prospect of avoiding insolvent administration or liquidation at a certain date (the "knowledge date"). The joint liquidators pleaded six different knowledge dates, which involved the judge carrying out a detailed assessment of the facts and the directors' knowledge at each of those dates. The judge did not agree with the argument that it must be known on the relevant date that insolvent administration or liquidation was inevitable by reference to a specific date in the near future, noting that the statute imposes no such time limit. However, the judge did note that the lapse of time between the knowledge date and the decision to actually put the company into administration would be an important evidential factor.
Findings of wrongful trading are relatively rare. The judge acknowledged that, in light of the Supreme Court's comments in Sequana4 (see our previous briefing note), he was satisfied that the bar for a wrongful trading claim is very high, requiring it to be demonstrated that the directors knew or ought to have known that insolvent liquidation or administration was inevitable.
This was illustrated by the fact that the judge refused to find the directors liable for wrongful trading from five out of the six alleged knowledge dates pleaded by the joint liquidators. The judge highlighted that there must be a rational basis for continuing to trade, rather than blind optimism, but the Court would not use hindsight to judge the directors' actions and will be slow to encourage directors to put a company into insolvent administration or liquidation at the first sign of trouble. Directors can therefore be reassured that the Court will not ignore the challenging reality in these sorts of situations.
The joint liquidators did find success on the final knowledge date pleaded, which was 8 September 2015, 6 months before the companies entered administration. A combination of cashflow insolvency, no prospect of obtaining any sustainable finance, a degenerative strategy, and an increasingly worsening financial position led to the conclusion that, on that date, a notional director would have concluded that there was no reasonable prospect of avoiding insolvent administration or liquidation.
Defence and liability
The judgment highlights that the defence to wrongful trading of "taking every step that the director ought to have taken to minimise loss to creditors" is a very high hurdle to overcome and was not met in this case.
In addition, the liquidators had to illustrate that there was a causal connection between the directors' actions in relation to the wrongful trading and the loss suffered by the company. In this case the court was examining the conduct of two directors in isolation from the other directors (most notably, Dominic Chappell, whose case has been severed to be heard at a later date). Nevertheless, the judge considered what would have happened if these directors had complied with their duties, and was satisfied that the companies would have gone into administration if that had been the case.
In terms of liability, the maximum liability the Court can impose in relation to wrongful trading is the increase in the net deficiency in the assets of the company from the date at which the wrongful trading started until the date when the company actually went into administration (which was accepted to be £45 million at the relevant knowledge date).
The court has discretion to impose joint and several liability or several liability, taking into account factors such as the levels of responsibility and culpability of the directors and the extent to which their conduct caused the increase in the net deficiency in the assets, together with non-causative factors such as insurance cover and means. The Court also has discretion as to the weight which it affords each of those factors. Ultimately, this discretion in apportioning liability is intended to enable the Court to mould the remedy to the facts of the particular case. The judge exercised this discretion to make liability several, given the differences between each director's involvement and culpability. Even though the judge acknowledged that Mr Chappell's case had been severed and that he may be found not liable, the judge, nevertheless, took the view that Mr Chappell was primarily liable, notionally apportioning 50 per cent. of the liability to him, with the two directors on trial being liable for 15 per cent. each.
Trading misfeasance
The law
The insolvency legislation allows a liquidator to apply for the recovery of property or compensation against a director where that director has misapplied or retained, or become accountable for, any money or other property of the company, or been guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company5.
Directors have various duties under the Companies Act 20066, with those relevant to the case summarised as follows:
- To act in accordance with the company's constitution and to only exercise powers for their proper purposes
- To exercise reasonable care, skill and diligence
- To promote the success of the company
- To avoid conflicts of interest
- To exercise independent judgment
- Not to accept benefits from third parties
In relation to the duty to promote the success of the company, as confirmed by the Supreme Court in Sequana, (see our previous briefing note), the directors have a duty to consider the interests of creditors (alongside the interests of shareholders) in the following circumstances: (i) where the company is insolvent or bordering on insolvency7; (ii) an insolvent liquidation or administration is probable; or (iii) a transaction is being entered into which would place the company in either of the two foregoing situations.
The interests of the creditors should be considered alongside the interests of the shareholders, with a sliding scale of importance given to the creditors' interests the more precarious the company's financial position becomes. Once an insolvent administration or liquidation becomes inevitable (which is the same trigger point for wrongful trading), the creditors' interests will become paramount.
The application in BHS
The liquidators advanced claims in relation to specific breaches of duty and were successful in relation to a number of individual instances of misfeasant transactions. However, of particular interest was a wider argument, that extends the concept of misfeasance to the ongoing trading of the business. The Court held that, that if the directors had complied with their duties, including giving appropriate consideration to the interests of creditors, at the relevant knowledge date they would have immediately filed for administration, rather than continue to trade. This is the first time such an argument has been made by liquidators.
Interestingly, the trading misfeasance claim was successful at an earlier date than wrongful trading. Moreover, at that time, most of the companies were not actually insolvent on a cash flow or balance sheet basis and an insolvent administration or liquidation was more probable than not, but not inevitable. The judge found that the board had failed to consider the interests of creditors in entering into a loan with fairly onerous terms and by continuing to trade, at a time when the creditors' interests should have been paramount (or, at the very least, should have carried more weight than the interests of shareholders).
The judge held that, if the directors had complied with their duties in considering the interests of creditors, they ought to have concluded that it was in the interests of creditors to put the companies into administration immediately, on the basis that the loan would be damaging to the interests of certain creditors because of its onerous terms and its degenerative effect on the group's assets, leaving the group exposed and without a sustainable working capital facility.
Defence and liability
There is a defence for a breach of duty claim if the Court is satisfied that the director acted honestly and reasonably (i.e. "in the way in which a man of affairs with reasonable care and circumspection could reasonably be expected to act in such a case"), and having regard to all the circumstances of the case, they ought to be fairly excused, or relieved in whole or in part from liability. It is for the directors to prove this, and the judge was not satisfied that the directors met this standard.
The judge declined to determine quantum of liability of the directors at the hearing, which will take the form of equitable compensation. The liquidators' case was that the quantum should be the same as what the wrongful trading quantum would have been at the time – i.e. the increase in the net deficiency of the assets (£133.5 million). The judge determined that appropriate time should be given for detailed submissions on this point, particularly given that it is a developing area of law and the large amounts being claimed.
Arguably, this judgment does cut across the previously well-understood threshold for a decision to cease trading. It will be interesting to see how this is determined in the future and whether it is possible to obtain a similar level of damages through a breach of duty claim as through a wrongful trading claim, which has a more stringent trigger point.
Key takeaways for directors
1. Monitor the situation – Directors should ensure that they are fully informed as to the position of the company (and in particular its financial state). The notional director for wrongful trading will be deemed to have such knowledge as would have been available to the directors from material they could have accessed with reasonable diligence. Directors are also expected to obtain sufficient financial information to monitor the company's solvency.
2. Have an objectively justifiable plan of action – It is permissible to continue to trade a company which is technically cashflow or balance sheet insolvent8. However, the directors should carefully consider whether there is a rational plan which gives the company a reasonable prospect of avoiding an insolvent administration or liquidation. This plan should be monitored regularly to ensure that it remains deliverable and should be formulated with professional advisers.
3. Even if administration or liquidation is not inevitable, care should be exercised on the means taken to ensure that – As noted above, the directors in the BHS case were found to be liable for misfeasance trading at an earlier date than wrongful trading. At this earlier date, the judge was not satisfied that insolvent administration or liquidation was inevitable (therefore there was no finding of wrongful trading). But he was satisfied that the action taken by the directors in taking out a further loan in order to continue trading was not in the interests of creditors, and that it would have been in the interests of creditors to instead place the company into administration. Directors should therefore be careful to consider both points when they are in the zone of insolvency – i.e.:
a. Is there a reasonable prospect of avoiding insolvent administration or liquidation?
b. Even if there is a reasonable prospect, and a point has been reached where the creditors' interests are to be given appropriately serious weight: (i) is it in the interests of creditors to take the action that you are considering; or (ii) would their interests be better served by immediately placing the company into administration or liquidation?
4. Directors' knowledge, skill and expertise – The notional director element to a wrongful trading claim, as well as similar requirements in relation to certain director duty provisions, mean that directors should ensure that they have the requisite knowledge, skill and experience to act as a statutory director of the relevant company and to carry out their specific role. The more complex the company, the higher the standards involved. It is no defence for a director to say that they had a lower level of general knowledge, skill and experience than the notional director.
5. Minuting meetings – Minutes should be precise and clearly outline how the directors have considered their duties and the advice received. A takeaway from the BHS case is that minutes which provide an accurate record of discussions are likely to be given more evidential weight than formulaic minutes prepared in advance by lawyers. If pro forma minutes are prepared for entry into specific documents (as is common in finance transactions, where minutes are commonly shared with third parties, such as lenders), it would be recommended to also have separate, more detailed minutes in distressed situations to outline the specific considerations the directors took into account.
6. Professional advice – Whilst taking professional advice will go a long way to illustrating that a director has performed their duties with reasonable care, the judgment is a reminder that the weight attached to that advice will depend on the scope of the adviser's engagement, the instructions the adviser is given, the knowledge which they had, and the assumptions they were asked to make. Directors should be careful to ensure that their advisers have all relevant facts and that the scope of their engagement is clear. Whilst it is ultimately for the directors themselves, rather than their advisers, to discharge their duties and to decide whether there is a reasonable prospect of avoiding insolvent administration or liquidation, proper advice can assist with the directors' decision-making process.
7. Delegation – Whilst it is permissible for directors to delegate functions to others, they should monitor and supervise the discharge of those functions. In addition directors are not permitted to leave board decisions to other directors. Directors who are appointed to have more limited functions should bear this in mind, in particular.
8. Insurance – As a matter of public policy, the judge in BHS declined to limit liability against the directors by reference to the limit of any insurance cover they had the benefit of or the specific director's means. The judge noted that to do so would send the wrong message to risk-taking or dishonest directors and would leave creditors exposed. Directors should therefore ensure that their insurance cover limits are adequate for the size of the business and should be aware of any specific limitations contained in the policy.
Footnotes
1. Re BHS Group Ltd [2024] EWHC 1417 (Ch)
2. The joint liquidators also brought various other claims for "individual misfeasance" in relation to specific transactions entered into by the directors.
3. Section 214 Insolvency Act 1986
4. BTI 2014 LLC (Appellant) v Sequana SA and others (Respondents) [2022. UKSC 25
5. Section 212 Insolvency Act 1986
6. Sections 171–177 Companies Act 2006
7. With insolvency being taken to mean cash flow or balance sheet insolvency under Sections 123(1)(e) and (2) of the Insolvency Act 1986
8. Each defined in Sections 123(1)(e) and (2) Insolvency Act 1986
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.