Licensed Insolvency Practitioner Neville & Co
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Six insolvency traps to avoid

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As small businesses consider insolvency to escape Covid loans, Lisa Thomas explains six actions which can land directors and shadow directors in deep trouble.

26th Oct 2021
Licensed Insolvency Practitioner Neville & Co
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When a UK Limited company enters liquidation or administration, the appointed Insolvency Practitioner (IP) has a statutory duty to investigate what caused the company’s demise and whether the directors committed any misconduct.

The IPs findings are reported to the Insolvency Services who can take the following action against the directors concerned:

  • Disqualify from being a director
  • Issue a penalty
  • Pursue civil proceedings
  • Pursue criminal charges leading to imprisonment.

The IP also has the power to bring proceedings against the directors (including shadow directors) personally.

1. Wrongful trading 

This is where the directors ought to have liquidated the company but instead continued trading, and the company’s position worsened during the period. This offence is least likely to be brought about, especially as a stand-alone claim, because it is difficult and expensive to prove (Insolvency Act 1986 s 214).

Directors need to be able to show they took every step to minimising the losses, so good record keeping of the financial figures and the rationale for decisions to continue, are both essential.

Case law (Ralls Builders Ltd [2016] EWHC 243 (Ch)) determined that IPs must prove the actual deficiency got worse. If upheld, the court can order the directors to make any contribution to the company’s assets as it sees fit.

Wrongful trading claims were suspended during the Covid pandemic between March 2020 and July 2021, but not in full as claims could still be brought about during that time. However, any accounting losses during the ‘suspension period’ must be taken out of the equation. In my opinion, this provided false comfort to directors, because the was no suspension of the easier claims to pursue (see below).

2. Fraudulent trading

This type of claim is also rare. It is defined as directors carrying on the business with the intent to defraud creditors or any other person - most commonly defrauding HMRC (Insolvency Act 1986, s 213).

Any guilty person can be held liable to make contributions to the company’s assets.

3. Transactions at an undervalue

This claim is triggered where assets are transferred for free, or sold at less than market value, at a time when the company was insolvent (Insolvency Act 1986, s 238).

The court shall make such order as it thinks fit for restoring the position to what it would have been if the company had not entered into that transaction. The best defence a director can have is to prove the transfer was at market value by obtaining a professional valuation of the assets at the time of the transfer.

The IP can challenge transactions that occurred up to two years prior to ‘the onset of insolvency’.

4. Illegal preferences

This is where one or more creditors were preferred for payment over others, at a time when the company was insolvent, (Insolvency Act 1986 s 239). This is the most common type of claim I see.

The IP can challenge transactions that occurred up to six months prior to ‘the onset of insolvency’ for unconnected parties, and up to two years prior for connected parties. The IP can pursue the creditor or the directors to restore the position to what it would have been had the preference not been made. In practice the IP will pursue the amount of the preference made.

One defence is that the company was influenced by desire to make the payment, which can be hard to prove against an unconnected party. However, ‘desire’ is automatically presumed in the case against connected parties making it harder for directors to defend any such claim brought against them.

 

The most common creditor preferences are when directors pay themselves, a family member, or a creditor for whom they have provided a personal guarantee.

5. Misfeasance

This is where a company officer has misapplied, retained, or become accountable for any money or property of the company, or been guilty of any misfeasance or breaches of duties (Insolvency Act 1986, s 212).

In the past, the most common type of misfeasance claims I would see would be illegal dividends drawn by shareholders and, to some extent, unprotected customer deposits. Going forward I expect the misuse of Covid funds will form misfeasance claims (see below).

The court can order the party to repay, restore or account for the money or property with interest, or to pay compensation.

6. Misuse of Covid funds

The IP will investigate fraud incurred with the following covid support schemes:

  • SSP refunds
  • Local authority grants
  • Eat Out to Help Out grants
  • CJRS for furlough pay
  • Bounce Back Loans (BBLs)

The IP report any such fraud identified to the Insolvency Services and to HMRC. The IP can also pursue the directors for misfeasance.

With a BBL the IP will investigate whether the company genuinely met the criteria to apply for the loan and what the funds were used for. The BBL terms stipulated the loan must provide an ‘economic benefit to the company and not be used for personal use’. If the directors spent the funds personally, resulting in an overdrawn director’s loan account we can also pursue repayment.

With furlough scheme fraud HMRC can charge a 100% tax penalty and 100% interest.

Conclusion

The IP will rarely bring a claim all the way to court as claims are often negotiated and settled out of court. If a director is in any doubt as to their position, they should seek independent legal advice.

Replies (7)

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By Hugo Fair
26th Oct 2021 17:38

Thanks. A salutary article that (copyright permitting) should be handed to any client at the first sign they may be heading in that direction - let alone if they start raising enquiries about this topic.

A couple of questions for Lisa if I may:

1. "ought to have liquidated the company but instead continued trading" ... is there a consistent definition of when that position is reached? It might often seem obvious, but I've encountered varying definitions.

2. "With furlough scheme fraud HMRC can charge a 100% tax penalty and 100% interest" ... is this on top of 100% repayment of the relevant CJRS amounts as well?

And a thought (though possibly not welcomed by Lisa!), has anyone thought of creating a kind of 'due diligence' pack (similar to the excellent framework above but filled out with more detailed questions/examples) that any client contemplating this route could be encouraged to follow ... as a pre-cursor to deciding what to do?

Thanks (1)
Replying to Hugo Fair:
Lisa Thomas
By Lisa Thomas
27th Oct 2021 11:57

1. It's basically the point of no return. We look at when the company could be determined as insolvent and at what stage ought the director/s have concluded that Liquidation was the only option.

We also have to take into account the skill and experience held by the director/s concerned.

2. Yes my understanding is the fraudulent amount of the loan is assessed, plus up to 100% penalty charged plus interest . See here for more info:

https://www.gov.uk/government/publications/penalties-for-not-telling-hmr...

If people have committed Covid funding fraud it will be too late to do much about it now.

Alternatively, if their company is insolvent and they want advice on what not to do, a 'due diligence' pack would be very useful however I suspect they will already be at the stage where they need to take insolvency advice.

This type of advice should be given to all directors when they first become a director and every time they set up a company in my opinion.

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Replying to Insolvency Practitioner:
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By Hugo Fair
27th Oct 2021 19:07

"This type of advice should be given to all directors when they first become a director and every time they set up a company in my opinion."
An excellent point ... even if accompanied by a wistful "If it were only so!"

Thanks for answering my two questions.
Your point about the relevance of 'skill & experience held by director/s concerned' probably explains why I've encountered some variation in the past (the use of personal judgement being sensible but prone to interpretative bias, I guess).

Thanks (2)
Replying to Hugo Fair:
Lisa Thomas
By Lisa Thomas
28th Oct 2021 09:03

You're welcome.

The other consideration is how hard and expensive it is to bring wrongful trading claims about. Illegal preferences are much easier to prove and pursue.

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By Justin Bryant
27th Oct 2021 09:49

Also, re BBLs etc., see the links at the bottom of this link re new retrospective legislation: https://www.accountingweb.co.uk/any-answers/dissolving-a-company-with-a-bbl

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By MattS
27th Oct 2021 11:38

I think that we will unfortunately see point 6 being raised all too often over the next few years.

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By Paul Crowley
27th Oct 2021 14:09

Much appreciated

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