What is Wrongful Trading

In law fraudulent and wrongful trading are two entirely different matters. It is important for any company director to understand the difference.

Definition of Wrongful Trading

Wrongful trading is not defined by fraud, that is the job of the Fraud act 2006. Trading while insolvent describes wrongful trading.

Negative net assets in the balance sheet represents balance sheet insolvency, negative net current assets (working capital); cashflow insolvency.

It is the responsibility of the directors and senior officers of the company (shadow directors) to ensure that creditors are paid on time. A company with negative working capital would be unable to do that from its own resources.

If the company folds, the insolvency act takes over from the Companies Act. An early consequence is that directors are likely to lose their protection under limited liability.

Responsibilities of Directors

As a director or senior company officer, you are expected to be aware of the financial condition of the business. This is best illustrated by sec. 214 (2b) of the the Insolvency act that states:

"…at some time before the commencement of the winding up of the company, that person  knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation."

Note the words "...ought to have concluded".

What is Insolvency

There can be no argument that a company has become insolvent if by the end of its financial year net assets / equity are in deficit but what really matters is the point at which insolvency occurred and what if anything was done about it.

The balance sheet is key. If net assets or net current assets fall into deficit, action must be taken to ensure the business will have access to enough cash to continue to pay its way until solvency has been restored.

Contribution Orders under Wrongful Trading

A liquidator who is of the opinion that there is a case to answer in respect of wrongful trading can apply to a court for an order requiring individual directors of the company to make financial contributions towards the creditors of the company. 

The scale of contributions are decided by the court and depending on perceived culpability will range from the nominal to substantial. Persons who have not been appointed as directors but who are regarded by the court as having acted as such (shadow directors) can also be ordered to make contributions.

Wrongful Trading and Financing.

A company with negative working capital can still argue that it is not insolvent if it has sufficient external financing to enable it to continue to meet its liabilities.

Working capital is defined by net current assets; i.e. Current assets (cash convertable within a year) less liabilities payable within a year. Because bank overdrafts are repayable on demand, they are always recognised as a current liability and therefore always a charge against working capital.

The links below will take you to important working (interactive) examples showing hiow this can be done using Figurewizard.

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