As companies navigate difficult financial circumstances, directors may make decisions that later prove controversial should the company fall into insolvency. Two key claims that liquidators often pursue against directors in these situations are misfeasance and wrongful trading. Recent case law provides insight into the complex issues around these claims, the tests applied by courts, and the steps directors can take to mitigate risks.

What is Misfeasance?

Misfeasance refers to Section 212 of the UK’s Insolvency Act 1986, which allows liquidators to apply to the court to examine the conduct of current or former directors where there is alleged misfeasance or breach of duty in relation to the insolvent company. The court can order that directors contribute to the assets of the company if appropriate.

To succeed in a misfeasance claim, a liquidator must show that the director has misapplied or retained company money or property, been guilty of misfeasance or breach of duty, or been found liable for fraudulent trading. Claims often relate to overpayment of directors’ remuneration, approval of improper loans or dividends, entering transactions at an undervalue, or failure to maintain proper accounting records.

The court will assess whether the director acted honestly and reasonably. Honest mistake or error of judgement is generally not sufficient for liability. Courts recognise that commercial decisions often need to be more imprudent in hindsight. The director must have acted in a way that lacks good faith or is contrary to the company’s interests.

What is Wrongful Trading?

Wrongful trading is covered by Section 214 of the Insolvency Act. It applies where a director knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation but continued to increase the company’s debt.

A key aspect is that directors must take every step a reasonably diligent person would take to minimise losses to creditors once they know or should know insolvency is unavoidable. If directors fail to do so, the court can declare they make a personal contribution to the company’s assets.

Wrongful trading focuses on the director’s failure to protect creditors when insolvency looms, not just poor management leading up to that point. However, it does not require fraudulent intent – a director can be liable due to incompetence or unreasonable failure to notice and address issues.

When Does Liability Arise?

With wrongful trading, the crucial issue is identifying when directors knew or ought to have concluded there was no reasonable prospect of avoiding insolvency. This is determined based on both subjective and objective factors.

The court will consider the general knowledge and experience reasonably expected of a person in that role, plus that particular director’s specific knowledge and experience. Non-executive directors are not usually expected to have the intimate expertise of executive directors.

Directors properly continuing to trade in the hope of turning things around will likely receive more sympathy than those displaying “wilful blind optimism”. However, hindsight bias is excluded – the appropriate time for action is assessed based on what the director knew or should have known then.

Does Professional Advice Offer Protection?

Seeking expert advice from accountants, insolvency practitioners etc., will provide some protection but does not absolve directors of responsibility. They may still face questions about verifying the accuracy of information supplied to experts.

While directors are entitled to delegate some functions and rely on specialists, they cannot abdicate responsibility. Recent cases make clear that merely instructing experts is insufficient – directors must show substantive engagement with their guidance.

Steps Directors Can Take to Mitigate Risks

• Formally record decisions on material matters in board minutes, stating the rationale
• Engage professional advice as early as possible, but continue to actively review financials and advice given
• Verify information supplied to experts is comprehensive and accurate
• As a non-executive director, clarify your specific oversight role in writing
• Ensure adequate D&O insurance cover for all directors
• Continually monitor the company’s financial situation for insolvency risks
• Once insolvency is likely, act decisively to minimise creditor losses

Trading Out of Difficulty

Trading while insolvent is not automatically wrongful trading. Directors can legitimately judge that continued trading is in creditors’ best interests if there remains a reasonable prospect of avoiding insolvency.

Equally, directors should not shut down too readily if difficulties can be resolved. However, any decision to continue trading must be based on careful analysis of the accounts and the company’s financial position.

Wilful blindness, reckless optimism and failure to address serious issues will not be accepted. But if directors have actively engaged with the reality of the situation and reasonably believe recovery remains viable, ongoing trade will likely be justified.

Gauging Knowledge and Steps Required

Applied standards of skill, care and diligence depend significantly on factors like:

• Company size: less is expected in smaller enterprises
• Field of expertise: e.g. a marketing director is not judged by financial acumen
• Executive vs non-executive role: full-time directors carry greater responsibility
• Allocated functions: directors are responsible for tasks delegated to them

While non-executives are not exempt, their required knowledge is assessed practically based on their specific oversight role.

Ultimately, the court will determine if directors took all reasonable steps to minimise potential loss once insolvency was unavoidable. Relying solely on professionals will not suffice – proactive engagement is required.

With both misfeasance and wrongful trading, courts strive to balance firm director responsibility against commercial realities. A genuine effort to salvage the company will be considered, but sustained failure to address deepening difficulties can incur liability. Actively monitoring the situation and seeking prompt expertise once problems arise is key.

This complex area remains unpredictable and fact-sensitive. Claims often entail substantial legal costs around disclosure, analysis and expert evidence. Comprehensive D&O insurance is a must. While professional advice provides some defence, directors must verify the information supplied and keep abreast of the company’s finances. Once insolvency looms, prioritising creditor interests is critical. With diligence and proactive management, directors can demonstrate they took all reasonable steps in difficult circumstances.