Fraudulent and Wrongful Trading: Dishonesty and Incompetence - Essay Example

?Fraudulent and Wrongful Trading: Dishonesty and Incompetence Introduction Recent recessions have cause a major “increase in the number of corporate fatalities”, bringing a newfound interest into the law surrounding insolvency (Tagg 1991: 22). The Insolvency Act 1986 was introduced as a method of allowing exceptions to be made to the corporate veil rule as held in Salomon v Salomon (1897), thus allowing the corporate veil to be lifted under certain circumstances. The difference between section 213 and 214 of the Insolvency Act 1986 (IA 1986) have caused interest in terms whether they recognise the difference between the incompetency contained in section 214 and dishonesty contained in section 213. This paper will argue that the distinction is not only clear, but difficult to miss because the scope of the application of both sections is rather different. Furthermore, they contain elements which cause them to be inherently different in nature, enabling them to differentiate between the different seriousness of dishonesty and incompetence. Section 213: Fraudulent Trading Section 213 of the IA 1986 requires actual dishonesty on the part of the director(s) – as in, dishonesty as defined by the ordinary standards of the criminal law (R v Ghosh (1982). The requirement is rather high – the case of Re a Company requires that “real moral blame” be attached to a director (Re a Company (No 001418 of 1988) (1990)): a claim lies “only if there was conduct which was deliberately and actually dishonest according to the notions of ordinary decent business people” (Re EB Tractors Ltd (1986), French et al 2006, 665). Additionally, it is not necessary to prove that the fraudulent company member knew that there was no reasonable chance of them benefitting financially from their behaviour (R v Grantham (1984) per Lord Lane CJ). In the case of Re Gerald Cooper Chemicals Ltd (1978), it was held that a creditor who knowingly accepts money which has been fraudulently obtained by the company will be held a party to the conducting of the business in a fraudulent manner. The response of the law and the courts is rather harsh if a company member is found to have undertaken fraudulent trading (Re Todd Ltd (1990), and the Companies Act 2006 even provides the possibility of criminal liability. These aspects have, however, caused a high burden of proof for intent to defraud, and this has served to restrict the application of section 213 somewhat. The standards as set out in Re Patrick and Lyon Ltd (1933) hence require that actual dishonesty be evident; mere unreasonable acts are generally not sufficient (Re L Todd (Swanscombe) Ltd (1990)). The dishonesty of the acts which fall within section 213 require intent and awareness; that members are “knowingly...parties to the carrying on of a company’s business with intent to defraud” (Review Committee 1982: 1758). This allows directors who are merely reckless in continuing a failing business to escape the harshness of section 213 (Dignam and Lowry 2006: 17.67). The test is, however like section 214’s hybrid objective/subjective test, though this has often been hailed as the appropriate test for both sections of the IA 1986 (Keay 2006: 123). Section 213 also applies to members of the company who possess knowledge of the fraudulent activities of others – extending even to “blind-eye knowledge, which requires a suspicion of the relevant facts existing coupled with a deliberate decision to avoid confirming that they did exist” (Dignam and Lowry 2006: 17.60, Morris v State Bank of India (2005)). This broad application of the section serves two purposes: (1) it eases the potentially narrow application of the section due to its high standard of fault, and (2) enforces the concept that any person connected to fraudulent activity within the company will not escape liability (R v Smith (1996), Dine and Koutsias 2007: 321). Section 214: wrongful trading Section 214 of the IA 1986 highlights the criteria necessary to establish those who can be held responsible for mismanaging the insolvent company. Firstly, it is important to recognise that wrongful trading does not require and intent to defraud; this depicts the lower degree of seriousness it generally revolves around than fraudulent trading, which requires the intent to defraud. This lower standard test was designed to avoid the harsh test and the difficulties faced by the courts in establishing intent to defraud under section 213. Wrongful trading can be found when it is considered that the directors of the company persisted in the trading of the company despite the fact that they knew or should have known that no reasonable prospect of avoiding insolvency existed (Rubin v Gunner (2004)), and they did not take ‘every step with a view to minimising the potential loss to the company’s creditors’. The courts will test whether wrongful trading has taken place by adopting a type of two-faceted objective/subjective test. They will assess the skill and knowledge expected of a reasonably diligent person carrying out the same functions as the director (Re D’Jan of London Ltd (1994) per Hoffman LJ). In the case of Re Barings Plc (No. 5) (1999)), Hoffman LJ adopted the wording of section 214(4), adding that the ‘general knowledge, skill and experience that that director has’ would also be assessed in such circumstances (582). This two-tiered test enables the first lower standard to be accompanied by a test which applies to directors with or without particular expertise. He added that the courts will take a case by case approach, taking into consideration “how the particular business is organised” (484). There will, however, always remain a certain set of minimum standards which will be applied to all cases, which extend to simple activities found in any form or size of company (Re Produce Marketing Consortium Ltd (No 2) (1989)). The test, although potentially broad, has been kept within protected boundaries by the courts, who are careful, for example to maintain the requirement that the director’s continued trading has to make the position of the company worse “rather than leave the company’s position at the same level” (Re Continental Assurance Co of London plc (2001) per Park J). Although the courts had focused on “attempting to formulate the duties of care and skill owed by directors in terms appropriate to the modern commercial world” (Hannigan 2003: 298), their eager acceptance of section 214 emphasized the need for codification (Re D’Jan of London Ltd (1994) per Lord Hoffman). It is clear that the degree of care and skill expected of directors has been evolved through case law. Although the courts have quite rightly refused to establish “a general professional standard of expertise required of directors” (Hicks 1994: 393), this allows the section to be applied flexibility to the various forms of business which are in existence (in accordance with the recommendations of the Law Commission (1999: 5.4)). Incompetence and Dishonesty: A Clear Division? It is primarily necessary to note that the two sections are based on two very different concepts; namely one of actual wrong intention, and one of negligence. Furthermore, the sections distinguish between the differing seriousness of incompetence and dishonesty in that section 213 (the more serious embodiment of dishonesty) can apply to any person connected to the conducting of the business, whereas section 214 (the less serious embodiment of incompetency) specifically applies to directors. The application of section 214 is limited to the ‘point of no return’, and directors are usually only found liable when the company has no actual prospects of surviving; this not only avoids the rigidity of this section (Davies 2006: 301), but also accentuates the differing degree of wrongfulness which is embodied in this section in comparison to the dishonesty of section 213. This is an important distinction, as it does not impose an absolute duty on directors to liquidate a company as soon as a risk of insolvency arises (Ho 2005: 1). Wrongful trading as defined and contained in section 214 deems fault to be irrelevant, whereas fault is entirely relevant in section 213: rather, “the statute simply looks to whether the company was insolvent and, if so, the conduct of the directors in relation to the company’s creditors” (Brandt and Vance 2006: 1). A breach of duty need not be found, but a simple failure of the directors to wind up the company. Although it has been argued that incompetent directors are dealt with far too leniently as a result of section 214 (Muwanguzi 2007: 1), it is an evident (and somewhat looser) response to the higher degree of wrongful behaviour contained in section 213. If one is to glance at the content of the behaviour contained in the sections, one will uncover a very different degree of wrongfulness. The dishonest behaviour caught by section 213 is a result of intentional wrongful behaviour, accompanied with a desire to fraud other members and creditors of the company. Behaviour contained in section 214 is more a result of negligent behaviour, which lacks the intent which is so important in section 213. Directors who fail to wind up a company lack the desire to fraud other members and creditors of the company – the definitions of incompetence and of dishonesty gather much ground in highlighting the difference between the two forms of behaviour. It is evident that the IA 1986 recognises this. Indeed, it is importantly recognised that “wrongful trading is a far sharper weapon...than the...provision for fraudulent trading” (Hicks 1993: 21, Hicks and Goo 2004). The embodiment of dishonesty under section 213, on the other hand, must be actual (Welham v DPP (1961)); the burden of proof is much higher than that of section 214, suggesting that the greater seriousness of the offence requires a greater degree of proof. Some degree of overlapping has occurred between acts which fall under section 213 and acts which fall under section 214. For example, acts which may primarily be considered to fall under wrongful trading may indeed be classed as fraudulent trading if a company is permitted to trade despite the knowledge that it will not be able to meet all of its debts (R v Grantham (1984)), or if advance payment is accepted for goods that have no prospect of materialising (Re Gerald Cooper Chemicals Ltd (1978)). However, it is clear that the courts will enforce section 213 in only exceptional circumstances, which again accentuates the greater degree of seriousness connected to dishonesty in comparison to incompetence. It is also noted that establishing a claim under section 213 has proven rather difficult due to the high burden of proof; as a result, section 214 has functioned to capture those cases which are not able to be caught by section 213. Does this weaken the distinctions made between dishonesty and incompetence? Not necessarily, for clear cases on dishonesty will fall within section 213 – if anything, this serves to increase the clarity of the distinction between dishonesty and incompetence as contained in section 213 and 214. The contrast between fraudulent trading and wrongful trading is preserved in the IA 1986, in that the former requires the establishment of dishonesty (Dine and Koutsias 2007: 322). The “variety and extent” of the provisions of the IA 1986 “show how seriously the use of companies for fraudulent purposes is regarded” (French et al 2007: 663). Indeed, the courts show a much greater willingness to apply the principles of section 214 than that of section 213. The courts have apparently strived to retain the notion that in the world of business, risks often must be taken – particularly when the company appears to be in trouble. For this reason, the court has stressed the lesser seriousness of section 214, and enshrined its lower degree of wrongfulness: “there is nothing to say that directors who genuinely believe that the clouds will roll away and the sunshine of prosperity will shine upon them again ...are not entitled to incur credit to help them get over the bad time” (Re White and Osmond (Parkstone) Ltd (1960) per Buckley J). The different approaches adopted by the provisions also encourage more attention to be paid to activities of directors (Re Purpoint Ltd (1991)). It is evident that wrongful trading claims carry a stereotypically less serious stigma than fraudulent trading claims, particularly in the fact that they are much easier to succeed (Oditah 1990). The distinction is obvious. The IA 1986 responds to the different contents and stigma attached to dishonesty as defined by fraudulent trading and incompetence as defined by wrongful trading. In the former circumstances, members of the company conduct their actions with a willing intention to financially harm others, whereas the latter circumstances often occur while a director was not winding up the company in trouble, yet nonetheless struggling to maintain it. There is hence a clear distinction maintained by the IA 1986, which can be found in the contents of the sections and the way in which the courts have applied and interpreted them, as well as the differing effects they have on members of the company. Bibliography Brandt, WA. and Vance, CE., ‘Deepening Insolvency and the United Kingdom’s Wrongful Trading Statute: A Comparative Discussion’ (2006) Insolvency Intelligence. Source: http://www.dsi.biz/articles/Deepening%20Insolvency%20and%20UK's%20Wrongful%20Trading%20Statute.pdf. Accessed: 2-11-2011. 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