Directors in the spotlight: wrongful trading

Briefing

Alongside the permanent reforms to English insolvency law introduced by the Corporate Insolvency and Governance Act 2020, the government introduced a temporary suspension of certain provisions of the Insolvency Act 1986 (the IA) to address the economic turbulence caused by the COVID-19 pandemic.

This included a temporary suspension of director liability for wrongful trading, in that the courts will assume that any worsening of the financial position of a company or its creditors that occurs between 1 March 2020 and 30 September 2020 is not the responsibility of its directors. The suspension has now been revived, to last until 30 April 2021.

However, a recent first instance decision at the Business and Property Courts, Re Bright Future Software Ltd (Manolete Partners Plc v Ellis) [2020] EWHC 1674 (Ch), highlights that company directors should continue to bear their duties in mind, especially as the world begins to return to something resembling normality.

Background

Bright Future Software Limited (BFS) was a software developer, service provider and trainer. Robin Ellis was a minority shareholder and a (non-executive) director of BFS at all relevant times. His partner, Eudie Thompson, was the majority shareholder and also a director of BFS.

From its inception, Mr Ellis provided funding to BFS via both his initial equity subscription and a series of loans. BFS was also financed by both grants and loans provided by the Regional Growth Fund (RGF), a government programme to support private sector jobs and growth in certain areas of England.

The RGF funding was advanced to support the creation of over 350 full time jobs in Salford, and on the basis that the shortfall between the funding provided by RGF and the costs of the project (totalling £10.2 million) would be made up from private investment on terms approved by RGF. The majority of this funding was expected to come from Mr Ellis himself.

Contrary to the projections submitted to RGF as part of its funding application, BFS proved to be unsustainably loss-making, and from December 2013 it also owed arrears to HMRC. HMRC presented a winding up position at the beginning of February 2016 and a few weeks later BFS entered into a Creditors' Voluntary Liquidation (or CVL). By this stage there were also rent arrears and balances owed to trade creditors.

The liquidators of BFS (the Liquidators) identified various claims against Ms Thompson and Mr Ellis in their role as directors, which they assigned to Manolete Partners PLC (Manolete), an AIM listed litigation funder specialising in insolvency claims.

Mr Ellis was the only respondent in this case, with Ms Thompson having previously been declared bankrupt. By far the largest claim brought against him was a wrongful trading claim for £6,569,168 contrary to s214 of the IA (the Wrongful Trading Claim), while the other claims related to transactions at an undervalue, preferences and breach of duty.

Here, we focus on the Wrongful Trading Claim, although in the end, only the smaller of the two preference claims (for £188,769) succeeded against Mr Ellis.

Judgment

Wrongful trading is a statutory offence under the IA which, broadly speaking, applies where a director knows (or ought to know) there is no reasonable prospect of avoiding an insolvency process and does not take every step with a view minimising potential losses to creditors. That is, they allow the company to continue trading beyond the point of an insolvency process becoming inevitable, have not taken "every step" with a view to minimising losses, and as a result worsen the position of the company's creditors.

In determining what a director "ought to know" they are judged by:

the standard of a reasonably diligent person having both the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and
the general knowledge, skill and experience that that director has, so there is both a subjective and an objective element to this test.

The Wrongful Trading Claim was pleaded by Manolete on the basis that, by January 2015, Mr Ellis knew, or ought to have known, there was no reasonable prospect of avoiding insolvent liquidation for BFS. The sum of just over £6,500,000 which Manolete sought to recover from Mr Ellis was calculated on the basis of the increase in the net deficiency of its assets between January 2015, when Manolete argued that BFS ought to have ceased trading, and February 2016, when it in fact ceased trading.

Manolete's argument was founded on the fact that by that time Mr Ellis knew, or should have known, among other things:

that BFS had been balance sheet insolvent since May 2014, and the deficit between the value of its assets against its liabilities had been increasing since September 2014
that BFS's sales were inadequate to suggest it could trade its way out of insolvency and there was no prospect of this improving, and
that it was unlikely BFS would secure any external funding.

The case presented by Manolete referred to various documents, including third party reports and financial projections which would have been available to Mr Ellis in order to reach the relevant conclusions. Mr Ellis acknowledged that he failed to sufficiently inform himself as to BFS's financial position (ie these matters were not known to him).

However, the court also had regard to the fact that the accountants Hurst & Co, as well as RGF, were monitoring the position and prospects of BFS and were not raising any alarm bells. The court found Mr Ellis was entitled to rely on that fact.

Similarly relevant was KPMG's continued involvement in the business. In an email from KPMG, having been asked for their view as to whether it was "ok" for BFS to continue trading, KPMG advised that this was ultimately a matter for the directors, and one on which they ought to seek independent legal advice, but given there were ongoing discussions between BFS and other potential investors it was not beyond hope. KPMG even stated that to "wind [BFS] up would not necessarily be the correct treatment, and you may be criticised further were you to take this route".

In his judgment, Richard Spearman QC noted that:

"even at that time [ie December 2015], these highly reputable external advisers do not appear to have concluded that there was no reasonable prospect that BFS would avoid going into insolvent liquidation, and so should be wound up".

He stated that it would be "very harsh" to find Mr Ellis liable for wrongful trading on the facts presented, and he was satisfied that Mr Ellis did not know, and nor ought he to have concluded, that there was no reasonable prospect of BFS avoiding an insolvent liquidation. The Wrongful Trading Claim therefore fell at the first hurdle.

Comment

On reading the full facts of the case, one might be surprised at the outcome, so it's a helpful illustration that bringing a successful wrongful trading claim is challenging. It's worth noting that this was only a first instance decision, and Manolete has indicated that it may consider an appeal.

Nonetheless, the judgment provides some useful pointers for company directors who are (or may one day find themselves) navigating a potential insolvency scenario. In particular, Spearman QC seemed convinced by Mr Ellis's statement that others around him, most notably RGF and KPMG, gave no indication that there were grave concerns as to BFS's solvency. Of course, there would be a limit to how far a director could take this argument, depending on the weight of evidence to the contrary, but it suggests that the benefit of taking professional advice at an early stage will outweigh the costs of doing so in the long run.

A final point to note – though not a significant element to this case (for the time being) – is that it casts some light on the ongoing tension between the importance of promoting access to justice while regulating the behaviour of litigation funders. While litigation funders might support this on the one hand, they might compromise it on the other by being motivated ultimately by their eventual return.

Counsel for Mr Ellis drew Spearman QC's attention to the fact that Manolete had acquired the claim for an up-front payment of just £5,000, but stood to benefit from a substantial share of any recoveries. Manolete's counsel dismissed this as "nothing out of the ordinary", pointing out that, given BFS's impecuniosity, the Liquidators had to use third party funding to best realise BFS's assets for the benefit of its creditors.

Spearman QC acknowledged these concerns, but found they had no bearing on the case before him. We will be interested to see if litigation proceedings are brought (whether in this matter or another) on the appropriate conduct of an insolvency practitioner in partnering with litigation funders such as Manolete in future, particularly as the litigation funding industry continues to develop new products and enter new segments within the UK litigation space.