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.

The Definition of Wrongful Trading

Wrongful trading is a legal concept under the Insolvency act: Although it is not concerned with fraudulent trading penalties can be severe.

It is instead concerned with a directors' responsibilities towards ensuring that the financial position of a business will avoid the prospect of trading while insolvent. Ignorance is not a defence. 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.

That point will be when a business runs out of cash and is unable to raise sufficient financing in good time so as to resolve the crisis. However even if that is possible the best way is still to plan for it not to happen at all.

A good example of how that can be done is illustrated by this monthly sample cash flow forecast which also includes undrawn and therefore available financing. If profits and crucially cash itself are to be delivered by a business plan, not a single month in this forecast can afford to fall into the red. If it does, the business plan must change.

The Companies and Insolvency acts.

All lilmited companies are subject to the Companies act 2006. Directors' responsibilities under the act include their statutory duties towards protecting the best interests of the company and its members.

Crucially that changes at the point at which a company becomes insolvent. The responsibilities of directors then change from protecting its members under the Companies act to protecting its creditors under the Insolvency act.

As ignorance is not a defence, any director is well advised to plan and forecast the financial performance of the company (which is what Figurewizard makes possible) for the financial year ahead to reasonably conclude there will be no immediate risk or expectation of insolvency.

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.

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

Such financing however will have to be long term if it is to be credible. Loans that are repayable within a year must always be disregarded as their due dates make them short term financing (i.e. payable 1 year or less) which is already contributing to the insolvent position.

It should be noted that bank overdrafts are also considered to be short term financing. That is because overdrafts are repayable on demand and cannot therefore ever be regarded as long term financial arrangements.

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

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