George M. Mangion | Tuesday, 16 October 2007

Wrongful and fraudulent trading

Autumn leaves are falling and the first torrential rains played havoc in low lying areas. Yet the autumn fresh air has also morphed into a landside court decision that took five years in the making. The Times of Malta reported last week that Mr Justice Tonio Mallia, sitting in the First Hall of the Civil Court, concluded that Victor Zammit, Christopher Gauci and Wallace Fino had committed fraudulent and wrongful trading in connection with PCO and the company’s creditors. They were held personally and unlimitedly responsible for the debts incurred by Priceclub Operators Ltd (PCO).
The court said that this manoeuvring took place to facilitate the workings of the private companies owned by Mr Zammit and Mr Gauci to the detriment of PCO’s creditors. Mr Justice Mallia added that PCO had commenced operating with a deficit and without a capital base culminating in the plight of unsecured suppliers been ignored by the directors. In a separate judgment, Mr Justice Tonio Mallia, also held Priceclub Holdings Ltd (PCH), Priceclub Birkirkara Ltd (PCB), Priceclub Swatar Ltd (PCS), and Priceclub Burmarrad Ltd (PCBU) unlimitedly responsible for the debts incurred by Priceclub Operators Ltd (PCO).
The impact of the collapse of the Priceclub on a tiny island ‘s business community is probably equal to or could even be in excess of that of the possible impacts of the Parmalat scandal.
This is a milestone judgement in the short history of our insolvency rules within the 1995 Companies Act. Insolvency practitioners point to article 214 of the Companies Act, 1995 which describes an insolvent company as one which is unable to pay its debts. Wrongful trading can be defined as occurring when a director of a company that has gone into insolvent liquidation and at some time before the commencement of the winding up of the company, knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. The court may hold him liable to make such a contribution to the company’s assets .
The court will not make such a declaration if it is satisfied that the director in question took every step with a view to minimising the potential loss to the company’s creditors. In insolvency law, fraudulent trading refers to a company has carried on business with intent to defraud suppliers.
Where during the course of a winding-up it appears to the liquidator that fraudulent trading has occurred, the liquidator may apply to the court for an order any directors were knowingly parties to the carrying on of such business are to be made liable to make such losses.
Fraudulent trading also existed in cases where the directors had no good reason to think funds would become available to pay the company’s creditors when the debts became due or shortly thereafter
Let me give some legal background to the terms wrongful trading and fraudulent trading. The main purpose of making directors responsible in law for wrongful trading was to reduce the number of phoenix companies being set up by the unscrupulous and crooked and protect the public and creditors from losses.
Whether that objective is being achieved is for others to say but it does mean that the honest director does not have to act fraudulently or negligently for the provisions to apply.
Wrongful trading is thus a form of civil liability which can result in a financial order for a return of funds to the company.
Directors have to ensure that the company has proper accounting and reporting systems in place and that you receive and act on financial information on a regular basis.
It is customary for directors to be vigilant and not rely solely on historical accounting information. They need to review future trading projections and question the underlying assumptions. It is no excuse that they relied on paid subordinates to give them up to date information on the daily trading status of the company. Directors are duty bound to compare actual performance with budgets and amend future budgets in the light of those comparisons.
The Price Club Supermarkets case is the casus classicus. Initially, the chain enjoyed one of Malta’s best turnovers. However, the chain’s demise was equally as outrageous. It is has ended up in July 2002 owning some Lm 8.5 million to over 200 creditors. Assuming the banks recover their money from Priceclub and as is likely the trade creditors do not, the loss in tax revenue would be in the region of Lm3 million, assuming Lm9 million creditors unpaid.
Not much disclosure was given by the financial press since the liquidation started five years ago.
However the late Julian Manduca (a journalist with Malta Today) had single-handle followed the case and covered the case unctuously. He pursued the legal proceedings and wrote about how the mystery of the sudden demise of the largest supermarket chain had occurred.
In his uncovering of court documents, Julian had revealed how the owners of the defunct supermarket chain managed to usurp massive funds from a company destined to face bankruptcy, diverting the funds into their own personal channels and fabricating stock figures and accounts.
Typically one reads in his reports how John Zarb is a leading auditor with PricewaterhouseCoopers and a consultant to the big six creditors that lost money in Priceclub.
He was appointed by liquidator to examine the books of a

Certainly the foremost auditing authority on the island, John Zarb, in his report for Pricewaterhouse Coopers on the Price Club demise, revealed how the multimillion market leader had continued to buy goods from its suppliers when the directors knew the company would never be in a position to pay for the goods ordered. In his court affidavit, Zarb showed how the Priceclub, despite being in severe financial trouble, decided its stock values without keeping stock records or carrying out substantial stock-takes.
So one may ask if the auditors of an insolvent company can be held liable for directors wrongful or fraudulent trading. Prima facie the answer is no. Quoting International Standard on Auditing 400: Risk Assessment and Internal Control (IFAC Handbook, 2003d), it states inter alia that an auditor should only be concerned with functions within the internal control structure relevant to the financial statements. The auditor would obtain an understanding of such a system and determine its limitations. No responsibility is placed upon the auditor by the standard.
In Malta, the Maltese Companies Act 1995 (the 1995 Act) is clear as to what should be the end result of an audit.
The auditor is responsible for drawing up a report, being a manifestation of his/her opinion on the financial statements of the company. The 1995 Companies Act specifically states (s 179) that the report represents the auditors’ opinion as to whether the annual accounts are in accordance with the relevant legislation and show a true and fair view. One should note that Section 176(1) of the Companies Act 1995 gives the responsibility for a company’s financial statements to the directors. The board of directors approves and signs the financial statements to be presented at the annual general meeting.
This decision will have far reaching albeit positive implications for corporate governance in Malta. Let us hope that a lesson is learnt by all officers of trading companies to make sure to observe to their best ability the duties to protect the interest of the suppliers and consumers .

George m.Mangion
[email protected]

ccount of Priceclub in relation to allegations against the Priceclub directors.