Malpractice and Misconduct of Company Directors

This is a company law question and the issue relates to malpractice and or misconduct of company directors and whether the actions of the directors will have a personal impact on them. Generally insolvency law in the United Kingdom deals with the insolvency of companies as well as individuals. The important Statutes that relates to insolvency in the United Kingdom are the Insolvency Act 1986 as amended by the Enterprise Act 2002 and the Company Director Disqualification Act 1989 and the Companies Act 2006.

A company becomes insolvent when it can no longer pay its debts. See Re Cheyne Finance PLC (2007) ALL ER (D) 25 and Cornhill Insurance PC v Improvement Services Limited (1986) 1 WLR114

When a company becomes insolvent many issues are usually considered. The questions that are usually asked is, is can the company be rehabilitated or is it better to put the company in to a better shape before it goes in to liquidation. [1] Another issue to be considered is the duties that the directors owe the company itself and its creditors and the sanctions that may be imposed for breach of those statutory duties by the directors. [2] All these issues and more fall within the orbit of corporate insolvency law. [3] In this case Derro Designs Limited is having problems of cash flow and the company employed certain measures through its directors to increase the company’s turnover. The measures did not work and the company continued to experience cash flow problems and from January 2009 onwards the company could no longer pay its debts to its creditors. It should be pointed out that many companies can continue trading, especially young companies in their early years whilst insolvent. There is nothing that is inherently wrong with a company trading whilst insolvent; however the directors of a company can be held for misconduct when a company continues trading when the company is in danger of insolvent liquidation. [4] Once a company has been wound up the conduct of the directors in their running of the company will come under the searchlight and will be thoroughly examined. [5] In this case, the conducts of the directors of Derro Designs Limited, Derek and Roger will be thoroughly examined to find out if they will be held liable for misconduct. Applying the law to the facts of the case, it appears that both Derek and Roger can be found liable for misconduct. The company was still trading despite the fact that the directors knew full well that the company was in danger of liquidation. The company started having difficulties in maintaining payment to its creditors in from 2009, despite that the company continued trading until a winding up petition was presented against the company in January 2011 for failing to meet its obligation to its creditors and her Majesty’s Customs and Excise.

One of the issues that the liquidator will consider when assessing the conduct of Derek and Roger is the date of insolvency of the company. The date of insolvency of Derro Designs Limited will also have an impact on any recoveries to be under sections 213 and 214 of the Act. It should be pointed out that there is a difference between the date of insolvency and the date of commencement of liquidation. In this case, the date of insolvency is January 2009, while the date of liquidation is January 2011.

When it was apparent that Derro Designs limited could no longer pay its debts, the directors of the company should not have sought out new customers and the company should not have taken fresh deposits from the customers. This is clearly a case of misconduct on the part of the directors of the company. Furthermore, the company should have put in place internal safeguards in the company to ensure that Derek and Roger (both directors) of the company remain aware of the company’s financial position. If those internal safeguards were in place in the company, the company directors will be able to monitor the financial health of the company and they would have been able to know when to stop trading and receiving new deposits from customers.

Derek and Roger can be found liable of misconduct for their actions. The directors can potentially be charged with wrongful trading and or fraudulent trading and the reuse of a similar company name. [6] It should be pointed out that disqualification of directors is a civil matter; however the directors of Derro Designs Limited can be charged with many criminal offences within the Insolvency Act 1986. [7]

Derek and Roger, the directors of Derro Designs Limited could be potentially liable for fraudulent trading. Fraudulent trading used to impose civil and criminal liability on directors of a company. However, the Insolvency Act 1986 by virtue of section 213 only imposes civil liability on directors for fraudulent trading. The provision of section 213 categorically imposes civil liability on company director and also extends to everyone who was knowingly a party to the fraudulent trading. This means that even people that are not directors of the company may be liable for fraudulent trading. See Gerald Cooper Limited and Bank of India v Morris (2005) EWCA Civ 693. In this case, the court held inter alia that if a person other than the director of the company is found to have knowingly participated in fraudulent trading then that individual was acting dishonestly. Furthermore, once it is established that the directors carried on the business of the company with the intent to defraud or for fraudulent purposes, the court may impose liability on the directors provided that the directors were aware that the company was carrying on such business. This also applies to people that are not directors in the company. [8] Applying the law to the facts of the case, Derek and Roger were the sole directors of the company; they both knew that the company was experiencing serious cash flow problems as early as 2008. This cash flow problem worsened in 2009, despite that Derek and Roger decided to allow Derro Designs Limited to continue to trade and paid its trade suppliers by letting debts to HM Revenue & Customs increase. This can be termed to be fraudulent trading. The company has a statutory obligation to pay its debts to HM Revenue and Customs as and at when due. Thus it can be said that the business was carried on with intent to defraud the HM Revenue and Customs. The directors were using the money meant to be paid to the government for paying for its supplies.

Furthermore a winding-up petition was presented against the company in July 2010. Also in July 2010, the company sold its two Mercedes vehicles to Roger, a director of the company for £5,000. In December 2010 the company’s remaining fixed assets were valued at £40,000 and were transferred to Derro Designs (Leicester) Ltd, a connected company, in part-payment of a debt of £50,000 which Derek and Roger claim was owed to Derro Designs (Leicester) Ltd. In January 2011 Derro Designs Ltd went into liquidation. This action by the directors of the company qualifies as fraudulent trading and or unlawful trading. An action may be brought against both Derek and Roger by the liquidator. In other words, before Derro Designs Limited an insolvency procedure, both Derek and Roger will be deemed to have committed a criminal offence if they dishonesty kept Derro Designs Limited in operation in order to deceive creditors. Derek and Roger will be made to pay compensation if they were trading knowing fully well that Derro-Designs would not avoid liquidation. [9]

Derek and Roger must have actually acted dishonestly by ordinary standards. See R v Ghosh (1982) EWCA Crim 2. In Re Augustus Barnett and Sons Limited (1980) BCLC, the court held inter-alia that fraudulent trading is based on a n actual moral blame that can be attributed to some-body else. Thus, applying the law to the facts of the case, Derek and Roger can only be held liable for fraudulent if they are found to have acted dishonestly. Therefore, the prosecution will have to prove that their actions of the directors were dishonest. The directors will not be found liable for fraudulent trading if the prosecution cannot prove that their actions were dishonest and intended to defraud. Dishonesty on the part of Derek and Roger will be ascertained by the court on the basis of whether at the time they carried out the acts under scrutiny, that the both of them were aware that the company could not be able to meet its obligations to its creditors. [10] The court will employ a substantive test and not an objective test in order to determine the state of mind of both Derek and Roger at the time they carried out the fraudulent trading. See Re Patrick Lyon Limited (1933) 1 Ch 706 and R v Grantham (1984) QB 675

Derek and Roger can be held liable under section 214 of wrongful trading. Section 214 of the Insolvency Act 1986 was introduced following the recommendation of the Cork Committee’s report. The Cork Committee strong criticised the insolvency law saying that directors can only be held for fraudulent trading. The Cork committee then went on to say that the law made it easy for directors to get away easily with trading knowing that the company cannot meet its obligations to its creditors. The Cork Committee then suggested that wrongful trading should provisions should be included as part of insolvency law, because it will provide a more transparent, efficient and accessible mechanism by which directors of insolvent companies could be held accountable for conducts that will harm their creditors. [11]

Thus the main objective of section 214 of the Insolvency Act 1986 is to hold directors accountable for delinquent trading activities without the need for the prosecution to prove fraud or dishonesty on the part of the directors. Thus, applying the law to the facts of the case, Derek and Roger can be held liable for wrongful trading. The prosecution does not need to prove that the directors acted fraudulently or dishonestly. All they need to prove is to show that the directors were still trading and taking money from new clients when they were aware that the company had liquidity problems and would not be in a position to meet its obligations to its creditors. In this case both Derek and Roger will likely be held liable for wrongful trading. They knew the company had problems and they ignored the problems and carried on trading. Thus, in other to succeed in a charge of wrongful trading all the prosecution needs to do is to show that the directors acted negligently. This is a lot easier to establish than fraudulent trading. Roger and Derek will be held liable or wrongful trading if it is established that their company continued to trade when at some time before the commencement of winding up procedure the company they both knew that there was no way that the company would have avoided going in to insolvent liquidation. The court will judge the skills that Derek and Roger ought to have had for carrying out their duties as directors. See Re Produce Marketing Consortium Limited (No 2) (1989) BCLC 520

The court will usually consider all the circumstances of the case before deciding if the directors were culpable for wrongful trading. See Re Brian D Pierson Contractors Limited (1999) BCC 26. Applying the law to the facts Derek and Roger are the sole directors of Derro Designs Ltd. The company has traded successfully since 1995 but began having difficulty in maintaining payment to its creditors in 2008. The company will consider the reasons why the company still continued trading in spite of the financial difficulties the company was experiencing in order to find out the true intentions of the company.

The unlawful trading provisions have one major limitation. The cause of action can only be maintained by the liquidator of the company. It should be pointed out that Derek and Roger can be tried for both fraudulent trading and wrongful trading at the same time. [12] See Re Purpoint Limited (1991) BCLC 491. Wrongful trading was introduced to complement the principle of fraudulent trading, however wrongful trading unlike fraudulent trading is not as serious and therefore is more rampant than fraudulent trading. Thus, Derek and Roger will be found guilty of wrongful trading if it can be established that their company continued to trade beyond the point when they both knew or ought to have known that there the company was surely going to enter in to insolvent liquidation and they both did not take every available reasonable step to minimise the potential loss that the company creditors will incur. [13]

Derek and Roger if found guilty of wrongful trading will be ordered by the court to make such contributions to the assets of the company. However this is subject to the discretion of the court. The burden of proof required in order to show that Derek and Roger committed the offence of wrongful trading is the civil burden of proof. The liquidator only needs to show that on a balance of probability that Derek and Roger committed the offence. The liquidator does not need to prove his case beyond all reasonable doubt. The courts usually apply a two-fold test for knowledge when determining whether Roger and Derek are both guilty of wrongful trading. The first test is whether David and Derek have the necessary skill required to be a director and the second test is usually a higher standard of knowledge and is usually applied in cases that the directors require a specialist skill. See Re Brian D Pierson Contractors Limited (1999) BCC 26

It should be pointed out that it is not an offence for a company to be trading while it is insolvent and Derek and Roger will be exonerated if they genuinely believed that the finances and liquidity of the company will be turned around and that the position of the creditors will improve. Thus, Derek and Roger will only be held liable for wrongful trading only if they ought to have realised that the position of their creditors will likely get worse from that position onwards and that there is a strong likelihood that the company will graduate to liquidation. This may be very difficult for the directors to prove. The directors should have sought for professional advice from a licensed insolvency practitioner in 2008 when they stated experiencing cash flow problems and could not meet up with their obligations to their creditors, however they decided against it because it was too expensive to engage a professional licensed insolvency practitioner. Thus the directors will need to prove to the court that they saw light at the end of the tunnel and genuinely believed that the company’s financial position will improve and that the company had a good chance of escaping insolvent liquidation.

If Derek and Roger are found guilty of wrongful trading, the court will impose on them an amount that they will be required to contribute to the company. The court has a wide discretion in making these awards and it is these contributions are usually compensatory rather than punitive in nature. The court will usually assess the right amount to be paid by Derek and Roger by computing the difference the net assets of Derro Designs Limited at the date that both Derek and Roger ought to have traded beyond and the net assets of the company at the time it went in to liquidation. However, the court usually exercises a wide discretion over matters like this and may award just a percentage of the actual amount that it computed. [14] See Re Brian D Pierson Contractors Limited (1999) BCC

In this case, it will be better to bring an action for wrongful trading against the directors than unlawful trading. The reason for this is that unlawful trading requires a higher standard of proof due to the fact that it is associated with fraud. Thus it is better to bring an action for wrongful trading against the directors because the standard of proof is lower. The directors will be charged with fraudulent trading if it is established that when the trading took place that the company was not insolvent. It should be pointed out that insolvency is usually a requirement in order to prove that the directors acted wrongfully, but it required for fraudulent trading

The Phoenix syndrome appears to also be involved in this case. The Phoenix synndrome occurs where corrupt and dishonest director’s exploits limited liability to their own selfish ends to the detriment of the creditors. Some unscrupulous directors set up a company then milk the company for the maximum amount of money and then liquidate the company. On the conclusion of the winding up of the assets of the company, the assets of the company are transferred to the new company and the circle starts all over again.

In this case, in December 2010 the company’s remaining fixed assets were valued at £40,000 and were transferred to Derro Designs (Leicester) Ltd, a connected company, in part-payment of a debt of £50,000 which Derek and Roger claim was owed to Derro Designs (Leicester) Ltd. This can be referred to as the phoenix syndrome. In Ricketts v Ad Valorem Factors (2003) EWCA Civ 1706, the court held inter-alia that if a director fulfils the legislative provisions then personal liability for the second company’s debts follows even if there was no unscrupulous intention and criminal sanctions appear harsh. Thus applying the law to this case, both Derek and Roger will incur personal liability for the debts of the second company.

Finally, the insolvency practitioner in charge of any receivership, administration or liquidation must make a report on the conduct of every director to a special unit of the Insolvency Service. In this case the company has failed and the Secretary of State is the person that will decide whether it is in the public interest to seek a disqualification order against Derek and Roger so that they can -not act as directors again in any company in the United Kingdom for a minimum of two years and a maximum of fifteen years. Thus, the conduct of Derek and Roger could impact on them personally if it is proven that their conduct was such that they continued to trade when they knew or ought to know that continuing trading will be to the detriment of their creditors at a time their company was insolvent. It should be pointed out that it is the court that will hear and decide any application that is brought to disqualify Derek and Roger from holding office as a director.