Misfeasant trading: How will the court calculate compensation?

Overview

In the previous edition of Newswire, we reported on the first successful case of misfeasant trading in the United Kingdom (UK) and arguably the most important decision on directors’ duties in the zone of insolvency since the UK Supreme Court’s landmark decision in Sequana¹. The claim had been brought by the liquidators of several companies in the well-known retail chain, British Home Stores group (BHS). In those proceedings, two directors were ordered to make payments exceeding £18 million in connection with BHS’ trading prior to the commencement of insolvency proceedings (the June 2024 Judgment), although the court deferred ruling on the total amount payable in respect of the misfeasant trading claim. In a new Judgment² issued on 19 August 2024 determining the quantum, the High Court has for the first time clarified how equitable compensation should be calculated where a director breaches their fiduciary duties to the company while continuing to trade after the point at which liquidation is probable.

The English High Court concluded that equitable compensation under section 212 of the Insolvency Act 1986 (IA 1986) relating to a breach of the equitable duty to have regard to creditors’ interests when a company is in the zone of insolvency, is calculated according to the increased net deficiency in the company’s assets incurred during the period of misfeasant trading and caused by the breach of duty. This mirrors the approach the court takes when calculating the level of contribution to the insolvency estate a director should make following a finding of wrongful trading under section 214 of the IA 1986³.

Traditionally, claims relating to trading in the zone of insolvency have been brought as wrongful trading claims. The threshold for liability in that case is that the director continued trading after the point at which they knew, or ought to have known, that there was no reasonable prospect of avoiding insolvent administration or insolvent liquidation⁴. However, following the UK Supreme Court’s decision in Sequana, misfeasant trading offers a previously under-explored cause of action. In the case of misfeasant trading, the June 2024 Judgment held that only the probability of insolvent administration or liquidation is required.

With wrongful trading and misfeasant trading potentially leading to identical awards - albeit with a lower bar for bringing misfeasant trading claims, - we expect to see more misfeasant trading claims in the future; particularly given the relative rarity of successful wrongful trading claims.

Background to the BHS litigation

BHS—a traditional High Street retail department store—was established in 1928 and became a household name in the UK.

In the decade prior to its collapse, its profitability declined and by 2015 it had a cumulative operating loss of £442 million. In March 2015, Retail Acquisitions Limited purchased the entire issued share capital of the parent company, British Home Stores Group Ltd, for £1. New directors were appointed to the BHS companies. Following a further unsuccessful trading period, the BHS companies entered administration in April 2016.

The liquidators brought various claims against the directors, which for convenience can be divided into the following categories:

• wrongful trading
• misfeasant trading
• further misfeasance claims

The June 2024 Judgment

In the June 2024 Judgment, each director was ordered to pay £6.5 million for continuing to trade past the point at which the Court concluded the directors knew, or ought to have known, that insolvency was inevitable and there was no reasonable prospect of avoiding liquidation (i.e., they engaged in wrongful trading). The directors also were ordered to compensate the companies for breaching their directors’ duties by continuing to trade the companies past the (earlier) point in time at which they ought to have concluded that an insolvency process was probable.

The court made key findings of fact and law on various issues of liability and causation in respect of both wrongful trading and misfeasant trading – the latter being a cause of action that was explored for the first time in this case⁵. This judgment deals with the quantum payable in respect of the misfeasant trading finding.

Causation

In terms of the relevant test to apply, the court confirmed there was “no reason to depart from the usual measure of compensation and that the breaches of duty which [the directors] committed were the effective cause of the total [“increase in net deficiency”]” (or IND). The court would then apply a “but for” test when assessing losses arising from the breaches of duty. In other words, if the losses would have happened in any event, then the relevant breach cannot be said to have caused the loss. 

Specifically, the burden was on the liquidators to prove that the directors’ breach of duty was “an effective cause” of the loss for which they sought a contribution, although it did not need to be “the sole or only effective cause” of loss.

The court ultimately concluded that:

“…those breaches of duty were not just the but for cause of the Companies’ continuing to trade but an effective cause of the total IND and, in particular, the property and trading losses which the Companies suffered…Indeed, I am satisfied that those breaches of duty were the principal if not the sole effective cause of those losses.”⁶

Calculating the quantum of liability

It was accepted by the parties that, in respect of both misfeasant and wrongful trading, the starting point for determining what contribution the directors should be ordered to make to the companies’ assets was the IND in the assets of the company following the relevant liability being triggered.

The parties agreed that on 26 June 2015 (the date on which the court held that the directors had sufficient knowledge such that misfeasant trading was triggered) and the date of administration (25 April 2016), the IND was approximately £133.5 million. However, the Court would need to consider whether, but for the breach of duty, a loss of £133.5 would have occurred.

The increase in the pension scheme deficit (£19 million) failed the ‘but for’ test, as the pension position was demonstrably volatile. A double recovery must also be avoided. The court therefore deducted the increase in the pension deficit of £19 million, and sums paid by directors in settlement of claims against them.

Taking this into consideration, the court held the directors jointly and severally liable to pay equitable compensation for misfeasant trading in the sum of £110,230,000.

In case the High Court was wrong in determining the basis of compensation, the court offered two alternative approaches to calculating quantum:

1. Aggregate decreases in the value of assets and increases in liabilities, i.e., the decrease in value of the companies’ property assets, the increase in other liabilities, and the decrease in other assets, less credit for sums received in settlement, or
2. By reference to the loss caused by individual transactions

Joint and several liability

In determining the incidence of equitable compensation, the court held that the directors should be jointly and severally liable for the losses. This is consistent with the well-established principle in English law that trustees should be jointly and severally liable for loss where they are involved in a collective breach of their duties.

The court considered whether it could exercise discretion to impose liability on a several basis only. Interestingly, the court’s view was that such an apportionment may not be available in misfeasant trading cases, stating that:

“I doubt whether such discretion is wide enough to enable the Court to impose liability on a several basis rather than a joint and several basis or to limit an award of equitable compensation for breach of the statutory duties of a director once a liquidator has proved liability to the civil standard.”⁷

The question of whether the court has a discretion to apportion liability for misfeasant trading was ultimately left unresolved.

Trading in the zone of insolvency: Overlap between wrongful trading and misfeasant trading

The award for misfeasant trading awarded in this case (i.e., the IND of a company’s assets during the period in which the company continued to trade) mirrors the approach taken in wrongful trading cases. However, unlike misfeasant trading, liability in respect of wrongful trading is subject to a strict “knowledge test” (i.e., a requirement that the directors knew, or ought to have known, that there was no reasonable prospect of the company avoiding insolvent liquidation or administration). Accordingly, the directors argued that in the future, liquidators may try to “shoe-horn” what should be wrongful trading claims into misfeasant trading claims in order to bypass the wrongful trading knowledge test. 

In the court’s view, however, the two heads of liability have different legal requirements and are not intended to be mutually exclusive. Therefore, the fact that liability for losses arising from misfeasant trading must fall within the scope of duties which have been breached should provide an “adequate control mechanism to limit the overlap”. 

Practical implications for directors

This decision is part of a developing and important area of law in the UK. It highlights that, not only are separate claims against directors possible arising from wrongful trading and misfeasant trading when a company is in the zone of insolvency, but the two actions have significant commonality. In all cases where potential liability is a concern, directors therefore should ensure they take independent professional advice.

Claims based on breach of duty misfeasant trading often will be easier to establish despite liability being calculated on the same basis as wrongful trading. Moreover, claims based on misfeasant trading potentially allow for a higher recovery because, at present, there is no established authority for apportioning liability between directors or finding directors severally liable for sums awarded pursuant to a misfeasant trading claim. This may give insolvency practitioners more scope for recovery where there are multiple defendant directors with differing levels of assets or, perhaps D&O cover.

On the other hand, notwithstanding the lower bar to establishing a claim, directors appear to have a wider defence to misfeasant trading claims compared with wrongful trading, as they need only show that they considered creditors’ interests and, acting in good faith, concluded that continuing to trade was in creditors’ best interests. Where wrongful trading is claimed, the statutory defence is much narrower i.e., that directors took every step with a view to minimising losses to creditors.

[1] BTI 2014 LLC v Sequana SA and others [2022] UKSC 25

[2] Wright and Rowley, BHS and others v Chappell and others [2024] EWHC 2166 (Ch).

[3] See Re Ralls Builders Ltd (in liquidation) [2016] EWHC 1812 (Ch)

[4] The director must also have failed to take every step to minimise losses to creditors.

[5] Re BHS Group Ltd & Others [2024] EWHC 1417 (Ch)

[6] At para [54].

[7] At [40].