The Wrong Target? COVID-19 and the Wrongful Trading Rule
Governments around the world are urgently considering how to support businesses in the COVID-19 crisis. In the UK context, one proposal is for the UK Parliament to temporarily suspend the operation of the wrongful trading rule in the Insolvency Act 1986 (see, eg, here).
In this short post, I suggest that the effects of a such a suspension would in technical terms be very limited, but that this does not mean that the proposal is necessarily a bad one.
The wrongful trading rule appears in ss.214 and 246ZB of the Insolvency Act 1986. The former provides the rule for companies in (insolvent) liquidation; the latter for companies in administration. These are the two collective insolvency procedures provided by English law. 'Wrongful trading' is a misnomer: the rules are not concerned only with trading decisions, and they contain no prescription or proscription in relation to such decisions. Instead, the rules provide more generally that a director who knows or ought to know that there is no reasonable prospect of avoiding the commencement of balance-sheet insolvent liquidation or administration is liable to be ordered to make a contribution to the company’s assets (in the event that the company ends up in those proceedings and the action is brought by the liquidator or administrator) unless they can establish that, from that point in time on, they took every step with a view to minimising potential loss to creditors that they ought to have taken. The standard is an objective one but can be raised by reference to the knowledge, skill and experience of the director in question.
The rationale for the proposed relaxation in the rules is presumably to avoid directors ‘shutting up shop’ too early, and in particular to avoid the unnecessary commencement of insolvency proceedings for debtors that become financially distressed in the COVID-19 crisis but whose underlying business is sound. Directors who do not have to fear personal liability for ‘wrongful trading’, it might be thought, may feel freer to ‘wait out’ the crisis, and this might be thought desirable if it seems unlikely that value will be maximised in formal insolvency proceedings. Such proceedings are very costly even in good times; in a time of pan-industry crisis, when courts are at risk of being overwhelmed and markets for going concern sales are likely limited, there seems a particular imperative to avoid unnecessarily filings (on this, see an earlier post by Professors Enriques, Eidenmueller and myself, here).
The problem with this analysis is that the wrongful trading rule is not the only source of personal liability for the directors of insolvent companies under English law. Instead, it is one of a number of rules which overlap with each other. These include the so-called 'common law' rule in West Mercia Safetywear v Dodd, and the compensation order provisions of the Company Directors Disqualification Act 1986 which were added to that Act in 2015.
The effect of the rule in West Mercia is that the ordinary duties owed by directors to the company are altered when the company is insolvent or is likely to become insolvent (BTI 2004 LLC v Sequana SA) so as to require directors to have enhanced regard for the interests of creditors. This duty shift affects all of directors’ duties, both of loyalty and of care. It is complemented by a restraint on shareholder authorisation or ratification, such that shareholders cannot cure a breach of creditor-regarding duty.
It seems to me that all of the behaviour that is regulated by s.214 is also perfectly capable of being regulated by directors’ duties, as those duties are affected by the rule in West Mercia Safetywear v Dodd; indeed, there are some forms of behaviour that are regulated more effectively by the West Mercia rule than s.214, which is rather restrictive when it comes to remedies (see van Zwieten 2018). The main difference between relying on s.214 and relying on West Mercia is that the former is an office-holder action, the fruits of which enure for the general body of unsecured creditors, while the latter is an action brought in the company’s name, such that the fruits are susceptible to capture by a secured creditor who has taken security over all the assets of the company, present and future.
The compensation order regime in the CDDA 1986 has only just begun to be applied in the courts, but on a plain reading it is clear that there is potential for substantial overlap between the compensation order regime on the one hand, and the wrongful trading and West Mercia rules on the other. But because the new rules have some novel features (including a focus on compensating for loss caused to creditors, rather than loss caused to the company), they may also result in directors being made subject to compensation orders in circumstances where no remedy would have been recoverable under either the wrongful trading rule or under the law governing directors’ duties as affected by the rule in West Mercia (see van Zwieten 2020, expressing concern about this).
The upshot is that it is doubtful whether suspending the wrongful trading rule will actually limit in any meaningful way the scope of directors’ personal liability under English law. The main effect in technical terms seems to me that where an action could previously have been brought either under s.214 or under the rule in West Mercia, only the latter will be available, with the result that secured creditors may benefit in a way they would not have benefited if the action had been brought under s.214. This potential cost to unsecured creditors must of course be balanced against the expected benefits of the suspension, and there does seem to me to be one such benefit: a public announcement of the suspension of a 'wrongful trading rule' might signal to directors of insolvent companies that a decision to attempt to continue to trade, in one form or another, is not per se unlawful. That has never been the law, but signalling this to directors who are currently ‘under siege’ and who might therefore be at particular risk of being misled by the misnomer ('wrongful trading') could still be helpful.
Should lawmakers go further, and relax the other rules I have identified? I am not convinced that the rule in West Mercia should be relaxed. It is true that rules of this kind might deter honest entrepreneurs from taking risks even where likely to be value maximising. That is a cost of duty-shifting rules (Hu and Westbrook 2007), and perhaps this cost is greater in the context of a crisis like the present one, where directors will already be feeling generally risk-shy. Against this, however, must be balanced the need to facilitate the extension of new credit to already distressed businesses, and (relatedly) to facilitate workouts in relation to existing indebtedness. The Government is rightly focused on encouraging and enabling creditors to do this, but they may well be less inclined to cooperate if the signal sent by lawmakers is that the ordinary rule, by which creditors are positioned as the constituency that directors must serve when the debtor is insolvent, does not apply. I doubt that support will be forthcoming if creditors cannot be assured that their interests will be treated as paramount if and for so long as the debtor is actually insolvent, and this is what West Mercia provides. I am far less enthusiastic about the compensation order regime, which seems to me to be far too wide, but suspect there will be little appetite for reviewing this flagship reform anytime soon.
Kristin van Zwieten is Clifford Chance Associate Professor of Law and Finance at the University of Oxford.
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