20 FAQs people ask about insolvency.
You are insolvent if you cannot pay debts when they become due (either now or, because of some contingent liability of the business, in the future) or if your assets are worth less than your total liabilities. The first is sometimes called ‘cashflow insolvency’ and the second ‘balance sheet insolvency’.
Having a profitable business is not, in itself, a guarantee that you will not be insolvent. Cashflow problems — for example, if customers fail to pay money they owe you, or if you over-invest in equipment — that mean you cannot pay your debts as they fall due could mean you are insolvent, even though the business is healthy otherwise.
The consequences of failing to take the proper steps once your business becomes insolvent can be dire and could affect you personally whether you are a sole trader or a director of a company. It is essential that proper advice is taken from a professional specialising in insolvency, at as early a stage as possible, to ensure that you minimise your personal exposure. Blindly trading on in the hope that you will be able to turn the business round may prove very costly to you personally if it does not work and you actually make the position worse.
You can reduce the risk of becoming insolvent by ensuring that your business is soundly financed and keeping good control of your cashflow. These are issues you should discuss with your advisors and your bank.
Building a good relationship with creditors — for example, your bank — can help to reduce the risk that they will instigate proceedings against you if your business does run into financial difficulties. The bank (and other creditors) can be more supportive if you keep them informed and have a good previous record of prompt payment.
You must also make sure you know what is happening in your marketplace. You can soon find your business in trouble if:
Choosing an appropriate business structure will help to reduce the potential consequences should you become insolvent in the future.
A limited company offers the most protection against personal bankruptcy should the business run into difficulty: as a director and/or shareholder you will not usually be personally liable for the company’s debts unless you have given a personal guarantee or you have acted improperly. This offers you much greater protection than operating as a partnership, as partners are personally liable for the debts of their partnership if things go wrong. Taking out Directors and Officers Liability insurance can provide a further degree of protection for directors of a limited company - although the limitations on the cover provided, and the cost of premiums, often make this unattractive for smaller companies.
Alternatively, if you wish to operate as you would in a partnership, but want the benefit of limited liability for the partners, trading as a limited liability partnership (‘LLP’) can help to reduce the degree of personal risk. An LLP is a corporate entity whose members only have to contribute a pre-determined, limited amount if the LLP is wound up, but the management of which can be organised so it ‘feels’ like a partnership – for example, so that all the owners have an equal right to participate in day-to-day management. It is a particularly appropriate trading vehicle for professional practices that are unable, or do not wish, to incorporate as a limited company.
If your business structure offers some degree of protection, for example, you operate through a limited company or an LLP, you should also try to avoid giving personal guarantees to lenders such as banks. These are contracts under which you promise, personally, to make up any shortfall if your company or LLP cannot itself repay the money it owes its bank. If you must give a personal guarantee, negotiate to limit the amount it covers and how long it will last. Where several people are giving guarantees, try to avoid ‘joint and several’ liability which could make guarantors liable for all of a debt rather than just their share. In practice, however, it may not be possible to raise bank finance without giving a personal guarantee, and banks may not be willing to vary their standard guarantee terms.
Finally, as a director it is essential to keep a close eye on the company's financial position. As well as improving your chances of avoiding insolvency in the first place, this will reduce the likelihood that you will be held personally liable for wrongful trading (see 15), or be disqualified as a director, if the company does become insolvent.
A simple practical step is to limit investments to amounts people can afford to lose. If you are trading as a sole trader (or in a partnership), you should also ensure that your spouse has a separate bank account, and that you do not give a charge over your home to secure a loan.
More broadly, it may be possible to provide some protection to investors by ensuring that their investments to the business take the form of secured loans, so that they rank higher in the list of creditors should the business fail (see 12). By contrast, investments in the form of shares will be most at risk if a company fails. However, taking investments in the form of loans may adversely affect the company's solvency position: loans will be treated as liabilities whereas share capital will be treated as an asset. This is clearly an area in which specialist advice should be sought.
Be aware that for these steps to be effective, you should put them in place when the investment is made. Trying to protect favoured investors when the business is already in difficulties could be construed as creating preferences (see 7).
The worst thing you can do is to bury your head in the sand. If you are a company director, you should certainly not just resign – you have a duty to take every step you can to minimise the loss to creditors of your company, and resigning could put you in breach of that duty.
You stand a better chance of reaching a successful resolution if you take action as soon as you identify a potential problem, instead of letting things drift until the business is in crisis. A licensed insolvency practitioner can advise on the best course of action and may offer a free initial consultation.
If long-term prospects are good, you may be able to arrange additional financing: for example, by taking out a new loan, factoring your debts, chasing customers who owe you for prompt payment, or selling non-essential assets. You may also be able to negotiate a compromise agreement with your creditors - for example, by offering revised payment terms - particularly if you make your creditors aware that the alternative may be the delay and cost of insolvency proceedings with the risk that the creditors will receive less or nothing at all. Investigate the alternatives which may be available to you (see 9 and 10), and if appropriate take steps to negotiate a voluntary arrangement (or apply for an administration order) before creditors instigate legal action against you.
If your prospects are poor, you may have little option but to cease trading. Beware of creating 'preferences' when paying creditors (see 7).
If you allow your limited company (or a limited liability partnership) to continue trading with no reasonable prospect of avoiding insolvency, you may be held liable for 'wrongful trading' if it does, in fact, become insolvent. This means you could become personally liable for the company's debts (as well as being disqualified from being a director). This personal liability can apply even if you did not know there was no reasonable prospect of avoiding insolvency - it is sufficient if you ought to have known. This makes it vital to keep close tabs on the financial state of your company's business at all times, so you spot any potential financial problems as early as possible. If you do, it is essential to seek specialist advice as soon as possible.
Paying your professional advisors will not usually constitute a preference (see 7) provided the payments are justifiable. Obviously, funds will be tight but that makes it all the more important that proper advice is obtained.
Actions such as taking money out of the business, or transferring assets at less than their value, may constitute fraud. You could face criminal charges.
In addition, transfers of the company's assets shortly before the onset of insolvency may constitute a preference or undervalue transaction and be overturned by the court (see 7).
(An undervalue transaction is either a gift or a transaction by which the value received by the company is worth less than the value it gives — in other words, it sells its assets cheaply. Undervalue transactions can be overturned in the same way as preferences.)
Even legitimate transactions which you would have carried out in the normal course of business may seem questionable if you subsequently become insolvent. Take advice from a specialist insolvency practitioner, and if appropriate discuss what you are doing with your creditors.
A preference is anything which puts one of the insolvent company’s creditors (or someone who has guaranteed your debts) in a better position than they would otherwise have been had that thing not been done. For example, repaying one creditor ahead of others, or granting new security for a debt.
Preferences can be ‘set aside’ if your company is liquidated (or you become personally bankrupt) within set time limits. The court can require a creditor who has been repaid in preference to others to return the money.
In practice, attempting to create preferences can also encourage other creditors to press for liquidation or bankruptcy to protect their interests.
Causing a company to prefer one creditor over another would also be a breach of the directors’ duties and they could, in an extreme situation, be made personally liable to repay the monies to the company in liquidation.
Any creditor or group of creditors owed more than £750 by your company can ask the court to wind up your company (or to make you bankrupt if you are personally liable for the debt). If this happens it is called a ‘compulsory winding up’. Usually, the creditor(s) send the company a ‘statutory demand’ first. If the company does not pay the sum due within 21 days, they can then apply to wind it up. It is therefore essential that you and your staff recognise a statutory demand if one arrives, so you can take prompt action.
Alternatively, you may decide to start insolvency proceedings yourself - shareholders in a company can decide to wind it up without involving the court (this is called ‘voluntary liquidation’ or ‘voluntary winding up’). This can be a good solution if you feel your company has no reasonable chance of avoiding insolvency and you want to resolve matters (as well as minimising the risk of accusations of, for example, wrongful trading – see 4). As with a compulsory winding up, a liquidator must be appointed to wind the company up, and the directors’ powers cease (see 9).
An individual may only be declared bankrupt by the court. An application may be made either by the individual himself or by one of his creditors.
If the business has no chance of surviving, it will be best for its operations to be wound up. By this process the company ceases trading, its assets are sold and the proceeds are distributed amongst its creditors (this is known as ‘liquidation’ or ‘winding up’). At the end of the liquidation, the company ceases to exist. A licensed insolvency practitioner will be appointed as the company’s liquidator, to carry out and oversee this process. Once a liquidator is appointed, the directors’ control over the company ceases and all powers vest in the liquidator instead.
If the underlying business of the company is sound but it is technically insolvent (either on a cash flow basis or a balance sheet basis), it may be possible to restructure the company in such a way as to protect the underlying business instead. The main vehicle for achieving this will be through an administration order or company voluntary arrangement, instead of a liquidation. You must take professional advice on the best option in your circumstances.
Administration is, essentially, a process whereby the company is given a breathing space within which to reorganise its affairs. An administrator is appointed (by the company or by a lender such as a bank), and takes control of the company’s assets and its business. The administrator will continue trading, and tries to put the company back on a sound footing. If they succeed, they hand it back to the directors to continue as before. If the administrator cannot save the business as a going concern, they at least try to get a better return for creditors, or sell the company’s property so that as many creditors as possible receive something. While the company is in administration, no-one (including lenders or landlords) can wind it up or repossess plant and machinery, cars, stock, etc.
Since the implementation of the Enterprise Act 2002 the administration process has been greatly simplified and it will often be possible for the directors to put the company into administration without even making an application to the court. An administrator must be a licensed insolvency practitioner.
A company voluntary arrangement (‘CVA’) is essentially a contract between a company and all of its creditors whereby they reach a compromise settlement. Typically, the creditors will accept a reduced payment over a period of time in return for which the company is able to continue trading – and thereby provide the creditor with ongoing business. Often, the alternative for the creditors will be a nil return on the liquidation, so the CVA is a better option. The process is supervised (but not controlled) by a licensed insolvency practitioner.
To achieve a CVA it is therefore necessary to appoint a licensed insolvency practitioner to be Supervisor and also to obtain the agreement of 75% by value of the creditors. For the majority of companies it will be possible to obtain a moratorium against all creditor enforcement action and all litigation whilst the CVA process is being put in train. However, CVAs are not common – although they most frequently occur immediately after an administration.
Finally, there is administrative receivership but this is not something over which the directors of the company will have control. A receivership is, essentially, a debt recovery tool available to holders of floating charges — that will, in most cases, mean your bank (see 12) – that were entered into before 15th September 2003. For charges entered into after that date, the procedure is not available – the government’s aim is to push banks and others towards an administration instead.
If the situation is hopeless, the obvious option is bankruptcy.
An alternative is an individual voluntary agreement (‘IVA’) with your creditors — similar to a CVA (see 9), except that the contract is between the individual who owns the business, and all of their creditors. At least 75% by value of the creditors who vote at a meeting must agree to it. Secured creditors will still be able to enforce their security. As with a CVA, a licensed insolvency practitioner must be appointed to supervise the process.
You will have a better chance of avoiding bankruptcy if you take action before a creditor tries to force you into bankruptcy. It can sometimes be possible, however, to reach a voluntary arrangement even after a bankruptcy order has been made and to have the order cancelled.
If you owe less than £15,000, the total value of your assets (excluding any car worth less than £1,000) is no more than £300, and your disposable income (after tax, national insurance contributions and normal household expenses) is no more than £50 per month, you may be able to apply to the court (online) for a debt relief order - although there are other conditions too. This stops creditors from enforcing their rights against you for (usually) a year, while you try to sort your affairs out.
The methods of dealing with an insolvent partnership are similar to those for a company: winding up, partnership voluntary arrangements and administration orders. (An administrative receiver can only be appointed to a limited liability partnership under a debenture created before 15th September 2003.) If you are a partner, you can be made personally bankrupt, with the debts of the partnership ranking as a claim in your bankruptcy alongside the claims of your personal creditors.
Once a company goes into liquidation or an individual is made bankrupt, it will be the responsibility of the insolvency practitioner to collect in all the assets and to distribute them amongst the creditors according to a statutory pecking order. The first payment out of those assets will be the insolvency practitioner's own costs and the costs of the insolvency process including legal costs.
After that, different creditors have different rights. Secured creditors with a 'fixed charge' over assets - for example, a mortgage secured on a property - will be paid first. Technically, assets covered by a secured charge do not form part of the estate of the bankrupt or the company in liquidation. Once those assets are given as security they, in effect, belong to the secured creditor who would be entitled to sell them if you failed to maintain your loan payments.
Then come preferential creditors who are the employees (for holiday pay and up to four months' arrears of wages to a set maximum).
Then come secured creditors with a 'floating charge', which normally covers assets such as stock and work in progress. This will usually be the company's bank (an individual cannot grant a floating charge). The floating charge holder's interest will be subject to a 'pool' that must be set aside for the benefit of the unsecured creditors.
Last to be paid are the unsecured creditors. Trade creditors are usually unsecured. In only the very smallest liquidations (where floating charge assets are less than £10,000), will there be a nil return to unsecured creditors.
It is highly exceptional that there will ever be anything left to pay to the shareholders - after all, if there were, the company would not usually have been insolvent in the first place.
It is only unsecured creditors who take part in voting in relation to the establishment of a voluntary arrangement. Any creditor with security (usually your bank) will not be entitled to vote for its debt to the extent that the debt is secured. By and large, creditors will regard the situation entirely pragmatically. If they feel that the debtor (be it an individual or a company) is making an honest attempt to achieve the best for his creditors then, provided the creditor would not be better off in bankruptcy or liquidation proceedings, they are likely to vote in favour. However, a full and frank disclosure of the debtor's assets must be made (indeed, it is a criminal offence not to) and the debtor must make a genuine attempt to make a decent offer to the creditors. As well as this, however, the attitude of creditors will be affected by their relationship with you and whether they see the voluntary arrangement as reasonable and credible. Your licensed insolvency practitioner can help in what are often complex and difficult negotiations.
If your business fails, you (and your family) are treated in much the same way as other creditors (see 12) in respect of monies that they have lent to the business.
Of course, if you are trading as a sole trader, or in partnership, or have personally guaranteed your company's debts, these claims may have to be met from your own assets.
Your first responsibility is to promote the success of the company, including the obligation to foster relations with customers and suppliers. If the company gets into financial difficulty, you should also ensure that the company does not continue incurring additional liabilities when there is no reasonable prospect of avoiding insolvency - you should not try to 'trade out of difficulty'. Doing this could constitute wrongful trading if you fail, and this could make you personally liable for the company's debts (see 4). You must obtain specialist insolvency advice as soon as possible.
If there is a reasonable chance of saving the business, you will need to take the appropriate action - for example, negotiating new financing and working with your creditors to reach an amicable solution. And if there is not, you should instigate the appropriate insolvency proceedings.
Be aware that these liabilities apply even if you are only a part-time or non-executive director.
Your main responsibility will be to supply information about the company's affairs to the insolvency practitioner or official receiver. Most of your responsibilities for managing the company will cease. You may, however, be asked to help, for example, with the sale of assets. You are under an obligation to provide all assistance reasonably requested. If you are an employee of the company, the administrator will also advise you when your employment is terminated.
If you are suspected of fraudulent or wrongful trading, action may be taken against you which could lead to personal liability for your company's debts (see 4), criminal prosecution, a fine, and/or disqualification as a director. If you have personally guaranteed the company's debts, you will be required to honour those guarantees. You could also face personal insolvency and possibly bankruptcy proceedings, if you are unable to pay.
Otherwise, however, there should be no significant consequences. You can continue to act as a director of other companies (though your credibility may suffer). For the next five years, however, you are not allowed to be a director of another company with a similar name without the court’s permission. (This helps to prevent unscrupulous directors of failed companies from setting up a so-called ‘Phoenix’ company which then carries on the same line of business, with a similar name to the failed company, without being obliged to pay back the original company’s creditors.) If you wish to trade under the same name in a new company, there is a procedure to be followed, which requires you to get court permission before you can do so. You should seek specialist legal advice.
When you are declared bankrupt, the Official Receiver takes ownership of all your assets apart from any that are necessary for your business or basic domestic needs. The Official Receiver will investigate your finances and will interview you to establish the circumstances leading to your bankruptcy, and to ensure that there is nothing suspicious in these.
After the initial period, either the Official Receiver or an insolvency practitioner will act as your 'trustee in bankruptcy', taking care of selling the assets and making payments to creditors. You will only be allowed to keep enough income to fund a modest lifestyle, with any extra going towards your debts. Additionally, you are not allowed to borrow more than £500 without disclosing that you are bankrupt. In most cases, you will remain bankrupt for a maximum of twelve months (although this may be less in some cases).
You will then receive an automatic discharge and will no longer be bound by the constraints of bankruptcy. Two aspects may however continue to affect you after this time. First, your assets will not be returned to you but will remain the property of your trustee in bankruptcy (including your house) if the trustee has not already sold it. The trustee in bankruptcy will have to realise his interest in your house within three years or lose his interest in it. Secondly, if your trustee has sought regular monthly contributions from your income, these will continue for a further 2 years.
If you have behaved culpably, recklessly or fraudulently, the court may impose a bankruptcy restriction order (BRO) on you for between two and fifteen years after you are discharged from bankruptcy. For example, this might happen if you continued borrowing at a significant level with little prospect of repaying the debt, spent recklessly, gambled heavily or tried to conceal assets. A BRO prevents you from being a company director, borrowing over £500 or trading under a different name from the one you were using when you were made bankrupt.
It’s common for former shareholders and directors of an insolvent company to form a new company to buy the business from the administrator. However, the administrator has a duty to get the best price they can, so the new company cannot buy the business at an undervalue – although a new company owned and run by the former management is often the best buyer for the business, especially if their knowledge of the business and its market, their personal contacts and their ability to act quickly will help keep key employees, customers and/or suppliers on board, so that creditors will benefit.
This will not, of course, be possible if any of the directors are liable to be disqualified from being directors because they acted improperly while directors of the old company. Also, there are restrictions on directors of an insolvent company being involved in a new company whose name is similar to the old company name (see 17).
Generally, yes, although there can sometimes be problems. Lawyers call the process a ‘pre-pack administration’, and the number of pre-pack administrations has risen sharply in recent years.
First, your company negotiates the sale of its business (or the saleable parts of it), with a possible buyer (which could be a third party, or a new company set up by you and/or your management team) and the proposed administrator of the company. The sale has to be at the best price obtainable. Once the sale agreement and other documents have been agreed, the administrator is appointed, and they sign the agreement.
Benefits are that the business is sold immediately, at a proper price, after an extremely short administration. This can reduce the potential damage to relationships with customers and suppliers that can occur while a company is trading in administration and, therefore, the potential losses to creditors. If the buyer is a company set up by the existing management (see 19), their personal contacts may make a pre-pack deal even more attractive.
The speed of the process can also mean jobs are saved, with employees having the right to continue their employment with the buyer company under the TUPE regulations – special rules that protect employees on a transfer of a business from one owner to another.
However, a pre-pack administration can be unattractive to the old company’s creditors, and they may try to stop it. They may feel that the business has not been properly marketed, so that the administrator is not getting the best price obtainable. They may be unhappy because it feels as if the deal has been done behind closed doors and then presented to them as a fait accompli.
The old company’s bankers may also be unhappy. Their concerns can be particularly acute if the buyers are the management of the old company, and many clearing banks will refuse to support a pre-pack administration in those circumstances.
The old company’s landlords may be unhappy with the new company becoming a tenant in its place (whether the new company belongs to the previous management or not), as it has no track record. They may try to withhold consent to the assignment of the lease from the old company to the new company.
Practically, the recession means it is currently difficult to find funding for the acquisition of businesses in any event. A buyer will often need to find specialist lenders or venture capitalists prepared to fund a pre-pack deal – and even then, many funders will require personal guarantees from the directors of small company buyers.
Clearly, a pre-pack administration should only be launched after taking specialist professional advice on whether a pre-pack administration is the best option, what the potential problems and issues are in the particular case, and how they can be addressed.