What’s so Wrong with Wrongful Trading?—on Suspending Director Liability during the Coronavirus Crisis

The UK Minister of Business, Alok Sharma MP, recently announced an action plan that would give vital support to frontline National Health Service staff battling Covid-19 and support businesses under pressure as a result of the coronavirus outbreak. The plan calls for fast-tracking personal protection equipment through the product safety assessment process, facilitating import and safety testing of hand sanitizer, and temporarily suspending wrongful trading provisions (namely, s 214 and s 246ZB of the Insolvency Act 1986) retrospectively from 1 March 2020 for three months for company directors ‘so they can keep their businesses going without the threat of personal liability.’

In a recent OBLB post about this initiative, Kristin van Zwieten points out that the wrongful trading rule is but a part of a broader regime that also includes the common law rule in West Mercia Safetywear v Dodd on directors’ duties in the zone of insolvency (on which see her article) as well as liability provisions under the Company Directors Disqualification Act 1986. Suspending ss 214 and 246ZB will thus have only a limited effect. Here I would like to follow up with some thoughts on why wrongful trading attracts such special attention and a proposal for the day after the crisis on the implementation of directors’ duties in the zone of insolvency and under the wrongful trading rule.

The UK is not alone with its initiative. Within days, New Zealand announced planned changes to their Companies Act 1993, aimed to allow directors of companies facing significant liquidity problems because of Covid-19 to take advantage of a 6-month ‘safe harbour’ from liability under s 135 and s 136 for reckless trading and incurring obligations during insolvency. Finance Minister Grant Robertson was careful to note, however, that these measures ‘must not be seen as a workaround for the obligations that businesses have to creditors, or the responsibilities of directors to act in good faith’ (see here).

Leading the pack is Australia. On March 25, it passed legislation inserting a new s 588GAAA to the Corporations Act 2001 (Cth). This section provides a temporary safe harbour relief in response to the coronavirus suspending director liability for insolvent trading under s 588G. As it happens, Australia already has a statutory safe harbour from such liability under s 588GA of its Corporations Act, so now it has two—one next to, or nested within, the other.

The havoc wrought by the coronavirus pandemic could cause even the more cynical observers to sympathise with government officials as they attempt to provide business people with some relief from the overall uncertainty now engulfing them. Apparently, directors’ liability for wrongful trading (or reckless trading or insolvent trading, as the case may be) is so disproportionately threatening that it justifies suspension precisely in a time likely to lead to many insolvencies. After discounting for politicians’ desire to be seen as doing something, anything, for business people, the abovementioned initiatives imply that these liability rules are inherently flawed; that there is something very wrong with wrongful trading liability. But is there?

Wrongful trading provisions are the director liability rules that everybody loves to hate. They have been on the books for decades and have been controversial since their enactment. Legal scholars have levelled various critiques against these rules. Some have underscored difficulties in their interpretation due to their use of vague and uncertain terms. For example, when is there (under s 214) ‘no reasonable prospect that the company would avoid going into insolvent liquidation’?  Others have noted practical difficulties in imposing liability having to do with litigation funding or channelling compensation money to unsecured creditors, especially with regard to the UK provision. More fundamentally, commentators have questioned the very wisdom of calling on directors to protect creditors’ interest, when creditors themselves have not yet taken the company to insolvency proceedings. This, the typical argument goes, puts directors in an irreconcilable conflict position.

Meanwhile, other countries have drawn inspiration from these rules, especially the UK’s wrongful trading rule. In 2019, the European Union adopted the Directive on Restructuring and Insolvency, which includes a provision influenced by the UK rule. On a smaller scale, Israel in 2018 enacted a rule that features a combination of elements used in the UK, Australia, and New Zealand.

Courts in particular have exhibited full understanding to the conundrum faced by managers of financially distressed companies. In Re Continental Assurance Co of London plc, Park J famously said that ‘Ceasing to trade and liquidating too soon can be stigmatised as the coward’s way out.’  In Cooper v. Debut Homes Limited (in liquidation), the Court of Appeal of New Zealand recently confirmed that ‘Directors do not become liable under [s 135] simply because they continue trading after a company becomes insolvent.’ Broader empirical evidence on the praxis of these rules has been mixed at best (see, with regard to the UK, Australia, and New Zealand, respectively, Williams 2015; Steele and Ramsay 2019; Taylor 2018).

The problem with wrongful trading liability does not stem from its use of vague terms. There is nothing special in this feature, and courts are accustomed to applying standard-type doctrines. Neither does it stem from uncertainty in assessing solvency. This feature, too, is not fanciful but familiar and reasonably handled in other settings. Moreover, suspending liability for wrongful trading as is now being proposed or implemented won’t suspend directors’ basic duties of loyalty and care, so legal exposure is not the issue. For the vast majority of owner-managers of small and medium firms, wrongful trading liability is not the primary concern when the family business is about to go down.

One explanation for the consternation over wrongful trading liability could be that it arises in a uniquely difficult legal point—a point that can metaphorically be described as warping of legal space. Wrongful trading liability arises at the very edge of the ‘zone of insolvency’, where a radical change in the firm’s strategy must take place—where a shift from a shareholder-oriented objective to a creditor-oriented one is called for but shareholder-appointed directors are still at the helm. This is the point in which insolvency is not only possible—a situation that many companies may experience and overcome—but actually forthcoming. The recent Court of Appeal decision in BTI 2014 LLC v. Sequana S.A. confirms this point beyond the narrow context of wrongful trading, as it implements a similar formulation—that ‘the duty [to consider creditors’ interest] arises when the directors know or should know that the company is or is likely to become insolvent.’

Suspending wrongful trading liability could provide some temporary relief during the coronavirus crisis. It will not do away with the fundamental challenge that it entails. Looking forward, a better formulation is needed for the content of directors’ duty under s 214 to minimise potential loss to the company’s creditors and their common law duty in the zone of insolvency.

When a company reaches the point in which directors’ duty to consider creditors’ interest is triggered—which, it is argued, subsumes their duty to minimise losses under s 214—the objective of the company undergoes a transformation. It is submitted that directors’ duties undergo a concomitant transformation at that point. While their fiduciary duties to the company remain intact, their duty of care changes in line with the change in the company’s objective. Specifically, directors should change the strategic management of the company from implementing an entrepreneurial strategy to implementing a custodial strategy that focuses on protecting the company’s assets with a view to returning it to a profit-oriented, entrepreneurial strategy when practical.

Custodial strategic management resembles the management approach required from trustees, including pension fund trustees, whose primary mission is to preserve the trust fund. As a corollary, managerial discretion during this stage would not be reviewed in a business judgment rule framework but rather in a custodial judgment framework, meaning that the court could review the substance of such discretion.

Whether ss 214 and 246ZB end up in suspension is yet to be seen. There is a good chance that they will, for the reasons mentioned here. Be it as it may, when the coronavirus crisis is over, courts will have to grapple again with both wrongful trading and zone-of-insolvency liability. Further clarification of the content of directors’ duties in these settings, in addition to the threshold conditions for their application, will be welcome.

Amir Licht is Professor of Law at the Radzyner Law School, Interdisciplinary Center Herzliya, Israel.