What to Do if Your Business is at Risk of Insolvency
A business becomes insolvent when it cannot pay its debts or employees in full.
If a company is a limited liability partnership, company insolvency would mean one of the following:
- voluntary arrangement with creditors
If the company is an individual, insolvency would mean bankruptcy (sequestration in Scotland) or a voluntary arrangement with creditors.
Types of insolvency
Cash flow insolvency
This is defined in two ways; known formally as cash-flow insolvency and alternatively as business insolvency, in the instance where a debtor may be cash-flow insolvent, they will consequentially be unable to balance due payments.
Balance sheet insolvency
To be balance sheet insolvent is to have negative net assets, where payments due outweigh assets.
It is not uncommon for a company to be balance sheet solvent as well as being cash flow insolvent in holding liquid assets, specifically within short term debts, facing the inability to realise if immediately required.
Equally, a company may display negative net assets on a balance sheet but can still be cash flow solvent in the event that ongoing revenue is forthcoming in meeting debt obligations. Frequently businesses function indefinitely in this position.
If your business becomes insolvent it may be put into liquidation. This is where the assets and property of the business are redistributed to satisfy all claims of your creditors.
The liquidation process can be instigated by the directors and shareholders of the insolvent business, but the process will only be legally effective if there is a convening of a meeting of creditors where they can appoint a liquidator of their choice – known as creditors voluntary liquidation (CVL).
Alternatively, a creditor can petition the court for a winding-up order which can place the insolvent business into a compulsory liquidation, also known as compulsory winding-up.
Compulsory liquidation occurs when a company sells all of their assets with orders from the court, and can be requested by the firm’s creditors when they are owed at least £750.
The creditors also usually have the right to appoint the liquidator. A winding-up process can be a rather expensive process, typically costing around £1,000 – if a legal advisor is needed, the cost can rise to £2,500. These fees are made up of company search, swearing and petition costs, which are compulsory.
A compulsory liquidation only occurs when a company can no longer pay off their debts. This is proven in a number of ways. The first of these is if they have received a statutory demand, which gives the company 21 days to pay off their debt. This only occurs when the debt is more than £750.
It is also important to know that the creditors are not permitted to combine their debts to reach the statutory limit. If the company is able to pay the debt in the future they will not qualify for compulsory liquidation as the debt must be a payable liquidated amount.
The debt also cannot be reduced below £750 by a genuine cross claim and it must not be on disputed grounds. The debt can also be proved if the court is satisfied the company is unable to pay off their debts or if it is proven to the court that the value of the company’s assets is less than the amount of their liabilities, keeping contingent and prospective liabilities in mind.
If this is the chosen method of proving the company’s debt it is important to know the creditor is not required to wait 21 days using the statutory demand process. The other ways the debt can be proven is if the court is satisfied to the extent that the company cannot carry out its main objective or if the company has deadlock in its management.
Priority of paying back creditors
Generally, the priority of claims on the insolvent company’s assets will be determined in the following order:
- Firstly, the costs of the liquidation are met out of the company’s remaining assets;
- Secondly, the preferential creditors under applicable law are paid;
- Thirdly, in many legal systems, the claims of the holders of a floating charge will be paid – other claims may also fit into this layer;
- Fourthly, if there is anything left, the unsecured creditors are paid out proportionally in accordance with their claims. In many jurisdictions, a portion of the assets which would otherwise be caught by a floating charge are reserved for the unsecured creditors;
- In the very rare instances where the unsecured creditors are repaid in full, any surplus assets are distributed between the members in accordance with their entitlements.
Administration is a process in which every part of the business is managed carefully to maintain its growth or stability. The majority of companies have a team of administrators to carry out this role. Until a restructuring plan is completed the by the process of administration the company is protected from its creditors. However, a company needs a licensed insolvency practitioner to act as the administrator. This individual is appointed by the court.
When a company goes into administration there are three main outcomes they hope to accomplish, the main outcome being that the company is rescued. They will also want the administrator to get a better result for the creditors than a winding-up of the company. They also hope the administrator can realise property to make a distribution to secured and preferential creditors.
The desired outcomes for administration depend on the administration proposal. This proposal will begin with details explaining the administrator’s appointment. It will then describe all of the circumstances as to how and why the company is going into administration. Details then follow as to how the administrator proposes to achieve the goals of the administration and how it will end. The proposal will generally finish with a statement of the company’s general affairs.
A creditors meeting will then follow from an invitation in the proposal. It is essential that the meeting is held within 10 weeks from the date the business entered administration. At the meeting the proposals outcome is decided – whether it is rejected, accepted or modified and then accepted. In the case of a rejection the administrator is required to report to the court to receive further directions. Once these procedures have been finalised the administrator will send a report of the final outcome of the meeting of the court. The administrator will then manage the company’s affairs based on the outcomes of the meeting.
Advantages of administration
Administration is one of the most useful tools to ensure the safety of the business and is a means of protection from the company’s creditors. It also flexible as it allows the administrator to appoint managers to run the company. It also prevents director’s form being accused of wrongful trading as no action is being taken.
Disadvantages of administration
Administration does have its downsides for example; directors may be removed from the business as they are not in control of the business. Also the majority of customers and suppliers usually become aware that the company has become insolvent. Costs are also high for this procedure and it is difficult to finance trade and other supplies.
Receivership is the act of securing the assets of a company when it is done by an external professional manager. The receiver is appointed by the courts of law after the creditors petition the court for receivership. The general process of receivership is started by the banks or creditors if they feel the company no longer has the ability to repay their debts. These are the debts that are registered at the house of the company in receivership in the form of a ‘charge loan’. The receiver is appointed with a view to selling the company’s assets, so in the long run the creditors can claim back the money they are owed.
Types of receiver
There are two main types of receiver; the administrative receiver and the receiver appointed by a secured creditor holding a fixed charge (fixed charged receiver). Administrative receivers have a wide range of statutory powers and also have control over the assets of the company in receivership, which means that they may be able to continue to trade the business and sell it on, maximising the return to the bank. A downside to this type of receiver is that they have to be licensed insolvency practitioners.
The fixed charged receiver has the power to take possession and sell the charged assets. These receivers can be appointed if there has been a default in the lending terms on a property which means that two months of interest have been unpaid, three months of the principle amount has been unpaid or if there has been a substantial breach of contract.
Company Voluntary Arrangements (CVAs)
A company voluntary arrangement is a deal between a business and its creditors. This can include the negotiation of unsecured debts and assets, trade and tax. Initiating repayment plans from future profits, or through the sale of assets for immediate balance settlements.
A typical CVA agreement is based on preserving a business whilst protecting or instigating effective cash flow. Unlike administration, a company voluntary arrangement is facilitated through a profit making company requiring gradual service fee payments, promised through future profits over a period of time to be agreed.
In many cases the directors are able to remain in control of the company or business, with other negotiable factors depending on the CVA supplier and business circumstance, including the absence of guarantees and flexible costs.
When a proposal has been made the insolvency practitioner will report to the court to reach an agreement on whether they are permitted to meet with their creditors or shareholders. This meeting will decide whether the proposal is approved and if 75% of the creditors do approve, it is then binding and the insolvency practitioner becomes the supervisor of the CVA. After a successful CVA the company’s liability to its creditors is then cleared and they can continue to trade during and after the arrangement.
Advantages of CVAs
A CVA is a popular approach when faced with the prospect of liquidation. It can be very advantageous to a company if they have experienced trading difficulties and need time to prove their business model and that they can be successful.
A CVA is also a popular option for companies that may need time to come up with a new business plan, if they will be profitable in the long term but are suffering from debts in the short term, if they want to avoid the stigma of liquidation or if companies simply wind down their trading and close down over a certain period of time.
There are numerous advantages to a CVA, providing it is successful. For example, if the company’s directors are honest about the company’s affairs and they work hard, it is more likely to be successful.
The CVA must also offer the creditors more money than what would have been received if they went into liquidation. They must also have sufficient working capital so they can pay the day to day expenses of the company and it also helps if they have business, such as a full order book, for example.
If the company and their creditors work in unison and are determined enough they will both experience the advantages of the CVA.
Fresh Start programmes for limited companies
When faced with serious financial difficulties a company may decide that the best option is to start again. When a company goes through with this it is called a ‘Phoenix’. Starting from fresh may be the only option a company has after insolvency.
The process of starting up again is a meticulous process in which you have to consider many aspects to start up smoothly.
When forming a limited company you will have to make negotiations with the bank as well as the HM Customs and Exercise and Inland Revenue.
They will also have to protect their assets and ensure their personal guarantees are safeguarded. It is also recommended to obtain as much legal protection as you can as the past and present companies may create confusion.
Getting business legal advice when using the Fresh Start programme is advised, as there are extra restrictions for Phoenix companies. For example, the Insolvency Act 1986 restricts the use of re-using company names.
Insolvency Act 1986
The Insolvency Act was brought in to prevent abuse of the Phoenix method. The act prohibits a company from using the same name or similar name (which may lead people to believe that they are associated) until 5 years after liquidation.
Disobeying this regulation will result in imprisonment or a fine, or even both. This regulation also involves any director involved in the management of the company, who cannot be involved in management of the new company for 5 years.
Another section of the act states that a person who is involved in the management of a company is also personally liable for the debts of the company incurred. It is important to know that there are exceptions to these sections of the act.
So starting from fresh may be the best option for a business and if this is the chosen method it is vital that people involved are aware of the laws and regulations associated with fresh start programmes for limited companies.
Get legal advice for your business
Getting legal advice for your business can be tricky, as you often need specialised advice that you can’t get from a consumer legal advice service.
However, if you do need business legal advice, our Instant Law Line service could be of great help to you. We can give you telephone legal advice on all aspects of business law in the UK, all for a low monthly or one-off fee.
Visit our Instant Law Line for Business section to learn more about how to take advantage of this.