Vol 13 (2016) - Issue 6

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Wrongful Trading: Scaring off Reckless Directors

Introduction
Experience has taught us that directors of financially suffering companies are inclined to engage in business dealings that involve more risk. Since the concept of limited liability shifts the economic risk of corporate failure from the shareholders to the creditors, the former will have little to lose, but plenty to gain, by taking risks. Accordingly, an issue of ‘moral hazard’ occurs, since the shareholders will see their wealth increased if the risk-taking pays off, but will remain financially unharmed if it does not. It will be the creditors that suffer the losses, as they have the residual claim over the corporate assets as the company draws near to insolvency. Attempts were made to counter this abuse of the limited liability privilege through imposing director liability via the former fraudulent trading provision, now section 213 of the Insolvency Act 1986 ('IA 1986'). Unfortunately, it failed to curb directors in their risky business dealings due to the absence of a dishonesty element. This led to the adoption of the wrongful trading provision under section 214 of the IA 1986, which does not require any fraudulent, illegal or unconscionable intent to hold directors liable. Convicted directors will have to make a financial contribution equal to the extra losses the company incurred for which they are responsible. Section 214 of the IA 1986 also serves the public interest as a conviction under this provision constitutes a ground for disqualification under section 10 of the Company Directors Disqualification Act 1986 ('CDDA 1986').
An important feature of the wrongful trading action is that neither it nor its proceeds are regarded as assets of the company. As a consequence, its compensatory function will serve the interests of the unsecured creditors to the fullest, because qualifying floating charge holders will not have recourse to the fruits of a successful action. However, the exceptional character of this action also added to the enforcement problems that the wrongful trading provision faced after its adoption in 1986, which gave rise to pessimistic voices expressing the failure of section 214 of the IA 1986 to deliver on its promise of ex post compensating wronged creditors and, consequently, ex ante deterring directors from limited liability abuse.
In this article the author analyses to what extent section 214 of the IA 1986 accomplishes its mission to fight irresponsible trading in the vicinity of insolvency. Albeit other common law countries have similar provisions, the focus of this article is on the situation in the United Kingdom. Firstly, it will give some attention to the wording of the provision. Subsequently, the substantive and procedural impediments to the effectiveness of section 214 of the IA 1986 will be discussed, including the debate as to the private and public law functions of the provision. Lastly, conclusions will be drawn concerning the prior success and the future prospects of section 214 of the IA 1986 in effectively preventing directors risking creditors’ money.