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 Company Law

Name:

Institution:
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Critically assess whether the introduction of section 214 of the Insolvency Act 1986

(the “Act”) adequately addresses the concerns levelled at section 213 of the Act

It is a common practice for creditors to seek compensation when a company is wound up.

A creditor is any legal or natural person with a financial claim against a company. Even when the

company is liquidated, there are often insufficient assets remaining to repay creditors. As such,

creditors try recovering their losses from the directors of the company. Under the Insolvency Act

of 1986, there are two sections including sections 213 and 214 that clarify when a director can be

held liable when a company becomes insolvent. Section 213 addresses fraudulent trading while

section 214 addresses wrongful trading. According to the Insolvency Act of 1986 section 213,

fraudulent trading occurs when any business activity is carried out with an intention of

defrauding creditors in the course of wounding up a company.1 In such a situation, the creditor

(through a liquidator) can seek assistance from the court to make liable any person who

knowingly participated in the activities. As such, the individual may be forced by the court to

contribute to the assets of the company so that creditors can be paid. Under section 214 of the

Insolvency Act of 1986, wrongful trading is assumed to have occurred when a director of the

company fails to take every possible step to prevent potential loss to the creditors of the company

when they knew that there was no possibility of avoiding insolvent liquidation.2

Basically, the introduction of section 214 of the Insolvency Act of 1986 has addressed

most of the issues associated with section 213. In analysing this point, it is important to

understand the differences and similarities that exist between the two sections to understand the

extent to which section 214 has addressed the issues related to section 213. Section 214 only

1
The Insolvency Act 1986.

2
The Insolvency Act 1986.
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applies to the directors of the company and does not require prove of dishonesty. Moreover,

section 214 clearly states that wrongful trading does not exist when the director has taken all the

necessary steps to minimize potential loss to the creditors of the company. Thus, the judgment of

the conduct of the director is based on the standards of a reasonably diligent individual having

the skill, experience and general knowledge to perform the expected functions and the

experience, skill and general knowledge of the director. From this point, it can be argued that

wrongful trading is essentially a negligence test. On the other hand, fraudulent trading depends

upon an individual knowingly being party to the mischief. Although fraudulent trading mostly,

affects directors, individuals who participate in the trade can be held liable.3

A key argument against section 214 is its perceptions as a normative provision guiding

the behaviour of directors. This provision prevents directors from engaging in risky behaviours

that can be detrimental to the creditors. Section 213 also follows this as it aims to control and

guide corporate behaviour.4 However, there are fewer criticisms that have been levelled against

section 213 as compared to 214 considering the usage and age of section 213. Although both

sections impose personal liability on the individuals implicated, there is an important factor that

makes fraudulent trading more effective than wrongful trading.5 That is, section 213 is also

supported by the Companies Act of 2006 where fraud attracts a prison sentence of up to ten

years.6 Although procedural barriers exist between criminal and civil procedures, it is accepted

that fraudulent trading has a greater influence due to the consequences of failing to follow its

provisions.
3
Alan Dignam and John Lowry, Company Law (University of London Press , 2009).

4
M. Christopher, And W. Shai, The Law and Practice of Restructuring in the UK and US (OUP Oxford, 2011) 123

5
Preetha S., 'The fraudulent trading offence: Need for a relook.' Nujs Law Review, 4, (2011), 231-249.

6
The Companies Act 2006.
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Fraudulent trading, both under the Companies Act of 2006 and the Insolvency Act of

1986, employs a test of the intention to defraud. This implies that an individual is held liable if

they had the intention of defrauding creditors by continuing operations. This requirement is

jurisprudentially problematic because it is a criminal law standard and successful application of

section 213 will bring a high evidentiary hurdle.7 Various cases have outlined key points that a

liquidator needs to present to develop a valid defence. For instance, in Re Overnight Ltd (2010),

Overnight limited was accused after winding up due to unpaid VAT amounting to £334, 800.8

The company was accused of purchasing zero rated goods from Far East Electronic Consulting

and selling them to WorldKey Limited in England where a standard VAT rate was applicable.

Rather than paying VAT to the relevant authority (HMRC), Overnight Limited took it as the

profit.

The liquidator who brought the case accused Overnight Limited of carrying out their

business with the intention of defrauding creditors. It was also argued that Overnight Limited

could have been operating at a loss if they had paid VAT. The respondents in the case included

the director of the company, the business operations manager and company secretary.9 In the

ruling, the three respondents were found to have knowingly participated in fraudulent trading.

However, only the company secretary was held liable for the loss of the company’s creditors.

This case clearly illustrates that for a fraudulent claim to be successful, evidence of dishonesty

must be presented. It should be noted that a single instance of failing to pay creditors does not

translate to fraudulent trading and this was clarified in Morphitis v Bernasconi [2003]. When
7
Alan SheelEy & Mehmet Ko, 'Fraudulent Directors and the Impact on Companies: Victims or Wrongdoers?' Turkish Commercial
Law Review, 1/2, (2015), 125-134.

8
Re Overnight Ltd [2010] EWHC 613.

9
Howes Percival, 'Insolvency Litigation: No questions asked a valid defense to fraudelent trading,'
http://www.howespercival.com/resources-and-events/case-studies/article/insolvency-litigation-no-questions-asked-a-valid-defence-to-
fraudulent-trading, 2013, (Accessed 7th March 2016).
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there is insufficient evidence to prove dishonesty as required under section 213 of the Insolvency

Act of 1986, the provisions of wrongful trading under section 214 becomes a viable option.10 The

challenge of proof is less under section 214 and the section covers most of the fraudulent

activities.

Although section 213 of the Insolvency Act of 1986 caters for all individuals including

third parties, it is difficult to accuse an external entity. This is clearly evident from Stone and

Rolls Ltd v Moore [2009] whereby the sole owner of the company (Stone and Rolls Ltd)

defrauded money from various banks.11 One of the banks, Komercni Banka AS sued the owner

of Stone and Rolls and was awarded $94 million. Due to the inability of the company pay the

fine, it was wound up and liquidated to recover the awarded money. Negligence proceedings

were then brought by the company against the auditors of the company (Moore). In the

proceedings, Stone and Rolls Ltd wanted the owner of the company and the company itself to be

treated as different entities. The liquidator argued that the auditors failed to detect the fraudulent

activities of the owner and thus made the company incur extra liability. In the ruling, the judges

argued that the auditors’ duty of care could only be extended to the shareholders of the company

and not the creditors.12 As such, the auditors cannot be held liable for the losses of the creditors.

In companies with a group of shareholders, auditors can be held liable if one or some of the

directors engage in fraud activities. On the other hand, directors owe their duties to the company

and thus any issues related to fraudulent trading can be traced to the directors.13

10
Skudra Henry, 'Fraudulent trading as a creditor’s remedy - time for a rethink?,' Amicus Curiae, 94, (2013), 11-17.

11
Stone & Rolls Ltd (in liquidation) v Moore Stephens (a firm) [2009] UKHL 39, [2010] 1 All ER (Comm) 125.

12
Matrix Chambers & Olswang LLP, 'Case Comment: Moore Stephens (a firm) (Respondents) v Stone & Rolls Limited (in liquidation)
(Appellants) [2009] UKHL 39. 2009,' http://ukscblog.com/case-comment-moore-stephens-a-firm-respondents-v-stone-rolls-limited-
in-liquidation-appellants-2009-ukhl-39/, 2009, (Accessed 7th March 2016).

13
Len Sealey and Sarah Worthington, Cases and Materials in Company Law (8th ed. Oxford University Press, 2008).
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In Bilta (UK) Ltd (in liquidation) v Jetivia SA and another [2015], the judge contradicted

the ruling made in Stone Rolls Ltd v Moore [2009].14 Bilta was involved in a VAT scandal in the

carbon trading scheme. Bilta bought VAT free carbon credits from different supplies and then

sold them to UK traders at a lower price. However, the traders paid the suppliers directly and this

left Bilta with VAT liabilities totalling to over £38 million.15 When the scam was unearthed, the

company was wound up. In the proceedings of the case, the liquidator sued a number of parties

who were perceived to have conspired in defrauding Bilta. The allegations levelled against the

respondents were dishonesty and conspiracy under section 213 of the Insolvency Act of 1986. In

the ruling, the judges argued that the suppliers were liable for the problems faced by Bilta.

Although the company was owned by a single individual and had two directors, the case was

treated differently from that of Stone Rolls v Moore [2009]. The argument was drawn from the

Companies Act of 2006 whereby directors are held liable for breach of duty.16 The ruling of the

case suggests that officers of companies that are established for carrying out fraud as well as

third parties can be charged under section 213.

In Madoff Securities International Limited (In Liquidation) v Stephen Raven & Ors

[2013], the judge also clarified the role of directors and when they can be held liable under

section 213 of the Insolvency Act of 1986.17 In the case, the liquidator of Madoff Securities

International Limited accused its former directors and a third party regarding the Ponzi scheme.

Although it was mutually recognized that the directors were not aware of the existence of the

scheme, the liquidator claimed that the directors were aware of the payments made to the third

14
Bilta (UK) Ltd (in liquidation) v Jetivia SA and another [2015] UKSC 23.

15
S. Ben, J. F. Emma and E. I. Kate, 'Illegality, insolvency and fraudulent directors: clarity at last?' http://www.lexology.com/library/detail.aspx?
g=9362b3f4-b9b7-4764-b0ef-58c3c04f8dc2, 2015, (Accessed 7th March 2016).
16
Companies Act 2006
17
Madoff Securities International Limited (In Liquidation) v Stephen Raven & Ors [2013] EWHC 3147.
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party (approximately US$27 million). The directors were made to believe that the payments were

meant for research but it was found that the payments were for the third party to introduce

investors to the company. The liquidators of Madoff Securities International Limited argued that

the directors were fraudulent and dishonest for allowing such payments. In the ruling, the judge

dismissed the allegations on the ground that the directors were not aware of the Ponzi scheme

and they made payments reasonably and honestly due to the business agreement between the

third party and Madoff Securities International Limited. Based on this case, it is evident that a

liquidator must prove that the directors acted dishonestly for them to be held liable.

As noted early, it is inherently difficult to prove dishonesty as required under section 213

of the Insolvency Act of 1986 and thus section 214 becomes favourable. Unlike fraudulent

trading allegations made under section 213 of the Insolvency Act of 1986, wrongful trading

claims often target current or former directors of a company.18 In Re Hydrodam (Corby) Ltd

[1994], the term director was clarified to include the actual directors, de facto directors or

shadow directors. Shadow directors are individuals who have significant influence on the

company’s corporate affairs and this definition was offered by the court of appeal in Secretary of

Trade for Trade and Industry v Deverell [2000]. In order to bring a successful wrongful trading

claim, various issues need to be established. One, the date when the director concluded that there

was no chance for the company to avoid insolvent liquidation need to be established. Two, it

should be established that the directors failed to take all measures to minimize losses of the

creditors to the company from the insolvency point. Finally, it should be established that the

wrongful trading resulted in a loss to the creditors. This requirement was utilised in Re

18
Konstanti Dmitry. 'Wrongful Trading: Comparative Approach (England and Wales, Russia and the USA).' BRICS LAW JOURNAL
2/1 (2015), 100-124.
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Continental Assurance Co of London plc [2007] where the judge ruled that loss in the part of

creditors should be proved.

Determining the point where a director can rule out the prospect of the company to avoid

insolvent liquidation is a key challenge. For instance, in Brooks and another v Armstrong and Re

Robin Hood Centre plc [2015], the liquidators (acting in the capacity of Robin Hood Centre plc)

accused the directors of the company for wrongful trading and misfeasance under the Insolvency

Act of 1986.19 In the case, the liquidator alleged that various events occurred that could have

helped the directors conclude that there was no chance for the company to avoid insolvent

liquidation. For instance, there was an increase in the service and rent charge and HMRC had

sent a letter confirming a VAT liability. The case aimed to address three issues including

whether the directors wrongfully traded as per section 214 of the Insolvency Act; whether higher

standards could be used to judge the directors based on experience; and which party could proof

that all measures were taken to safeguard creditors from incurring losses.20 In the ruling, the

judge clarified the burden of proofing that all measures were taken lie with the directors.

Although the directors were not dishonest in continuing to trade, their failure to take action when

they received the VAT letter meant that that they were wrongfully trading and hence they were

ordered to pay compensation. Further, the balance sheet indicated clearly that the company was

unlikely to avoid insolvent liquidation.

The balance sheet test is a key factor in determining whether a company can avoid

insolvent liquidation and its interpretation can be linked to BNY Corporate Trustee Services Ltd

19
Brooks and another v Armstrong and another; Re Robin Hood Centre plc (in liquidation) [2015] EWHC 2289 (Ch), [2015] All ER (D) 45
(Aug).
20
Leslie Stephen, 'Establishing the requirements of a wrongful trading claim—Brooks v Armstrong; Re Robin Hood Centre plc (in
liquidation),' http://blogs.lexisnexis.co.uk/randi/establishing-the-requirements-of-a-wrongful-trading-claim-brooks-v-armstrong-re-
robin-hood-centre-plc-in-liquidation/, 2015, (Accessed 7th March 2016).
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v Eurosail-UK [2013].21 In the case, the court was required to clarify the scope of the balance

sheet test in determining the inability of a company to pay its debts. In this test, it is determined

whether the current assets of a company are sufficient to pay current and expected liabilities. The

facts of the case were that Eurosail purchased residential mortgage loans using the capital raised

from investors. The capital raised from the investors was in different denominations and Eurosail

partnered with Lehman to manage interest and exchange rate fluctuations.22 However, Lehman

collapsed and Eurosail incurred a loss. Although the company continued to make all payments,

some investors were worried regarding the ability of the company to pay off all its debts and

presented the case to the high court. The court ruled that the company was able to pay its debts

under section 123 (2) specifying that future liabilities and contingencies should not be used in

determining the ability of a company to pay its debts. Thus, current contingencies and liabilities

are key factors to consider when determining the ability of a company to avoid insolvent

liquidation and this formed one of the bases of determining the case of Brooks and another v

Armstrong and Re Robin Hood Centre plc [2015].

The establishment of whether a director had sufficient knowledge to conclude that a

company cannot escape insolvent liquidation was also examined in Earp v Stevenson, Re Kudos

Business Solutions Ltd [2011].23 In the case, the company was private and had only one director.

Through a third party, the company contracted another company to offer mailing services.

Advance payments were made to the company under the contracts. The director believed that the

third party would fulfil the contracts without reasonable grounds and eventually the service was

21
BNY Corporate Trustee Services Limited and others v Eurosail-UK 2007-3BL. PLC [2013] UKSC 28.

22
Ken Baird and Katharina Crinson, 'Eurosail: past the point of no return,'
http://www.freshfields.com/en/knowledge/Eurosail_past_the_point_of_no_return/, 2013, (Accessed 7th March 2016).

23
Earp v Stevenson, Re Kudos Business Solutions Ltd (In Liquidation), [2011] EWHC 1436 (Ch).
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not provided. In the case, the judge based the ruling on the balance sheet test and found that the

company was balance sheet insolvent. The fact that the company was having financial

difficulties as well as the rational expectation of the director that the contracts could be fulfilled

meant that insolvent liquidation was inevitable.24 Thus, the director was ordered to contribute

personal assets as specified under the Insolvency Act, section 214. This ruling implies that

directors need to understand their roles as specified in section 214 of the Insolvency Act. A

director should take a responsible and realistic approach to estimating the prospects of the

company because they will be held liable if the company fails.

In summary, section 214 of the Insolvency Act of 1986 addressed some of the concerns

levelled at section 213 but it narrowed the scope of individuals that could be held liable. Section

214 specifies that only directors or former directors of a company can be held liable. However,

section 214 provides more flexibility in determining whether an individual is liable as compared

to section 213. Section 213 requires a liquidator to prove dishonesty on the side of directors of

third parties. On the other hand, section 214 requires the establishment of whether the director

knew of the intimate insolvent liquidation of the company and whether they took any measures

to protect creditors from losses. Although section 214 offers more flexibility, both sections are

required to protect creditors.

24
Richard Baines and Matthew McCormick, 'Wrongful trading, the benchmark for directors’ duties: recent developments,'
http://www.inhouselawyer.co.uk/index.php/insolvency-and-corporate-restructuring/9951-wrongful-trading-the-benchmark-for-
directors-duties-recent-developments, 2012, (Accessed 7th March 2016).
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Bibliography
Case laws
BNY Corporate Trustee Services Limited and others v Eurosail-UK 2007-3BL. PLC [2013]
UKSC 28
Brooks and another v Armstrong and another; Re Robin Hood Centre plc (in liquidation) [2015]
EWHC 2289 (Ch), [2015] All ER (D) 45 (Aug).
Earp v Stevenson, Re Kudos Business Solutions Ltd (In Liquidation), [2011] EWHC 1436 (Ch)
Jetivia SA and another v Bilta (UK) Ltd (in liquidation) and others [2015] UKSC 23
Madoff Securities International Limited (In Liquidation) v Stephen Raven & Ors [2013] EWHC
3147
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Morphitis v Bernasconi [2003] EWCA Civ 289

Re Overnight Ltd [2010] EWHC 613
Re Hydrodam (Corby) Ltd [1994] 2 BCLC 180
Re Continental Assurance Co of London plc [2007] 2 BCLC 287
Secretary of State for Trade and Industry v Deverell [2000] 2 All ER 365
Stone & Rolls Ltd (in liquidation) v Moore Stephens (a firm) [2009] UKHL 39, [2010] 1 All ER
(Comm) 125.
Legislations
The Insolvency Act 1986
The Companies Act 2006
Journal articles
ALAN SHEELEY & MEHMET KO, 'Fraudulent Directors and the Impact on Companies:
Victims or Wrongdoers?' Turkish Commercial Law Review, 1/2, (2015), 125-134.
KONSTANTI, DMITRY. 'Wrongful Trading: Comparative Approach (England and Wales,
Russia and the USA).' Brics Law Journal 2/1 (2015), 100-124.
PREETHA S., 'The fraudulent trading offence: Need for a relook.' Nujs Law Review, 4, (2011),
231-249.
SKUDRA HENRY, 'Fraudulent trading as a creditor’s remedy - time for a rethink?,' Amicus
Curiae, 94, (2013), 11-17.
Books
CHRISTOPHER, M., AND SHAI, W., The Law and Practice of Restructuring in the UK and
US (OUP Oxford, 2011).
LEN SEALEY AND SARAH WORTHINGTON, Cases and Materials in Company Law (8th ed.
Oxford University Press, 2008).

ALAN DIGNAM AND JOHN LOWRY, Company Law (University of London Press, 2009).

Websites
BEN S., EMMA J. F. AND KATE, E. I., 'Illegality, insolvency and fraudulent directors: clarity
at last?' http://www.lexology.com/library/detail.aspx?g=9362b3f4-b9b7-4764-b0ef-
58c3c04f8dc2, 2015, (Accessed 7th March 2016).
HOWES PERCIVAL, 'Insolvency Litigation: No questions asked a valid defense to fraudelent
trading,' http://www.howespercival.com/resources-and-events/case-
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studies/article/insolvency-litigation-no-questions-asked-a-valid-defence-to-fraudulent-
trading, 2013, (Accessed 7th March 2016).
KEN BAIRD, KATHARINA CRINSON, 'Eurosail: past the point of no return,'
http://www.freshfields.com/en/knowledge/Eurosail_past_the_point_of_no_return/, 2013,
(Accessed 7th March 2016).
LESLIE, STEPHEN, 'Establishing the requirements of a wrongful trading claim—Brooks v
Armstrong; Re Robin Hood Centre plc (in liquidation),'
http://blogs.lexisnexis.co.uk/randi/establishing-the-requirements-of-a-wrongful-trading-
claim-brooks-v-armstrong-re-robin-hood-centre-plc-in-liquidation/, 2015, (Accessed 7th
March 2016).
MATRIX CHAMBERS & OLSWANG LLP, 'Case Comment: Moore Stephens (a firm)
(Respondents) v Stone & Rolls Limited (in liquidation) (Appellants) [2009] UKHL 39.
2009,' http://ukscblog.com/case-comment-moore-stephens-a-firm-respondents-v-stone-
rolls-limited-in-liquidation-appellants-2009-ukhl-39/, 2009, (Accessed 7th March 2016).
RICHARD BAINES, PARTNER, AND MATTHEW MCCORMICK, 'Wrongful trading, the
benchmark for directors’ duties: recent developments,'
http://www.inhouselawyer.co.uk/index.php/insolvency-and-corporate-restructuring/9951-
wrongful-trading-the-benchmark-for-directors-duties-recent-developments, 2012,
(Accessed 7th March 2016).