COVID-19: Emergency reforms to the insolvency regime

31st March 2020

Tiernan Fitzgibbon updates you on the recently announced proposed changes to the insolvency regime in light of the Covid-19 pandemic. This is the first in a series of briefings from the Insolvency and Company Practice Group at Five Paper.

The Government announced the proposed changes on 28 March 2020. The detail has not yet been published, but is said to include:

• Suspending wrongful trading provisions affecting company directors (and LLP members) for a period of three months, with the suspension to retrospectively apply from 1 March 2020; and
• A moratorium on applications from creditors to place companies into administration or liquidation that are undergoing rescue or restructuring.

Wrongful trading: “Wrongful trading” occurs where a company continues to trade despite its inevitable upcoming insolvency within the meaning of s123 Insolvency Act 1986 (“IA 1986”). Office holders can bring actions to hold directors personally liable for such losses incurred: see s.214 (liquidation), and s.246ZB (administration).

In order to be held liable, the director must have known or ought to have concluded prior to the commencement of the company being wound up that there was no reasonable prospect of the company avoiding going into insolvent liquidation or administration. Liability accrues from the moment that the director had actual or constructive knowledge, leading to it being termed as the “moment of truth” test.

The test for determining a director’s knowledge involves both an objective and subjective element:

• 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 (an objective test); and
• The general knowledge, skill and experience that the accused director is said to possess (a subjective test).

Thus, a director who is deficient in their abilities as well as one who exceeds them will be caught under the terms of the moment of truth test unless they can be said to have a defence by having taken every step after the “moment of truth” with a view to minimising the potential loss to the company’s creditors.

Such a defence involves the same hybrid test for determining a director’s knowledge i.e. looking at whether the steps taken were reasonable having regard to the knowledge, skill and experience subjectively possessed by the director as well as objectively determined by looking at what steps a reasonable director ought to have taken (ss 214(3) and 246ZB(3), IA 1986).

If liable, a director can be held personally liable for all losses incurred by a company for “wrongful trading” after the “moment of truth”. The “appropriate amount that a director is declared to be liable to contribute is the amount by which the company’s assets can be discerned to have been depleted by the director’s conduct which caused the discretion under s.214(1) to arise” (Produce Marketing Consortium (In Liquidation) Ltd, Re (No.2) (1989) 5 B.C.C. 569).

In addition to the risk of personal liability, directors also run the risk of being disqualified. A court may make a disqualification order, even on its own motion, against any director who is ordered to contribute to a company’s assets for wrongful trading (s.10 Company Directors Disqualification Act 1986).

It is difficult to see whether there will be any practical benefit to the proposed changes. In our experience, wrongful trading applications are already rare as the fact-sensitive enquiry is necessarily expensive, and courts are generally reluctant to criticise the actions of a director with the benefit of hindsight where the director can reasonably be said to have been attempting to make the best of a bad situation.

The suspension of wrongful trading may also create a rogue’s charter as it fails to distinguish between directors of companies whose operations were genuinely impacted by the Covid-19 pandemic and could reasonably expect to recover to normal trading conditions on the end of the pandemic, and directors guilty of gross mismanagement, irrespective of the pandemic.

Moratorium on administration/liquidation: It is proposed to establish a moratorium on creditors’ rights to place an insolvent company into administration or liquidation where the company is undergoing a “restructuring or rescue”. A restructuring or rescue is effectively an agreement with creditors on how to reorganise the repayment of the company’s debts and so are not statutorily defined processes. It remains to be seen what criteria or mechanism the Government proposes to allow companies to seek such a moratorium.

One idea may be a court-sanctioned process requiring the company to justify the moratorium, similar to that used in Schemes of Arrangement. Another solution may be to require the approval by a certain percentage of its creditors. However, as is often seen in similar voluntary arrangements, this can cause prejudice to some creditors and the process may encourage bogus claims for the purpose of voting.

Once the Government has published detailed proposals, we will provide a further update informing you of the changes and our analysis as to what their likely impact will be.