If your business is struggling financially, the temptation is to go on trading and creating new debts in the hope that you’ll be able to dig yourself out of a hole.
But your company could be insolvent, in which case, the Insolvency Act 1986 will apply. Your duties shift too. Once the company is insolvent or close to it, or an insolvent liquidation or administration is probable, you must give weight to the interests of creditors as a whole, and more weight the worse things get. That duty is not the same thing as wrongful trading, and the two are routinely confused.
Wrongful trading is a narrower and later test than the duty to consider creditors. Under sections 214 and 246ZB of the Insolvency Act 1986, a director can be ordered to contribute to the company’s assets where they knew, or ought to have concluded, that there was no reasonable prospect of the company avoiding insolvent liquidation or insolvent administration, and carried on regardless. It is a civil claim, not a criminal offence: there is no finding of guilt and no fine. Separately, conduct in the run-up to an insolvency can lead to disqualification for up to 15 years, and to other claims such as preference or misfeasance. That’s why it’s so important to check if your struggling company is insolvent and take immediate action if it is.
How Do you know if a Company is Insolvent?
A company is insolvent when:
- It cannot afford to pay its debts when they become due; and/or
- Its total liabilities outweigh the value of its assets.
It’s usually the case that a business slips into insolvency gradually, rather than it being the result of a single event such as the loss of a key customer. That’s why the severity of the situation can go unnoticed and the warning signs can be missed.
The typical warning signs of insolvency include:
- Recurring problems with cash-flow
- Accrued debts with HMRC
- Constant pressure from creditors
- Creditors threatening or taking legal action
- A high turnover of staff
- Difficulties paying staff wages
- Being refused credit by suppliers and finance providers
- Delays in the delivery of stock and production or sales falling behind
- The loss of major contracts
- Delays in producing and providing financial information when it’s required
In many cases, directors who see these warning signs are overly-optimistic about their company’s future. They tell themselves that it’s just a temporary bump in the road and that a new customer or a big sale will come along and solve all of their problems. However, by burying their heads in the sand and failing to take action immediately, they reduce their business’s chances of making a recovery and increase the risks for themselves.
How Do I Know If My Company Is Insolvent?
Section 123 of the Insolvency Act 1986 sets out when a company is deemed unable to pay its debts. Two core tests come from it: cash flow and balance sheet. A third heading below covers the legal steps that often signal, or help a creditor prove, that a company cannot pay:
- The cash-flow test
Poor cash-flow is usually one of the first signs of an insolvent business. It can be the result of a market downturn, poor credit control procedures or the loss of one or more customers. Poor cash-flow will affect the day-to-day running of your business and make it difficult to grow.
The test:
- Can you afford to pay debts that are due for payment now or that will become due in the reasonably near future?
If you are consistently making payments long after they’re due and there’s no sign of things changing anytime soon, your company is likely to be insolvent.
- The balance sheet test
A balance sheet provides a snapshot of the business’s assets, liabilities and capital at a point in time. It’s important your assets are valued correctly and all of your contingent liabilities (a potential loss that may occur in the future) are taken into account.
The test:
- Do your company’s liabilities exceed its assets i.e. does it owe more than it owns?
If your company’s liabilities exceed its assets, you would not have sufficient funds to repay all of your creditors even if you sold all of the company’s assets. That means the company is insolvent. If the value of the company’s assets and liabilities are comparable then the business is on the verge of insolvency.
- Legal action: evidence, not a separate test
If a company owes a creditor more than £750 that is already due, the creditor can serve a statutory demand at the company’s registered office. If the company does not pay, secure or settle the debt to the creditor’s reasonable satisfaction within 3 weeks, it is deemed unable to pay its debts under section 123. In England and Wales, a creditor may also obtain a county court judgment and attempt execution. If execution is returned unsatisfied, that is another of the statutory routes. Scotland and Northern Ireland have their own rules. These are ways of proving inability to pay. They are not a separate definition of insolvency.
The test:
- Has any legal action been taken against the company that is still outstanding?
The question to ask: has any legal action been taken against the company that is still outstanding? An unpaid statutory demand or an unsatisfied judgment is a serious warning sign, and it gives a creditor a route to a winding-up petition. It does not automatically prove the company is insolvent, and it does not settle the position where the debt is genuinely disputed. A winding-up petition is not the right way to resolve a real dispute about whether money is owed, and the court can restrain or dismiss a petition founded on a substantially disputed debt, often with costs against the creditor. If you dispute the debt, say so in writing straight away and take advice immediately, because the deadlines are short.
What Can I Do If My Company Is Insolvent?
If one or more of the insolvency tests indicate that your company is insolvent, it does not necessarily mean it’s the end. There are several informal and formal procedures that could help to turn the business around.
The first step is to contact an insolvency practitioner. Taking advice early, and acting on it, is good evidence that you took the position seriously. It does not by itself make out the statutory defence to a wrongful trading claim. That defence requires you to show that, from the point you knew or ought to have concluded that insolvent liquidation or insolvent administration could not be avoided, you took every step to minimise the potential loss to creditors that a reasonably diligent director would have taken. Advice you do not follow will not help you. The practitioner will work to minimise the losses for creditors and explore the various options and procedures available to you. If the underlying business is sound, they will explore ways to turn the company around. If the company is no longer viable then it’s in everyone’s best interests to close it down. They will help you do so in the most efficient manner.
The options available to the directors of insolvent companies include:
- Seeking alternative finance – If you act quickly enough, it may be possible to save the company by securing alternative finance. Options include securing finance against the value of your debtors book via invoice finance or borrowing against the business’s assets.
- Negotiating with your creditors – If relationships between you and your creditors are still reasonably good, it may be possible to contact your creditors to reach an informal repayment agreement. That will allow you to repay your debts while continuing to trade.
- Entering into a CVA – If your creditors are threatening legal action against your business, then entering into an official insolvency procedure known as a company voluntary arrangement (CVA) could be your best course of action. Once creditors approve it, a CVA binds every unsecured creditor who was entitled to vote on it, or would have been if they had been given notice. Those creditors cannot then pursue the debts it covers outside the arrangement, and the company repays them over time. It does not stop secured creditors enforcing their security without their consent, gives no automatic protection while it is being proposed (a separate moratorium may be available), and does not release directors’ personal guarantees.
- Going into administration – Putting the company into administration will provide respite from creditor action and allow the company to be restructured to return it to profitability or for company assets to be sold.
- Closing the business – If the business has no chance of survival, it’s in everyone’s best interests to close it down. A creditors’ voluntary liquidation (CVL) is usually the most effective way to close a company with debts. Its assets will be sold for the benefit of its creditors and the company is normally dissolved three months after Companies House registers the liquidator’s final account.
Is Your Company Insolvent?
For more information on company insolvency or to discuss the best course of action for you, please get in touch with the insolvency practitioners at AABRS® . We’ll provide a free, no-obligation initial consultation to help you take back control.