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BHS - Wrongful and misfeasant trading - what directors need to know

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Published Date

Jun 24, 2024

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In this alert, we consider the implications from the recent High Court judgment finding two former directors of BHS liable for various heads of wrongdoing, including wrongful trading and "misfeasant trading".

What directors need to know

On 11 June 2024, the High Court issued a lengthy and detailed judgment ^[1] in a case brought by the liquidators of several British Home Stores group companies against two of their former directors. Mr Justice Leech determined that Dominic Chandler and Lennart Henningson were liable under several heads of wrong-doing, resulting in the highest ever award for wrongful trading in the UK (GBP6.5m on a several basis), and the first ever award for “misfeasant trading” (in an aggregate amount to be determined at a hearing to be held on 24-25 June 2024 but potentially up to a maximum of GBP133.5m)^[2]. The directors were also held liable for certain “individual misfeasance” claims resulting from breaches of specific statutory directors’ duties, with Mr Henningson liable for GBP300,000, and Mr Chandler liable for approximately GBP5.3m.

Summary

While it is possible that the judgment will be appealed, this case serves as a useful reminder to directors of the “duty shift” which applies when a company becomes financially distressed and the importance of properly assessing their duties on an ongoing basis (and the impact of any operating and strategic decisions on the likelihood of minimizing losses to creditors) as a company gets closer to the “zone of insolvency”.

The possibility of liability for “misfeasant trading” and failure to adequately consider creditors’ interests in circumstances of financial distress but where there is still a reasonable prospect of avoiding insolvency highlights the necessity for directors to obtain professional financial and legal advice at as early a stage as possible if a company starts encountering financial difficulties, as well as making sure that any such advice is properly targeted and tailored to the relevant circumstances.

Background

The troubled BHS group was acquired by Retail Acquisitions Ltd (principally owned and managed by Dominic Chappell) in March 2015 for GBP1 and new directors were appointed (include Mr Chandler and Mr Henninson). Having received creditor approval for a company voluntary arrangement (designed to compromise leasehold obligations, amongst other things) in March 2016, but failing to secure the funding required to continue trading, four BHS companies entered administration in April 2016 with a pension deficit of nearly GBP600m (which was the subject of a subsequent and separate GBP363m settlement with Philip Green, the former owner of BHS).

Timeline

May/June 2015

The directors knew that if BHS did not get access to new liquidity immediately then it would be unable to cover rent cheques, and that there was no reasonable prospect of achieving the restoration of trade credit insurance (which had been withdrawn in February/March) in the short term. At this point, the directors ought to have known it was more probable than not that BHS would enter insolvent administration; accordingly, they owed a duty to consider creditors' interests. The directors' liability for misfeasant trading/failure to have regard to creditors' interests arose from this date - even though the companies were not yet cash flow or balance sheet insolvent and insolvency was not inevitable.

September 2015

BHS group companies were cash flow insolvent, and the court held that the "Knowledge Condition" was satisfied - i.e. where the director knew, or ought to have concluded, that there was no reasonable prospect of the company avoiding an insolvent administration or liquidation. The directors' liability for wrongful trading arose at this point.

April 2016

The BHS companies entered into administration.

What is Wrongful Trading?

Sections 214 and 246ZB of the Insolvency Act 1986 provide that, when a company has gone into insolvent administration or insolvent liquidation, a director will be liable for the debts and liabilities of the relevant company if they continued to trade the company following the date on which the Knowledge Condition is satisfied. There is a defence available if, from the date the Knowledge Condition was satisfied, the directors took every step with a view to minimizing the potential loss to the company’s creditors as they ought to have taken. This can be difficult to demonstrate in practice – it is not enough for the directors to prove that they continued trading with the intention of minimizing losses. They generally must also show that their actions were designed to minimise the risk of loss to individual creditors.^[3]

The law looks at the knowledge, conclusions and steps as would be known or ascertained, reached or taken by a reasonably diligent person who has: (i) (objectively) the general knowledge, skill and experience of a person carrying out the same functions as are carried out by that director in relation to the company; and (ii) (subjectively) the general knowledge, skill and experience of that particular director, where this is superior. For example, in this case, the judge held that while Mr Chandler (who held the position of Group General Counsel) did not hold the level of knowledge required in respect of a general counsel of a group of the size and complexity of BHS, this did not absolve him from the objective standard required by the first limb of the test above.

Key takeaways for directors

Causation

While it is necessary for a liquidator to prove that there is a causal connection between the relevant wrongful conduct and the losses suffered by the company for the purposes of wrongful trading, it is not necessary to show that the director’s conduct was the sole or effective cause of such losses. The question instead is whether the director’s conduct caused the company to continue trading and that it would have ceased trading (and entered insolvency proceedings) if the director had complied with his duties.

Timing

The court will not lay down a specific time limit in respect of which directors must file for insolvency after satisfying the Knowledge Condition. However, the gap between the date the Knowledge Condition is satisfied and the decision to place the company into an insolvency process will be an important evidential factor as to whether the directors took every step to minimise losses. Directors cannot escape liability simply because they are unable to precisely predict when they would have to place the company into an insolvency process.

Delegation/board function

Even if it has been agreed by the board that a director’s responsibilities are limited to a particular area, this will not absolve that director of his wider duties to the company and its stakeholders. For example, the judge in this case found that Mr Henningson’s functions in the group were limited to introducing financial contracts and dealing with the international side of the business, but this did not allow him to transfer responsibility for those decisions and duties in respect of which all directors are responsible to the other members of the board. All directors must actively participate in the decision-making process of the board, and ensure that such decisions are appropriately documented.

Professional advice

If the directors have obtained and acted upon the advice of professional advisers when taking decisions on whether to continue trading, they will be considered to have “gone a long way towards performing [their] duties with reasonable care”.[4] However, the court will consider any such advice in light of the scope of the adviser engagement and their instructions, the knowledge and information the advisers had, the extent to which the directors relied on that advice and other related factors, and will place the ultimate burden on the directors to decide whether or not to continue trading in the relevant circumstances.

Scope of liability

The maximum amount which a court can declare directors liable to contribute in respect of wrongful trading is the “increase in the net deficiency” in the assets of the company in the period from (i) the date the Knowledge Condition is satisfied until (ii) the date on which the company enters insolvent liquidation or administration.[5] Liability can be imposed by the court at its discretion on a several or joint and several basis, and the court will take into account, amongst other things, the relative culpability of the director, the extent their conduct caused the increase in net deficiency, and where they sat in the hierarchy of decision making when assigning liability.

D&O insurance

The directors argued that any liabilities awarded against them should be capped or reduced on the basis (a) that the BHS group’s D&O insurance policy only cover claims (including defence costs) of up to GBP20m and (b) of their general ability to pay. The court rejected these arguments, noting that it would “send the wrong message to risk-taking directors that they could escape liability” if they did not obtain adequate D&O cover.

What is Misfeasant trading?

Section 212 of the Insolvency Act 1986 provides that where, in the course of the winding up of a company, it appears that a director (or other person concerned with the management of the company) has misapplied or retained any money or other property of the company, or has breached any fiduciary or other duty in relation to the company, the court can order them to repay the money or property or any part of it, or otherwise contribute such amount to the company’s assets by way of compensation in respect of the misfeasance or breach of fiduciary or other duty, as the court thinks fit. The court has wide discretion with respect to the orders it may make and it is able to apportion the order made against individual officers in proportion to their involvement and culpability.

When a company is solvent, the directors have a duty under section 172 of the Companies Act 2006 to act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Where the company is insolvent or bordering on insolvency, or where an insolvent administration or liquidation is probable, this duty to promote the success of the company is modified such that the company’s interests are taken to include the interests of the company’s creditors as a whole. The rationale for taking creditors’ interests into account is that as a company’s financial situation deteriorates, it is increasingly “their money” that is at stake.

When this “creditor duty” is first triggered, directors should consider the interests of creditors and balance them with the interests of the shareholders. As considered in the recent Sequana case[6], the duty operates on a sliding scale – so the greater the financial difficulties, the more the directors should prioritise the interests of creditors. When an insolvent administration or liquidation is unavoidable, the creditors’ interests become paramount.

There is a general defence under section 1157 of the Companies Act 2006 to a breach of duty claim where a director has acted honestly and reasonably and, in the circumstances, the court concludes that the director ought fairly to be excused.

Key takeaways for directors

“Misfeasant trading” as a concept results from a novel application of section 212 in this case. Misfeasant trading encompasses a failure to comply with section 172 of the Companies Act 2006 (as modified by the creditor duty) where the risks of continuing to trade are so high in terms of possible dissipation of assets such that, even where there is a reasonable prospect of reducing the net deficiency of assets by continuing to trade, it would be in the interests of creditors for the company to be placed into an insolvency process immediately.
It bridges a perceived “gap” in the law identified by Lord Hodge in Sequana, who considered that there needed to be a remedy in respect of the interests of creditors in certain “egregious circumstances”, available prior to the point at which a director of a company in financial distress knew (or ought to have known) that there was no reasonable prospect of avoiding insolvency, whereby the directors adopt a course of action to the probable detriment of the creditors without a proper consideration of their interests.