The Zone of Insolvency – Part Two
The risks of getting it wrong
Why does all this matter so much? Because if directors get it wrong in the zone of insolvency, they can face serious personal risks. Normally, one comfort of running a limited company is that directors aren’t personally on the hook for the company’s debts. However, if mismanagement leads to greater losses in insolvency, the shield of limited liability falls away. Under UK law, directors can be held personally liable for certain misconduct in the lead-up to insolvency. The biggest pitfalls include wrongful trading, fraudulent trading, and misfeasance, among others.
Wrongful trading occurs when directors continue to trade when they knew or ought to have known the company had no reasonable prospect of avoiding insolvent liquidation and failed to take every step to minimise losses to creditors (Insolvency Act 1986, s.214). If a liquidator later proves wrongful trading in court, the directors can be ordered to personally contribute to the company’s assets to cover creditor losses. A recent high-profile example is the case of British Home Stores (BHS). When BHS collapsed in 2016, its liquidators sued the former directors for wrongful trading. In a 2023 judgment, the court found some directors liable and ordered two of them to pay £6.5 million each in compensation, the largest wrongful trading award on record. The judgment revealed that the directors had continued a “degenerative strategy”, taking on more debt and deepening the insolvency hole. at a time when they should have known the end was nigh. This case is a stark reminder: if you keep trading in the zone of insolvency without a viable plan, you risk personal financial ruin. There are various defences to wrongful trading, but wise directors avoid having to provide a defence!
Fraudulent trading is even more serious (and thankfully, rarer). This is when directors run the business with intent to defraud creditors or for any fraudulent purpose (Insolvency Act 1986, s.213). Unlike wrongful trading (which can be a matter of poor judgment or negligence), fraudulent trading involves dishonesty – for example, taking customer deposits when you know the business is bust, or moving assets out of the company to put them beyond creditors’ reach. Courts can order personal contributions for fraudulent trading, and it’s also a criminal offence that can lead to fines or imprisonment.
Beyond those specific issues, misfeasance is a broad term for breach of fiduciary duty or misapplication of money/property of the company (Insolvency Act 1986, s.212). Insolvency practitioners can pursue misfeasance claims where directors have breached their duties and caused losses. The BHS case introduced the idea of “misfeasance trading” – essentially continuing to trade in a way that breaches the duty to creditors even before the point of no return. The BHS directors were found liable for this as well, because they failed to consider creditor interests at an earlier stage, even though collapse wasn’t imminent.
Other potential risks include preferences (favouring one creditor over others before insolvency), transactions at undervalue (selling assets for peanuts to the detriment of creditors), and directors’ disqualification. The Insolvency Service can investigate directors of failed companies and seek to disqualify those guilty of misconduct for up to 15 years. Disqualified directors can even face compensation orders, meaning they have to pay money to creditors as a consequence of their actions. In short, if you mishandle things in the zone of insolvency, you could lose more than your business – your personal wealth and career as a director could be at stake.
The information provided in this article is for general information purposes only and does not constitute legal advice. Whilst we endeavour to ensure that the content is accurate and up to date, it may not reflect the most recent legal or regulatory developments related to insolvency. Accordingly, nothing in this article should be relied upon as a substitute for professional advice tailored to your specific circumstances and no liability will be accepted from you acting or refraining from acting in relation to any information provided in this article. Should you require specific insolvency advice please contact us.
