Contractors, beware the wrongful trading rules

Clients insisting upon it; recruiters insisting upon it and your financial sense insisting upon it – there are lots of good reasons to become a limited company as a contractor. The main one though is to get the shelter of limited liability status.

Yet some contractors we come across don’t understand that, despite this apparent protection should things go wrong, they as the director of their own ‘Ltd’ can be made personally liable for their company’s debts, writes Steve Parker, partner at Opus Restructuring LLP.

This often overlooked issue stems from the ‘wrongful trading’ provisions of the 1986 Insolvency Act. These provisions say, in effect, that when a company runs into financial difficulties, its directors have an obligation to ensure that from the moment they ‘knew or ought to have known’ that an insolvent liquidation of the company is unavoidable, they take ‘every step possible to minimise losses to creditors’.

Basically, these provisions mean that you (a contractor who’s the director of a company in trouble) must run the company in the interests of its creditors above all other considerations. If you ignore this duty and creditors suffer as a result, then you risk being asked to make good those losses. You can understand why, at first glance, some contractors say this is the stuff of nightmares, as it threatens people simply doing their best to run a troubled business who don’t have any intention of seeing creditors go short.

Fortunately, prosecutions for wrongful trading are rare. Better still, there are some basic steps that contractors directing a limited company that’s going to the wall can take to protect themselves. Most importantly, draw up and keep a log of your major decisions once you become aware there’s a problem – record what you’re doing and why.

This is no easy task when directors are under financial pressure. But because a liquidator has the benefit of 20:20 hindsight, having a record that you created at the time to show them is a  powerful defence that we recommend directors prepare, no matter how tough or tedious it may seem. That’s because your decisions may not turn out to be right, but this does NOT matter provided certain principles are followed.

Firstly, directors must ensure that no creditor’s position is made materially worse because the business has been continued after that tipping point where insolvency is inevitable. Secondly, individual creditors can NOT be paid ahead of others (‘preferred’), unless there is a clear justification that this benefited all of the creditors. Thirdly, directors mustn’t sell assets too cheaply just to raise cash (‘transactions at an undervalue’). And fourthly, they should NOT borrow more money in the hope that something might turn up (even from friends and family), nor should they start running up credit with new suppliers if their existing ones won’t support them.

In addition, directors can’t simply walk away from the situation however desperate things are. They must think carefully about what is best for creditors; take independent professional advice about the situation at the earliest opportunity and then follow it. Insolvency is a highly technical matter; specialist input is essential.

If the worse does happen, there are various insolvency procedures for companies:

• Administration -- mainly used when the business can be rescued.
• Company Voluntary Arrangement (‘CVA’) -- essentially a deal between the company and its creditors where they agree to accept less than 100% of their debts.
• Liquidation -- can be voluntary (a Creditors Voluntary Liquidation or ‘CVL’) if the directors decide to call a halt or compulsory (a Compulsory Winding Up or ‘CWU’) when a creditor goes to court to force a company into insolvency.
• Administrative Receivership -- can only be initiated by a bank, but is dying out because of changes in the insolvency legislation.

Keep in mind, some procedures may lead to another (companies can exit an Administration via a CVA or a CVL). However, in the end, all liquidations lead to a company being struck off the company register.

Whatever procedure you’re facing, the highly technical nature of it means specialist assistance is vital. But contrary to popular belief, the choice of insolvency practitioner (IP) to be appointed is for the creditors. Indeed, the person may not necessarily be the one nominated by the directors, although in most cases it is. 

Once the company has gone into the appropriate form of insolvency, its affairs are under the control of the IP who has been appointed. At this stage especially, remember that the IP is working for the creditors and NOT for the directors. In fact, the directors do NOT have any control over the process except if they happen to be a creditor themselves, for example for money that they lent to the company.

However as a director, you will be written to by the IP soon after their appointment and presented with a Company Directors Disqualification Act 1986 (CDDA) questionnaire. This must be completed. They will also send a copy of a circular to creditors enclosing a report setting out the circumstances of the company’s failure, or else details of how it can be downloaded. This asks creditors to give the IP “any evidence of wrongdoing by directors in their conduct of the company.”

But this is routine and is NOT an accusation of guilt. An IP has a duty to investigate the conduct of every director appointed in the three years preceding liquidation, and report confidentially to the Secretary of State within six months on their findings. The SoS then decides whether or not proceedings should be taken to disqualify errant directors from being “involved or concerned in the promotion, formation or management of a limited company”.  This is where your log that you drew up and kept as soon as insolvency looked inescapable comes in to bat in your defence. It really is important not to get caught out without it -- particularly for those who love being limited -- because disqualification can be for up to 15 years.