Overtrading V Wrongful Trading: what are the key differences?
How can Insolvency Practitioners help directors avoid Overtrading and Wrongful Trading?
Two of the most common issues that businesses encounter that we see are overtrading and wrongful trading, terms which sound similar, but which have different meanings and consequences and are important issues to be aware of as part of a Director’s responsibilities. In this article, we look at what overtrading and wrongful trading are, their causes, and the legal implications of each. As Licensed Insolvency Practitioners, we will also discuss how Directors falling foul of them can be avoided and the steps that can be taken if your business is facing these issues.
What is the difference between Overtrading and Wrongful Trading?
Overtrading usually happens when a company is expanding too quickly and does not have sufficient cash or resources to support this growth, a situation that is often called ‘operating beyond its means’. This can happen, for example, when a company’s sales increase rapidly, and it starts to invest more in stock, equipment and staff without considering the impact on its cash flow. Overtrading can lead to cash flow problems, debts that cannot be paid, and ultimately insolvency. Overtrading trading can also happen when a company takes on new debts that it cannot repay or sells assets at a lower price than their market value to avoid insolvency.
Wrongful trading has a legal definition and stems from Section 214 of the Insolvency Act 1986. It refers to the actions of a director or directors who have concluded (or should have concluded) that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration, they have a duty to take every step which a reasonably diligent person would take to minimise potential loss to the company’s creditors. If, after the company has gone into insolvent administration or liquidation, it appears to the court that a director has failed to comply with this duty, the court can order the director to make such contribution to the company’s assets as it thinks proper.
The causes of Overtrading
A good example of overtrading is when a business experiences a sudden and unpredicted increase in demand for its products or services. In such circumstances, a company could easily be tempted to take advantage of this growth opportunity and invest heavily in expanding its operations. However, this can easily lead to cash flow problems, in particular if the company does not have enough working capital to finance this growth.
Another frequent cause of overtrading is poor financial management. If a company does not have a clear enough understanding of its financial position and/or does not have effective financial controls in place, the result can be overspending, inefficient use of resources, and cash flow problems. If not swiftly addressed, the outcome can be insolvency.
The causes of Wrongful Trading
The causes of wrongful trading are much the same as for overtrading, but the key difference is that although overtrading is not necessarily illegal, the latter is. Overtrading can be a result of poor financial management or a lack of planning, while wrongful trading can stem from a deliberate act of continuing to trade despite the directors knowing that the company cannot pay its debts, which is to the detriment of its creditors.
A director has a number of statutory and fiduciary duties including the exercise of independent judgement, and needs to use reasonable care, skill and diligence in the performance of those duties. In other words directors cannot claim ignorance of a company’s financial position as they are deemed to have such knowledge and have the skill to understand that position.
Overtrading can, of course become wrongful trading. At this point, when directors continue to trade even when they knew or should have known that the company could not pay its debts, and liquidation is the inevitable outcome, the directors may be held personally liable for the company’s debts. In addition, the directors might also face a director disqualification investigation, or even criminal charges.
How Licensed Insolvency Practitioners can help Directors to avoid Overtrading and Wrongful Trading
To reduce the risk of overtrading, companies need to have effective financial management practices in place, including having:
- a clear understanding of their financial position,
- setting realistic growth targets, and
- having appropriate financial controls in place to monitor cash flow and risks.
Companies should also ensure that they have enough working capital to support their growth and avoid taking on too much debt. The key is to be able to assess the financial situation and to have a plan to address any problems. Such a plan could include action to reduce expenses or increase its revenue to improve its cash flow. A company might also need to renegotiate its debts or seek additional funding to support its growth. Insolvency Practitioners can help with this.
To reduce the risk of wrongful trading – and as mentioned previously, ignorance is not a defence – directors need to seek professional advice quickly. Appropriate professional advisers include: insolvency practitioners, accountants or solicitors. It is also important for directors to keep accurate financial records and documents and be open and transparent with their creditors about their financial situation. These documents are what an insolvency practitioner will examine if appointed as liquidator and if they are missing or not in order, it is more likely that insolvency claims, or worse, will be the outcome.
If a company is facing insolvency, and there is no obvious prospect of avoiding insolvency, directors should seek professional advice on how best to proceed before things get any worse.
The impact of Overtrading and Wrongful Trading on Insolvency
Overtrading and wrongful trading can both lead to insolvency. If liquidation is the only option, then the company will be wound up and its assets sold to repay its creditors.
However, the sooner advice is taken, the more likely it is that a recovery procedure, such as an Administration or a Company Voluntary Arrangement may be appropriate.
Two recent examples of Overtrading and Wrongful
Overtrading and wrongful trading can happen to any business of any size in any sector. Here we briefly look at two of the larger, more high profile cases in recent years.
- Firstly, Carillion, the UK-based construction company, which collapsed in 2018. Carillion had been overtrading for several years, taking on too much debt and expanding too quickly. When its cash flow problems became too severe, the company went into liquidation, leaving its shareholders, employees, and creditors with significant losses.
- An example of wrongful trading is the case of BHS, the department store chain that went into administration in 2016. BHS had been facing financial difficulties for several years, but its directors continued to trade, knowing that the company could not pay its debts. The company was eventually sold for £1, and its pension scheme was left with a significant deficit.
Talk to us if worried about Overtrading or Wrongful Trading
Overtrading and wrongful trading are two of the most common financial issues that businesses face, so understanding the differences between them is especially important for directors of companies to be able to take the right action to protect their financial health and avoid legal issues such as insolvency claims and director disqualification investigations.
If you are concerned about the financial position of your company and are worried about overtrading or wrongful trading, please contact us or call one of our offices for an initial free of charge, confidential and no obligation discussion.
Also, K&W Recovery, trading as Antony Batty and Company, Thames Valley: