The English courts recognise the inherent tension in such decisions, and that there are no easy answers. However, Mr Justice Leech's extensive judgment in Wright and others v Chappell, Henningson and Chandler [2024] EWHC 1417 (Ch) handed down on 11 June 2024 and the record fines for wrongful trading of £6.5 million each imposed on two of the BHS directors, have provided a timely reminder that directors who decide to trade on must not base their decisions on 'wishful thinking' at the expense of the company's creditors. Their decisions must be rational in the circumstances and made with the company's creditors' interests in mind if they are to avoid later penalty.
The June decision dealt with liability, causation and quantum for all issues other than the quantum of equitable compensation for “misfeasance trading”. This has subsequently been considered in a further decision handed down on 19 August 2024 (Wright and others v Chappell, Henningson and Chandler [2024] EWHC 2166 (Ch)), and again has resulted in significant awards being made against former BHS directors.
Background
The BHS Group was one of the most recognised brand names in the UK for many years, following its establishment in 1928. Its retail business encompassed clothing, homeware, lighting and furniture. It traded profitably but by March 2015, the business was struggling and it was purchased by Retail Acquisitions Limited ("RAL") for a nominal amount. At the time of the acquisition, the BHS Group had cumulative operating losses of £442 million and a defined benefit pension plan deficit valued in excess of £200 million.
Mr Dominic Chappell, Mr Dominic Chandler and Mr Lennart Henningson, among others, were appointed directors of four group companies, British Home Stores Group Ltd, British Home Stores Ltd, Davenbush Ltd and Lowland Homes Ltd following the acquisition (the "Companies"). They were unable to turn the business around. In March 2016, the Companies proposed a CVA, but it was not capable of implementation and administrators were appointed in April 2016. The Companies moved into liquidation in December 2016. The joint liquidators, Mr Anthony Wright and Mr Geoffrey Rowley (the "Joint Liquidators"), brought claims against the three directors under s212 and s214 of the Insolvency Act 1986 (the "Act"). The judgment concerned the claims against Mr Chandler and Mr Henningson, with the case against Mr Chappell having been severed, to be heard separately.
The activities of the Companies' boards in the 12 month period to March 2016 bear many hallmarks familiar to restructuring professionals of a group grappling with acute liquidity issues. These included stretching creditors, entering into sale and leaseback transactions to fund short term liquidity, securing loans with alternative funders, hiring professional advisers and engaging with His Majesty's Revenue and Customs and the Pensions Regulator. Such steps are commonly encountered in distressed situations where boards are seeking a resolution to solvency issues. However, the manner in which directors navigate such issues, and act on any advice which they take in relation to those issues, is critical to dispelling any risk of personal liability arising under both s212 and s214 of the Act at a later date. As seen from the unprecedented quantum of the contributions which Mr Chandler and Mr Henningson were ordered to make, directors get these decisions wrong at their peril.
Wrongful trading
The offence of wrongful trading is designed to ensure that directors do not trade on at the expense of creditors and dissipate assets which should otherwise be available for distribution to those creditors on the company's insolvency.
The 'reasonable prospect' test
S214 of the Act provides that if in the course of a winding up of a company it appears that the company has gone into insolvent liquidation and "at some time before the commencement of the winding up of the company, [a] person knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation or entering insolvent administration" then the court may order the person to make a contribution to the company's assets. This is commonly referred to as the "reasonable prospect" test. The "person" in question must have been a director or a shadow director of the company at the time of the offence, although they do not need to still be in office at the point a claim is made. However, if it can be shown that, once the person knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation or entering into insolvent administration, they took "every step with a view to minimising the potential loss to the company's creditors", the court will not order the director to make a contribution to the company's assets. What actions constitute "every step" will depend on the facts of the case. Additionally, it is not sufficient to show that the overall net deficit was reduced by the director’s actions - the actions must be designed to minimise the risk of loss to individual creditors.
The Joint Liquidators claimed that the directors had, from the date of their appointment as directors or alternatively on five subsequent "knowledge dates" concluding with 8 September 2015, the requisite knowledge for the wrongful trading claim and did not take every step to minimise potential loss to creditors. Unusually for a wrongful trading case, the parties agreed in advance of the trial that there had been an increase in the net deficiency of the Companies' assets, i.e. a loss for the purposes of s214, of £45.5 million between 8 September 2015 and 25 April 2016. Mr Justice Leech therefore focussed his judgment on an assessment of the directors' knowledge on the various dates, concluding that by 8 September 2015 (some seven months in advance of the Companies' entry into administration), they ought to have concluded that there was no reasonable prospect that the Companies would avoid going into insolvent liquidation or insolvent administration. He was not satisfied that even if there had been a reasonable prospect of reducing the net deficiency as regards the general body of creditors by continuing to trade over the 2015 Christmas period, the board believed the BHS Group would trade profitably over that period, or that the directors ever considered the risks to unsecured creditors or individual creditors, such as the pension trustees.
When does liability for wrongful trading arise?
Mr Justice Leech confirmed that s214 does not impose a time limit or limitation period and the knowledge date may arise some months or even years before the onset of insolvent liquidation or insolvent administration. This reflects the position articulated by David Richards LJ in the Court of Appeal in BTI 2014 LLC v Sequana SA [2019] EWCA Civ 112, in considering the duty of directors under s. 172(3) of the Companies Act 2006 to consider or act in the interests of the creditors of the company rather than its members when promoting the success of the company (the so called 'modified duty'). He described the difficulty in pinpointing the precise moment at which a company becomes insolvent. "If the test is that insolvency is "imminent", or if similar words are used, it suggests that actual insolvency will be established in a very short time. That may well describe many situations in which the duty is triggered, but it does not or may not cover the situation where, although the company may be able to pay its debts as they fall due for some time, perhaps a considerable time, to come, insolvency is nonetheless likely to occur and decisions taken now may prejudice creditors when the likely insolvency occurs." Bus LR 2178 at [218] and [219].
Mr Justice Leech considered the status of the directors' knowledge in the context of the reasonable prospect test (the "Knowledge Condition") in light of the decision of the Supreme Court in Sequana, in particular the timing difference between the point at which the modified duty to consider or act in creditor interests is engaged versus the point in time when directors become liable for wrongful trading [469 to 473]. The Supreme Court's approach to the modified duty was that it arises from the point when the company is "bordering on insolvency or an insolvent liquidation is probable" [Lord Reed PSC at [94]]. Mr Justice Leech confirmed liability for wrongful trading arises at a later point, holding "In light of Sequana, I am satisfied that the bar is a very high one and that the Joint Liquidators have to demonstrate that Mr Henningson and Mr Chander knew or ought to have known that insolvent liquidation or administration was inevitable".
The Notional Director
S214(4) provides for the purposes of assessing the Knowledge Condition, that the facts which the director ought to know or ascertain, the conclusions which the director ought to reach and the steps which it ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both (a) the general knowledge, skill and experience that may be reasonably expected of a person carrying out the same functions as ae carried out by that director in relation to the company and (b) the general knowledge, skill and experience that the director has. Mr Justice Leech referred to this standard as the "Notional Director" test and confirmed that it applies to directors individually, rather than the board as a whole, and that the standard will depend in part on the size and sophistication of the company.
Mr Justice Leech confirmed that the Notional Director standard imposes a minimum standard of general knowledge, skill and experience reasonably expected of a person carrying out the director's functions [479]. If the director's general knowledge and skill is higher than that of a reasonably diligent person, then the director will be held to the higher standard. However, if the director's general knowledge and skill is lower, it is no defence for the director to say that they didn't have that knowledge, skill or experience.
Rationality of decision-making
The Notional Director standard requires an assessment of what the individual director did, the material available to that director and the material which it could (with reasonable diligence) have accessed, including sufficient financial information to monitor the company's solvency. The key question for the director is not whether it knew the company was insolvent, but whether the director knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation or entering insolvent administration. There must be, in the words of Lord Briggs in Sequana "light at the end of the tunnel". If the director concluded that the company could trade out of insolvency, "there must be a rational basis for that conclusion…there must be something more than blind optimism or micawberism (meaning the unfounded and naïve belief that something will turn up in the future to conquer financial adversity) for the director to justify the company to trade whilst insolvent"). Mr Justice Leech concluded that s214 is engaged when "the directors have no rational basis for continuing to trade and they are only liable for continuing to trade if at that point they fail to take steps to minimise the loss to creditors". [473(5)]
Assessing the actions of the directors at each of the knowledge dates, Mr Justice Leech considered that by 8 September 2015 (the latest knowledge date proposed by the Joint Liquidators), while the directors themselves may not necessarily have concluded that the reasonable prospect test had been met, a Notional Director carrying out their functions would have come to that conclusion [904]. The business was cashflow insolvent even if it drew down on the only short term loan available to it, having been unable to put any sustainable working capital facility in place. Trade credit insurance had been withdrawn. There was no prospect of the business achieving its turnaround plan where the bridge to positive EBITDA relied on property sales which could not be achieved in the time available. Incurring further debt and engaging in major property sales was therefore ultimately a "degenerative strategy…which would only lead to the BHS Group running out of assets to fund its loses long before the turnaround of the business could be achieved" [904].
Professional advisers
The fact that the boards of the Companies had received advice from professional advisers, including lawyers, in relation to their decisions did not absolve the directors of their personal liability under s214. Mr Justice Leech accepted the proposition articulated by Sir Alistair Norris in Sharp v Blank [2019] EWHC 3096 (Ch) that in general, a director who takes and acts upon expert advice "has gone a long way to performing his duties with reasonable care" [629]. However, Mr Justice Leech was clear that the importance that the Court will attach to the professional advice taken will depend on "the scope of the engagement, the instructions which the adviser was given, the knowledge which they had or the assumptions they were asked to make, the advice which they gave (or did not give) and the extent to which the directors relied on that advice (or not)" [485]. In the case of the directors, Mr Justice Leech concluded that the legal advisers were not appraised of all the facts, had not been given relevant financial information and could not have been expected to do more than to identify the legal issues which the boards of each of the Companies had to consider and the severity of the financial position on 1 September 2015. The question of whether the Companies had a reasonable prospect of avoiding insolvent liquidation or insolvent administration remained a question of individual judgment for the directors, and in Mr Justice Leech's view, the advice given by the professional advisers was not particularly considered or relied on by the boards of the Companies.
Misfeasance
In addition to the wrongful trading claims, the Joint Liquidators brought various claims against the directors under s212 of the Insolvency Act 1986 in relation to misfeasance. S212 provides a summary remedy where, in the course of a liquidation, it appears that a person who is, or has been a director, has "misapplied, retained, or become accountable for, any money or other property of the company or been guilty of any misfeasance of breach of any fiduciary or other duty in relation to the company", and enables the liquidator to seek an order for the director to repay, restore or account for the money or property, or to contribute to the company's assets.
Mr Justice Leech described the Joint Liquidators' claims as the "Trading Misfeasance Claim" and the "Individual Misfeasance Claims". The factual basis for the Trading Misfeasance Claim was the same as for the wrongful trading claim, i.e. that from the date of the acquisition and the directors' appointments, the directors either knew, or ought to have known, that there was no reasonable prospect of avoiding insolvent liquidation or insolvent administration. The Individual Misfeasance Claims involved nine individual claims against the directors in relation to various individual assets or funds of the Companies.
Trading Misfeasance
The Trading Misfeasance Claim was pleaded on the basis that the directors had breached their duties under the Companies Act 2006, including failing to have sufficient regard for the interests of the Companies' creditors at any material time (i.e. a breach of the modified duty referred to above) and acting for the purposes of RAL and/or their own purposes, rather than those of the Companies. The Joint Liquidators argued that had the directors discharged their duties properly, then they would have concluded that the Companies should not continue trading and the losses occasioned by that continued trading would not have been incurred. This was a novel argument and one which found favour with the Court. In Mr Justice Leech’s view, it was clear from Sequana that “insolvency-deepening activity” could amount to a breach of duty by directors even though, when the activity was carried out, insolvent liquidation was not inevitable and there was no liability for wrongful trading [546].
Mr Justice Leech considered the point at which the modified duty for the purposes of s172 Companies Act arose, and was satisfied that it had arisen by 17 June 2015. At that time, the directors had received a cashflow forecast identifying a number of key headroom issues which indicated that with or without further funding, rent payments could not be met and there was no working capital to support the business's turnaround plan. Mr Justice Leech considered that, while the Companies were not cashflow insolvent at this point and insolvency was not inevitable, the interests of the creditors should have been paramount. It was not in the creditors' interests for the Companies to enter into additional expensive loans which formed part of the 'degenerative strategy'. The directors' decision to move ahead with entering into further loans was therefore in breach of their s172 duty and Mr Justice Leech was satisfied that 'but for' this action, the Companies would not have continued to trade and would have been placed into administration. [1131].
The August 2024 decision
By the time of the hearing for the quantum of equitable compensation which the directors should be ordered to pay for the Trading Misfeasance Claim:
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Mr Chandler had reached agreement with the liquidators and was therefore excluded from the August decision; and
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The court had held that Mr Chappell had no real prospect of defending any of the claims made against him and found him liable for wrongful and trading misfeasance. He was ordered to make a contribution to the assets of the Companies under s.214 of £21.5m.
The August decision therefore covers the liability of Mr Henningson and Mr Chappell.
Although the concept of the modified duty was central to and developed by the Supreme Court in Sequana, the court did not have to consider how compensation for breach of the modified duty should be calculated. Mr Justice Leech was therefore faced with the perhaps unenviable position of having to determine the issue by reference to the wider authorities on both equitable compensation and s.212.
The court accepted the liquidators’ argument that the starting point for assessment of compensation for misfeasance under s.212 where the company continued to trade as a result of the breaches of duty was the increase in the net deficiency in the company’s assets. Although the liquidators had to prove that the breaches of duty were the effective cause of the losses suffered by the Companies by continuing to trade, they did so in this case. The court was satisfied that, save in one respect, “all of the losses fell within the scope of the Sequana duty which Mr Hennningson and Mr Chappell owed to the creditors of the Companies. In particular, I am satisfied there is a clear nexus between the risk of harm against which they assumed a duty to protect the Companies’ creditors and the losses which the Companies have suffered” [71].
So, the breaches of duty by Mr Chappell and Mr Henningson were the effective cause of the total increase in the net deficiency in the Companies’ assets in the period from 26 June 2015 to 25 April 2016. The only exception was the pension deficit, which was extremely volatile and the increase or decrease in deficit was unrelated to the breaches of duty.
Agreeing with the liquidators’ argument that the amount of equitable compensation should be calculated by reference to the total increase in net deficiency (but making an allowance for an increase in the pension deficit and for an amount paid by another director for wrongful trading), the court ordered Mr Henningson and Mr Chappell should pay £110,230,000 on a joint and several basis.
Counsel for the directors argued that if liquidators were able to recover the increase in net deficiency for breach of the modified duty, “liquidators would try and “shoe-horn” wrongful trading claims under s.214 into misfeasance claims under s.212 and by-pass the stringent knowledge requirement in s.214(2)(b)” [33], however the submission was rejected by the court. A liquidator was able to pursue claims under both s.212 and s.214, and the fact the breach of duty had to be the ”effective cause” of the loss provided an adequate control mechanism to limit the overlap between the two provisions.
Despite rejecting counsel for the directors’ argument that compensation should be limited to the loss suffered by the company arising out of a single transaction or single venture, the court went on to consider two alternative bases for calculating equitable compensation for breach of duty: one based on individual increases in net deficiency, and another based on losses caused by an individual transaction or venture approved by the directors (in this case the entry into of expensive lending arrangements).
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the first looked at the decrease in value of the Companies’ property assets, the increase in their other liabilities, and the decrease in their other assets between 26 June 2015 and 26 April 2016, which led to a figure of c.£88m;
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the second looked at what the compensation would be if calculated by reference to the loss caused by the relevant single transaction, which led to a figure of £34m.
Conclusion
It remains to be seen whether either the June or the August judgments will be appealed, in particular, Mr Justice Leech's conclusions on the Trading Misfeasance Claim and the 'but for' test, which some legal commentators are concerned blurs the lines between breach of the modified duty and liability for wrongful trading. However, what is clear from both judgments is that directors who find themselves at the helm of distressed businesses must act rationally and assess the impact of their decision-making as regularly as possible, including appraising their professional advisers of the full situation in order for them to provide appropriate support.
Authored by Camilla Eliott Lockhart and Margaret Kemp.
