DIRECTORS' PERSONAL LIABILITY FOR WRONGFUL TRADING.

Directors have a fiduciary duty. This duty mandates them to act in the best interests of the company and its stakeholders. One significant aspect of this duty is the obligation to avoid wrongful trading. Wrongful trading occurs when directors allow a company to continue doing business while knowing (or should have known) that there is no reasonable prospect of avoiding insolvency. If this duty is violated, directors can be held personally liable. Here's an overview of director liability for wrongful trading:

LEGAL FRAMEWORK

a.????? What is wrongful trading?

Wrongful trading is where the directors continue to trade and incur financial liabilities when they know, or ought to have known (or concluded), that there is no reasonable prospect of the company avoiding insolvent liquidation or administration. The justification for wrongful trading is to shield creditors from directors who incur unpayable debt while being aware that the company is insolvent.

The goal of this rule is to prevent an insolvent business from accruing more debt and financial responsibilities and worsening its already precarious financial position.

b.???? Legal Basis:

The legal basis is Section 506 of the Insolvency Act No. 18 of 2015, which provides that:

506 Power of the Court to make orders against officers of a company engaging in wrongful trading

(1)? This section applies—

(a) to a company that is in insolvent liquidation; and

(b) to a person who, at a time before the commencement of the liquidation, was an officer of the company.

(2)? For the purposes of this section—

(a) a company is in insolvent liquidation if, at the time the liquidation commences, its assets are insufficient for the payment of its debts and other liabilities and the expenses of the liquidation; and

(b) the person in respect of whom an application is made under subsection (3) is the respondent to the application.

(3) If, in the course of the liquidation of a company, it appears to the liquidator that a person to whom this section applies knew or ought to have known that there was no reasonable prospect that the company would avoid being placed in insolvent liquidation, the liquidator may make an application to the Court for an order under subsection (5).

…………

(5)? On the hearing of an application made under subsection (3), the Court may make an order declaring the respondent to be liable to make such contribution (if any) to the company's assets as the Court considers appropriate, but only if it is satisfied that, at the relevant time, the respondent knew or ought to have known that there was no reasonable prospect that the company would avoid being placed in insolvent liquidation.

CRITERIA FOR ESTABLISHING WRONGFUL TRADING

The law imposes a duty on directors to minimise potential losses to the company's creditors once they realise that insolvency is unavoidable. To establish wrongful trading, the following elements typically need to be proven:

a.????? Knowledge of Insolvency:

The director knew or ought to have known that there was no reasonable prospect of the company avoiding insolvent liquidation.

b.???? Failure to Take Action:

The director failed to take every step to minimise the potential loss to creditors.

CONSEQUENCES AND LIABILITY FOR WRONGFUL TRADING

a.???? Personal Liability:

Directors found guilty of wrongful trading can be held personally liable for the debts incurred by the company after they should have known that insolvency was inevitable.

The court can order the directors to contribute to the company’s assets, making them personally liable for a portion of the company's debts.

b.???? Disqualification:

Directors guilty of wrongful trading may also face disqualification from serving as directors of any company for a specified period.

c.????? Criminal Sanctions:

There may be criminal sanctions for wrongful trading, especially if fraudulent intent is involved.

DEFENCES

Directors may avoid liability for wrongful trading if they can demonstrate:

1. They took reasonable steps: They took every step to minimise potential losses to the company's creditors.
2. Sought professional advice: They sought and followed professional advice, such as from insolvency practitioners or financial advisors.
3. Had honest and reasonable belief: They honestly and reasonably believed that the company could be turned around. This defence has to be justified, and directors cannot have an honest belief if it can reasonably be determined from the financial records at that time that the business was doomed.

The above defences will not be successful when the directors close their eyes to the company’s financial position and realities and continue trading after it is obvious that the company is insolvent. The test is that there must be more than a mere connection between the director’s wrongful action and the losses to be incurred. A finding of wrongful trading is likely to be reached when the company goes into more financial difficulty.

RECOMMENDED BEST PRACTICES FOR DIRECTORS

To mitigate the risk of wrongful trading, directors should:

1. Set up regular financial monitoring: Directors are required to keep a close eye on the company’s financial status and cash flow. Directors have a duty to understand the company's financial position to determine when to stop trading. The directors cannot rely on ignorance or lack of knowledge.
2. Have the company implement early warning systems: This can be achieved by implementing systems to detect early signs of financial distress.
3. Get professional advice: Directors should obtain timely advice from accountants, insolvency practitioners, or legal advisors when financial difficulties arise. The decision to continue trading must be supported by professional advice. This advice can be the basis for continued trading.
4. Document and record the decision-making: the company should maintain detailed records of decisions and actions taken in response to financial difficulties.
5. Consider several insolvency options: Evaluate restructuring or insolvency options as soon as insolvency appears likely.

KEY TAKEAWAY

Director liability for wrongful trading underscores the importance of diligent and responsible management, especially in financial distress. Directors must act promptly and prudently to mitigate losses and protect the interests of creditors to avoid personal liability. By understanding the legal framework under the Insolvency Act and adhering to prudent practices, directors can better navigate the complexities of corporate insolvency and fulfil their fiduciary duties.

https://www.kenyalaw.org:8181/exist/rest/db/kenyalex/Kenya/Legislation/English/Acts%20and%20Regulations/I/Insolvency%20Act%20-%20No.%2018%20of%202015/docs/InsolvencyAct18of2015.pdf

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NOTICE: THIS IS NOT LEGAL ADVICE. SEEK LEGAL ADVICE FROM YOUR LAWYERS.