When your business is struggling to pay its debts, it can be a stressful time. You may simply have cashflow issues, in which case an injection of capital from lenders or investors can tide you over. However, if your company is ‘insolvent’ – unable to pay its debts as they fall due and with no realistic prospect of doing so by cashing in assets for example, then you may have no option other than to seek expert corporate restructuring advice and enter an insolvency procedure.
Not all insolvency procedures lead to the termination of businesses and liquidation of their assets, as some are designed to rescue the company concerned. Some insolvency procedures are designed to keep creditors at bay for a period so that a buyer for the business can be found. If you’re a company director, and your business is in financial trouble, you do need to be aware that there is the potential for you to be held personally liable in certain circumstances, so you should always get professional advice if you find yourself in this situation. This article takes a look at the various insolvency procedures, as well as directors’ duties and potential liabilities.
Note that as a result of COVID-19, the Corporate Insolvency and Governance Bill (the Bill) that is due to pass into law in 2020 now includes provisions whereby creditors’ ability to make or enforce statutory demands or invoke winding-up petitions where their debts have not been paid as a result of the Coronavirus will be affected, unless the creditor has reasonable grounds for believing that (a) coronavirus has not had a financial effect on the debtor, or (b) the debtor would have been unable to pay its debts even if coronavirus had not had a financial effect on the debtor.
- When is a company insolvent?
- Corporate insolvency procedures
- Rescue: administration
- Rescue: pre-pack sale
- Rescue: administrative receivership
- Rescue: company voluntary arrangement (CVA)
- Rescue: scheme of arrangement
- Liquidation or winding-up
- Compulsory liquidation
- Voluntary liquidation
- How are creditors repaid?
- Transactions that may be set aside
- Directors of an insolvent company
- Restrictions on suppliers
- Practical points
When is a company insolvent?
If you find that your business is running short of funds, and you are concerned you may be insolvent, you need to ask yourself the following questions:
- Can I pay my bills when they come due? This is known as the cash flow test. The kinds of bills you are likely to be facing are for PAYE, VAT, or national insurance, payments to suppliers, or maybe your periodic rental payments or bank loans. If your cash flow is very tight and you feel you won’t be able to pay, you may be insolvent.
- Do I own more than I own? This is known as the balance sheet test. If your debts are more than the value of your assets, including cash in the bank, you are likely to be insolvent.
- Am I facing legal action from creditors, such as county court judgements or statutory demands that I may not be able to pay? A creditor needs only be owed £750 to be able to force your company into liquidation.
If any of these scenarios apply to you, your company may be insolvent, and you should seek legal advice.
Whether or not your company is currently insolvent, if this is a possibility, you need to check your loan agreements and major contracts as often these contain terms that would trigger a default if you are technically insolvent. This can result in their terminating or security being enforced.
Corporate insolvency procedures
Insolvency procedures can be divided into two types, those that are designed to save the company from liquidation (rescue procedures), and those that are designed to realise the company’s assets and distribute them to creditors via a liquidation or winding-up.
These are the rescue procedures:
- Administration. This allows the company to protect itself from its creditors for a period of time so that a buyer can be found, or its assets realised.
- Pre-pack sale. This is a procedure where a sale of the company’s business or assets is agreed prior to an administrator being appointed.
- Administrative receivership. This is where the holder of a charge over the company’s assets can ask for an administrator to be appointed to run the company and realise its assets.
- Company voluntary arrangement or CVA. This is where the company and its creditors come to an arrangement about how its debts will be handled.
- Scheme of arrangement. This is most suitable for large companies, and it involves creditors or shareholders or groups of them reaching agreement with the court as to how the company’s debts will be dealt with.
These are the liquidation and winding-up procedures:
- Compulsory liquidation. This is where a creditor owed at least £750 and that’s unpaid asks the court to wind-up the company and distribute its assets.
- Voluntary liquidation. This is where the shareholders or the creditors agree to wind-up the company.
A company in financial trouble may be able to reach an informal arrangement with its creditors whereby the business is allowed to repay its debts over time, rather than becoming insolvent. This is usually only effective if there are only a small number of creditors.
Administration places a moratorium on debts being called in against a company without the administrator’s or court’s consent. It allows a business time to be rescued, to reorganise or to realise its assets and pay creditors.
The aim of an administration is to:
- Preserve the company as a going concern, or
- Achieve a better return for creditors than the winding-up of the company, or
- Realise the company’s assets and distribute the proceeds to secured or preferential creditors.
In an administration, either the court, a company, its directors or a creditor with a floating charge (a security interest in the company’s assets) will appoint an insolvency practitioner (a specialist in insolvency (an IP), as the administrator.
To be placed into administration, the company must fail either the cash flow test or the balance sheet test, unless the application has been made by a qualifying floating charge holder.
The administrator will take over the management of the company, and they have wide-ranging powers. They will act as the company’s agent and must act in the best interests of the creditors as a whole.
Administration may come before an eventual CVA or liquidation, but sometimes the company is able to be rescued as a result of the administration process. Administration will end after one year unless an extension has been agreed.
Further information can be found in our guide Corporate Insolvency: Administration.
Under the Bill, a company that’s in financial difficulty but that has a good chance of survival can get a 20 business-day moratorium allowing them time to restructure or get new investment.
The company continues in existence, run by the directors, but a ‘monitor’ (an IP) is appointed to oversee the company’s business. In order to qualify for the moratorium, directors need to make an insolvency statement, and the monitor must state that it’s likely that a moratorium would result in the company’s rescue as a going concern.
The moratorium can be extended for an additional 20 business days, but an extension beyond this will need the consent of creditors or the court.
As long as the moratorium continues:
- Landlords can’t forfeit a lease.
- Security can’t be enforced without the court’s consent.
- Administrators can’t be appointed except by the directors.
- Goods under hire purchase can’t be repossessed.
- No legal proceedings can be started other than employment claims without the court’s consent.
Creditors will be able to challenge the actions of the directors or the monitor on grounds that their interests have been unfairly prejudiced.
Rescue: pre-pack sale
A pre-pack sale is where a company agrees to sell its business or assets before an administrator is appointed. Once agreement has been reached, the administrator is appointed, and the deal is completed.
For more information see Corporate Insolvency: Pre-pack Administration.
Rescue: administrative receivership
Administrative receivership allows a creditor with a floating charge over all or the majority of the assets of the company to appoint an administrative receiver to manage the company and its assets. An administrative receiver can’t be appointed if the company is in a moratorium, because, for example, administration proceedings have begun.
The terms of a floating charge will include the right to appoint an administrative receiver, for example where the company defaults on a loan secured by the charge. The administrative receiver will be an insolvency practitioner, and their role is to run the company and sell assets if necessary. Administrative receivers’ duties are extensive, but their principal duty is to act in the best interests of the creditor.
Administrative receivership is less common than it used to be as it does not apply to security created after 15 September 2003. A creditor with security created after this date can instead put the company into administration.
Rescue: company voluntary arrangement (CVA)
A CVA is a way to avoid or delay insolvency proceedings. In a CVA, the company and its creditors come to an agreement about how the creditors’ debts will be handled. The directors can suggest a CVA if insolvency proceedings have not started, but if the company is already in administration or liquidation, it must be proposed by the administrator or liquidator.
Often, creditors will agree to accept less than they are owed or to reschedule their debts in order to keep the company afloat. Provided that at least 75% in value of the creditors agree to the arrangement, the CVA will be binding on all unsecured creditors of the company who are owed debts covered by the CVA. An IP is appointed to put the arrangement in place.
A CVA may be used in parallel with administration, where the moratorium allows the company time to agree the arrangement with its creditors.
For further information see our guide ‘Corporate Insolvency: Company Voluntary Arrangements‘.
Rescue: scheme of arrangement
A scheme of arrangement is an agreement with the creditors or a certain class of creditors, or with shareholders (or members) or a certain class of shareholders (or members). It requires the agreement of the majority of the relevant group and must also be sanctioned by the court, after which it will bind all creditors and members whether they were aware of it or not.
Schemes of arrangement are usually more complicated than CVAs and so tend to be used in relation to larger companies.
For more information see our guide on setting up a scheme of arrangement.
A scheme of arrangement may be used in parallel with administration, where the moratorium allows the company time to agree the arrangement with its creditors.
The Bill, if it passes into law, will introduce a new restructuring procedure that’s similar to the scheme of arrangement, but with the ability for the court to impose a restructuring plan on certain types or classes of creditors, even if they’re not in agreement with it. It will also bind both secured and unsecured creditors, unlike a CVA. Both solvent and insolvent companies can propose that they enter into a restructuring procedure.
Under a new procedure, creditors will be divided into classes, depending on the type of debt they hold. They will vote on the plan by class, and at least 75% of each class will have to agree to the plan. However, even if some classes don’t agree to the plan, the court can still approve a restructuring plan if they feel it’s fair overall.
Liquidation or winding-up
Liquidation or winding up mean the same thing, and results in the company being dissolved. An insolvency practitioner is appointed as a liquidator, and their job is to gather the company’s assets, sell them and distribute the proceeds among the creditors to settle the company’s debts. Once this has been done, the company is dissolved.
Liquidation can be compulsory or voluntary and may take place after another insolvency procedure, such as administration, has come to an end. The liquidator has extensive powers and will take over from the directors although, in a voluntary liquidation situation, the directors may retain some authority to make decisions.
Once a winding up petition has been made to the court, the company can’t dispose of any of its assets without court approval.
A compulsory liquidation is usually brought by a creditor who presents a winding-up petition to the court because the company is unable to settle its debts. As such, it is the only insolvency proceeding that a creditor can begin without the company’s participation.
To present a winding up petition, the creditor must be owed at least £750 that has not been repaid within three weeks of a statutory demand. Following the presentation of the winding up petition, the court will then decide whether to grant a winding-up order.
Read more about the compulsory liquidation process here.
A voluntary liquidation can be instigated either by the members or the creditors.
- Members – for a members’ voluntary liquidation, the directors must give a statutory declaration of solvency stating that the company can repay all of its debts within 12 months. As a result, this form of winding-up is also known as a solvent liquidation and may be used if the corporate group needs to be reorganised, the company is no longer needed, or the members want to be repaid their investment. Once the statutory declaration is given, the members have five weeks to pass a special resolution agreeing to the winding up. The members retain control of the liquidation and so can choose the liquidator and are not required to pass much information to the creditors.
- Creditors – if the directors cannot or do not wish to give a statutory declaration of solvency, the members can still pass a special resolution agreeing to the winding up of the company, but the creditors will have control over the process and can, for example, appoint the liquidator, who will act in their best interests.
How are creditors repaid?
When a company goes into administration or liquidation the creditors are repaid in a strict order as follows:
- Secured creditors with a fixed charge or mortgage over the company’s assets
- Expenses of the administration and liquidation
- Insolvency practitioner fees
- Preferential creditors, including employees
- Prescribed part – this is a sum capped at £800,000 where the first ranking floating charge was created after 6 April 2020, and £600,000 if created before then) that has to be set aside to pay unsecured creditors. It is worked out based on the value of assets covered by any floating charge
- Secured creditors with a floating charge
- Unsecured creditors
- Members (shareholders) – it is extremely unusual for the members to receive anything unless it is a solvent liquidation situation.
For more information on creditor priority, read Who gets paid first in insolvency?
Transactions that may be set aside
Where a company is facing insolvency, and during the period immediately before its insolvency, certain decisions made by the directors can be set aside by the court as they are deemed not to be in the best interests of the company or its creditors. These include:
A preference is a transaction in which the company, in effect, prefers one creditor over another, by intentionally putting them in a better position than they would have been if the company were insolvent. If the creditor happens to be connected with the company (such as a director, shadow director or an associate of a director), then the intention to prefer them is presumed.
To be classified as a preference, the transaction must have taken place no more than six months (or two years in the case of a connected person) before the insolvency proceedings began.
Transactions at an undervalue
Where a company is insolvent and it transfers an asset for nothing, or for considerably less than the amount it originally paid for it, or the company becomes insolvent as a result of the transaction and within two years enters into insolvency proceedings, the transaction is deemed to be at an undervalue.
A transaction won’t be deemed to be at an undervalue if there were reasonable grounds to believe that the company would benefit from the transaction, and it was entered into in good faith to carry on the business.
Extortionate credit transactions
Where a company enters into a transaction the terms or payment of which are particularly unfair or high, it may be considered an extortionate credit transaction if it was entered into three years or fewer before the insolvency proceedings began.
Avoiding floating charges
A floating charge won’t be valid if it is given 12 months or less (two years or less if in favour of a connected person), before the insolvency proceedings began, if the company was unable to pay its debts at the time of creation or as a result of the relevant transaction. This will not apply if the floating charge was created in respect of new financing.
Directors of an insolvent company
Being a director of an insolvent company isn’t necessarily a negative situation, particularly if the company was a start-up or there were valid reasons for its failure. Unless a director has been disqualified or is personally bankrupt, there is nothing to stop them from becoming a director of a new company. However, in certain situations, a director of an insolvent company can be held personally liable, convicted of an offence or disqualified from acting as a director.
- Personal liability – a director can be ordered to contribute to the insolvent company’s assets in some cases. This attempts to compensate creditors who have been adversely affected by the director’s action or inaction.
- Disqualification – a director can be disqualified from being a director of any company for between two and 15 years if the court thinks fit. Disobeying a disqualification order is a criminal offence.
Directors and anyone involved with the management of a company should be aware of the following and should seek legal advice as to their duties, responsibilities and potential liabilities, that are extensive:
If a company becomes insolvent under the balance sheet test, and a director knew or should have known that insolvency was likely but allowed the company to continue to trade, a liquidator may begin proceedings against that director for wrongful trading.
This could result in the director being held personally liable and having to contribute to the assets of the company as well as disqualification. A director who did everything possible to reduce the potential loss to creditors once they became aware of the impending insolvency may have a defence.
Note that under the Bill, and in respect to companies other than insurance companies, banks, PFI/PPP companies and foreign companies, directors’ personal liability for wrongful trading will be suspended from 1 March 2020 to 30 June 2020 (or one month after the Bill comes into force) as a result of COVID-19. These temporary provisions may be extended by the Secretary of State.
If a liquidator or administrator considers that the company has carried on business with fraudulent intent, those involved in the fraud may be required to contribute to the company’s assets out of their personal funds. In addition, they may be disqualified from acting as a director and could face criminal penalties.
Directors who have given personal guarantees may be held liable under them when a company is insolvent.
Breach of fiduciary duty/misfeasance
If the court considers that a director or anyone involved with the company has kept company property or money or acted in breach of their duty to act in the best interest of the company, they may be required to repay or account for that property or money or contribute to the company’s assets.
A director of an insolvent company cannot be involved with a company with a similar name to that of the insolvent company for five years following its liquidation. If they do, they can become personally liable for the new company’s debts, imprisonment or a fine.
Restrictions on suppliers
The Bill has introduced new clauses designed to stop suppliers terminating or threatening to terminate contracts for their arrears where a company is either in insolvency, or subsequently enters into an insolvency procedure. These clauses are designed to help companies that are facing financial difficulties stay in business. Suppliers will have to continue to honour their obligations under their contracts with insolvent businesses unless this causes them ‘hardship’. As a result of COVID-19, and for the period to 30 June 2020, ‘small’ suppliers are excluded.
- Insolvency law and procedure is complicated and is regularly amended. We advise you to get advice from a corporate solicitor who specialises in insolvency law or an insolvency practitioner as soon as possible if you are considering insolvency procedure, or if you’re a director of a company that you think may be in financial difficulty.
- If you are a director of a company that’s in financial difficulty, hold regular board meetings to discuss and keep track of the situation. Keep proper minutes setting out the basis for commercial decisions and transactions entered into by the company, and the reasons for the board acting as it did, together with the information supplied to the directors to help them make these decisions.
- If the company is part of a group structure and any director is on the board of two or more of the group companies, that director must bear in mind that each company is a separate legal entity. It may help to hold regular board meetings to discuss each company’s position. Again, you should take full minutes and keep all information used in making a decision.
- Directors need to know the company’s true financial position, and make sure that they put in place clear and accurate financial reporting. Look at any covenants given in financing documents and find out what constitutes an event of default under your major contracts, loans, and leases.
- As a director of a company in financial difficulty, don’t be tempted to resign. Walking away is unlikely to help your situation and certainly should not be undertaken without professional advice.