Fraudulent Trading Vs. Wrongful Trading – A Legal Analysis

Further to our previous article on the Duties of Directors in a Financially distressed or Insolvent Company in Kenya and as a follow up thereto, we shall in this article discuss at length the difference between fraudulent and wrongful trading as conduct that could result to accrual of personal liability on directors in the event of a company becoming insolvent.

What is Fraudulent Trading?

This is provided for under section 505 of the Insolvency Act and it invariably involves an element of fraud or dishonesty.

Generally, fraudulent trading can be established where a liquidator (in the course of the insolvency process) forms the view that: –

the business of the company has been carried on with intent to defraud the creditors of the company or third parties, or for any fraudulent purpose and;
that in those cases the directors or officers of the company had participated (directly or indirectly) in the business with the knowledge that the business was being carried on in that manner.

Where fraudulent trading has been established, the liquidator can apply to insolvency court for the responsible directors to make such contributions to the company’s assets as the court considers fair and reasonable. This can be easily established where it is proved that the directors had acted deliberately to avoid payment of company liabilities or debts by continuing to trade or accepted supplier credit or taken payments from customers knowing that the company will not fulfil the orders before liquidation.

Cases of fraudulent trading are common in creditors’ voluntary liquidation as well as in compulsory liquidation processes where the liquidator is required to investigate the directors’ conduct leading to insolvency and make a report to the Insolvency Court or the Official Receiver.

Fraudulent trading is both a criminal and a civil offence. Therefore, it will invariably trigger criminal sanctions. In many cases, the culpable director will also be disqualified. This means that such person would be banned for a certain duration (upto 15 years) from being or acting as a director of a company or a partner of a limited liability partnership or in any way, whether directly or indirectly, being concerned in the promotion, formation or management of a company or limited liability partnership.

What is Wrongful Trading?

This is provided for under section 506 of the Act. Unlike fraudulent trading, wrongful trading does not involve dishonesty.

Under this section, a company is considered to be in insolvent liquidation if, at the time the liquidation commences, its assets are insufficient for the payment of its debts and other liabilities as well as the expenses of the liquidation.

A director will be liable for wrongful trading if he knew or ought to have known that there was no reasonable prospect that the company would avoid being placed in insolvent liquidation and neglected to take reasonable measure or steps to prevent potential loss to the company’s creditors.

Where culpability and failure to act reasonably is established, the court will usually, in its own discretion, order the culpable director or directors to make such contribution to the company’s assets as it may consider appropriate.

Moreover, such director or directors may also be liable to repay the increase in creditor claims that arose between the time they should have stopped wrongful trading and when the insolvency proceedings were initiated.  The disqualifications discussed above will similarly be imposed on the wrongdoers.

However, whereas Section 506 seem to suggest that continuing to trade despite making a finding that the company is insolvent constitutes wrongful trading, this is not the case. The said sections are not to be interpreted to mean that if a company does not survive if it continues trading while insolvent the directors should be found liable for wrongful trading. The foregoing was affirmed by the court in Grant & Anor v Ralls & Ors (re Ralls Builders Ltd) [2016] EWHC 243 wherein the court was called upon to exercise its mind on Section 214 (1) & (3) of the UK Insolvency Act which are a replica of the aforementioned section 506 of the Insolvency Act, 2015.

As discussed above the test for wrongful trading as envisaged in the aforementioned sections 506 (5) & (6) is therefore whether the officers of the company despite being aware of the insolvency company knew that there was no reasonable prospect of the Company avoiding an insolvent liquidation and yet continued trading. The court in the aforementioned case while affirming the foregoing to be the test, set out the elements that are to guide the court in making such a decision as to whether a finding of wrongful trading ought to be made as follows;

“Whilst the question of whether a director knew that there was no reasonable prospect of the Company avoiding an insolvent liquidation is a question of (subjective) fact, the question of whether the director ought to have concluded that this was so is an objective question. In that respect, section 214(4) of the 1986 Act provides that the facts which the director ought to know, the conclusions which he ought to reach, and the steps which he ought to take, are those which would be known, reached or taken by a reasonably diligent person having the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as those of the director, and the general knowledge, skill and experience that that director in fact has.”

The Intersection Between Wrongful and Fraudulent Trading

The key difference between wrongful and fraudulent trading is that the basis of liability for wrongful trading is negligence and not dishonesty. Also, fraudulent trading attracts criminal liability as envisaged under Section 503 of the Insolvency Act, 2015 whereas wrongful trading only attracts civil liability.

While there exists a difference between the two as shown above, kenyan courts have usually used them interchangeable. A case in point is M. Da Costa Luis (The Liquidator for Nzaa Kuu Cement Co. Ltd v Christopher M. Musau [2013] Eklr wherein the court was called upon to exercise its mind on Section 323 (1) (a) of the repealed Companies Act which was a replica of the aforementioned section 505 and in doing so, the court heavily relied on the English case laws on wrongful trading. In the said case the court held as follows as regards the threshold of proving fraudulent trading;

“The Applicant seeks for a declaration that the Respondent was responsible for all the debts and liabilities of the company and should therefore be personally liable for repayment of the said debts and liabilities. It follows that if the Respondent acted “honestly and reasonably” and “or knew or ought to have known” that the company would become insolvent, he should have acted diligently and in a manner such as to mitigate any losses that may have been incurred or accrued in the ordinary course of business.”

Also, in the case of Edward Ndungu & 9 Others V Patch Osodo [2006] Eklr the court quoted with approval the case of Re William Leitch Bros Ltd – [1932]2 Ch 71, wherein the court had while defining trading with intent to defraud held as follows;

“… I must hold with regard to the meaning of the phrase carrying on business ‘with intent to defraud that, if a company continues to carry on business and to incur debts at a time when there is to the knowledge of the directors no reasonable prospect of the creditors ever receiving payment of those debts, it is, in general, a proper inference that the company is carrying on business with intent to defraud …”

Further, in the recent case of Asterisk Limited v Humming Healthcare Limited [2021] eKLR, the court also held that continue trading while being aware that the company was not able to pay its debts constituted fraudulent trading and proceeded to lift the veil of incorporation.

It therefore follows that wrongful trading will in most instances lead to a finding of fraudulent trading. This is because the logical conclusion if the officers of the company continue trading despite making a finding that the company could not avoid liquidation is that they were intent on defrauding creditors unless it is shown otherwise.

Upon making a finding of wrongful trading and/or fraudulent trading, the court is empowered to lift the veil and find the directors liable to a certain extent for the liabilities of the company as discussed above.

In our follow up article we shall be looking at transactions under value, preference to a creditor and transactions defrauding creditors which transactions are also likely to invite personal liability on the directors.

The post Fraudulent Trading Vs. Wrongful Trading – A Legal Analysis appeared first on CM Advocates.

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