What is wrongful trading? And how does is differ from fraudulent trading? Caroline Clark of RMCSC explains the differences and how coronavirus has affected legislation.

What is wrongful trading?

Wrongful trading is a concept introduced by the Insolvency Act 1986 (IA1986) as part of an attempt by the government to make company directors more responsible for the management of the companies they run.

Wrongful trading is not specifically defined in IA1986, however if a company goes into creditors' voluntary liquidation, compulsory liquidation or administration and sometime before the company entered the insolvency procedure a director of the company should have known that there was no reasonable prospect of the company going into insolvent liquidation or administration, then the director may be ordered by the court to make a contribution to the assets of the company.

Wrongful trading therefore takes place when a director is aware or should be aware that the company cannot avoid a formal insolvency procedure but allows the company to continue trading regardless, resulting in losses to creditors.

Wrongful trading action may also be brought against ‘shadow directors’, people who are not directors according to the information filed at Companies House but who are in accordance with whose directions the directors are accustomed to act.

How does wrongful trading usually occur?

Often wrongful trading is identified when an officeholding insolvency practitioner reviews management accounts and minutes of board meetings. The insolvency practitioner will see that a company's accounts showed a trend of increasing losses and there was no prospect of returning the company to profitability through new clients, developing a new product/service or reversing the cause of the ongoing losses. However, the directors allowed the company to continue to trade.

Wrongful trading could also occur if a company depends on one client for the majority of its turnover and that client either ceases to trade or brings the contract with the company to an end. This could result in a sudden change in profitability and if it was not possible to find new clients and return to profitability within a reasonable time and the directors allowed the company to continue to trade and increase losses rather than putting the company into liquidation or administration, then wrongful trading actions could be bought against the directors.

It should be noted that directors do have the defence to a charge of wrongful trading that after becoming aware of the likelihood of insolvency they took every step to minimise the loss to creditors.

How has coronavirus affected wrongful trading?

Given the significant effect coronavirus (COVID-19) has had on the UK economy, the Corporate Insolvency and Governance Act 2020 (CIGA2020) was recently introduced to help businesses experiencing financial difficulties because of the pandemic.

As part of CIGA2020, amendments have been made to wrongful trading legislation which means that losses incurred because of coronavirus between 1 March 2020 to 30 September 2020 will not be considered for the purposes of wrongful trading.

What is fraudulent trading?

Fraudulent trading is defined in IA1986 as carrying on any business of a company with intent to defraud creditors of the company or for any fraudulent purpose.

There are many similarities between wrongful trading legislation and fraudulent trading legislation:

• both apply when a company is in liquidation or administration and are concerned with the time before the formal insolvency procedure
• charges of both are brought by the officeholding insolvency practitioner
• the court may declare that the person found guilty of either should contribute to the company's assets
• both provide a way for making incompetent or dishonest directors pay financially for their actions after a company has gone into liquidation or administration
• both are likely to be included in disqualification reports against the director that may result in the director being disqualified from acting as a company director

What are the differences between wrongful trading and fraudulent trading?

However, there are material differences between wrongful trading and fraudulent trading:

• An action for wrongful trading may only be brought against a director(s) or a shadow director(s) of a company. An action for fraudulent trading may be brought against any person who was knowingly a party to the fraudulent trading.
• The standard of proof is also different. For an action for fraudulent trading to succeed the officeholding insolvency practitioner will have to prove dishonesty on the part of the defendant. This is much more difficult than showing ongoing trade and increasing losses at a time when there was no prospect of the company avoiding insolvency, as with a wrongful trading action.

While both can result in directors having to make a financial contribution to the assets of the company and effectively being held personally liable for some of the company fines/debts, only fraudulent trading may result in criminal action against the director.

About the author

Caroline Clark is director of RMCSC, a fellow of the Insolvency Practitioners Association and R3, and has an MBA. She established RMCSC in 2013, providing consultancy advice for insolvency practitioners about compliance with insolvency and anti-money laundering legislation.

See also

What are the responsibilities and duties of a company director?

What you need to know about Corporate Insolvency and Governance Bill

Insolvency notices

Find out more

Insolvency Act 1986 (Legislation)

Corporate Insolvency and Governance Act 2020 (Legislation)

Image: Getty Images

Publication date: 25 August 2020

Any opinion expressed in this article is that of the author and the author alone, and does not necessarily represent that of The Gazette.