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If your business cannot meet its liabilities, it may face insolvency. If you are the director or shareholder of a company facing insolvency, the law can pursue you if your conduct amounts to fraudulent trading. This article will look at what directors and shareholders of companies facing insolvency should know about fraudulent trading so you can limit your liability.
Insolvency and Fraudulent Trading
The law defines insolvency in several ways. Generally, insolvency describes companies that either:
- lack the cash to pay their debts as they come due; or
- have insufficient assets to meet their liabilities.
If your company becomes insolvent, in many cases, a liquidator or administrator will take over the management of your company. The law gives liquidators and administrators broad powers to review your company’s affairs before insolvency.
Where a liquidator or administrator concludes any person’s conduct amounts to fraudulent conduct carried on for fraudulent purposes, they can apply to court seeking a fraudulent trading order.
What is Fraudulent Trading?
The liquidator or administrator must prove on the balance of probabilities that the conduct in question amounted to fraudulent trading. This means the liquidator or administrator must prove that it is more likely than not that the party in question is liable.
Any person can face liability for fraudulent trading concerning a company in liquidation or administration. However, the liquidator or administrator must first prove that:
- the company was engaged in fraudulent conduct; and
- the person in question used the company for fraudulent purposes.
Directors are more likely than anyone else to face liability for fraudulent trading. This is because directors:
- have direct control over the company; and
- can personally benefit from fraudulent conduct, especially if they are also shareholders.
That said, the law can hold anyone liable. This includes shareholders that are not directors. It can also include third parties like accountants and bankers. However, liquidators and administrators have difficulty proving that third parties acted dishonestly.
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Examples of Fraudulent Trading
Whether or not the liquidator or administrator can prove someone’s conduct amounted to fraudulent trading largely depends on the circumstances.
| Likely Fraudulent Trading | Unlikely Fraudulent Trading | |
| Example 1 | Suppose a sole director intentionally misstates her company’s annual turnover to receive a much larger COVID-19 Bounceback Loan than it would otherwise be entitled to. The director did so because she thought the government would write off the loan. Unfortunately, when the company receives the loan, the director spends it on trivial company expenses and personal use. As a result, the company is now insolvent. | Suppose the same sole director used the revenue from last year to forecast the company’s current year’s performance when applying for a COVID-19 Bounceback Loan. At the time of the application, the director genuinely thought this was a legitimate approach. But because she is not an accountant, she failed to account for material factors likely to impair the company’s performance in the current year. As a result, the company pursued a venture which has since failed, and now the company is insolvent. |
| Example 2 | A wealthy shareholder of a company who is not directly involved in its management approaches a business contact. The business contact is considering providing a loan to the company but is hesitant due to the risk. The shareholder assures the business contacts that the company’s finances are in great shape. The shareholder knows the company desperately needs the cash injection to meet other liabilities. The business contact lends the money. The company is now insolvent. | A company shareholder not involved in the company’s management attends a networking event. She meets an angel investor and discusses the company she is a shareholder. She explains its business model and why it is a good investment. She knows that the company is raising equity financing. However, she found out the directors have failed to disclose that the company is close to insolvency. Based on the shareholder’s advice, the angel investor purchases shares in the company, which is now insolvent. |
Nevertheless, conduct in the right-hand column can give rise to other liabilities, like wrongful trading and negligence.
Consequences of a Fraudulent Trading Order
Suppose the court is convinced by the liquidator or administrator’s application. In that case, the law gives the court broad discretion to order the liable party to pay into the insolvent company’s assets. The purpose behind such orders is to enlarge the company’s assets for the benefit of the creditors.
Practically, this means the court will look at the conduct in question and assess:
- how much control the liable party had over the company’s affairs; and
- what benefit (if any) the liable party obtained from the fraudulent trading.
The more control and benefit the liable party possesses, the more the court will make that person pay. However, the court cannot attempt to punish the liable party. This is the function of criminal proceedings for fraud. In any case, if you are found liable for fraudulent trading in the context of an insolvent company, your financial liability may be substantial.
Key Takeaways
A company facing insolvency is at risk of actual insolvency proceedings. Often this results in a liquidator or administrator’s appointment to manage the company for the benefit of its creditors. If so, they have broad powers to review the company’s affairs. Suppose they conclude that someone engaged in fraudulent trading, they can apply to the court seeking a contribution order.
If you need help with your business facing insolvency, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
In insolvency, fraudulent trading is where any person involved in the insolvent company’s affairs knows the business amounted to fraud. It requires actual dishonesty and intent to defraud.
Anyone can be held liable for fraudulent trading if their conduct amounts to fraudulent trading. This includes directors, senior managers, shareholders, and even third parties like banks.
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