Sometimes they fail – Gemini Print in Shoreham-by-Sea being an example – and cannot be resurrected, with their assets sold off to repay creditors. Others, such as Folio, fail but re-emerge, almost immediately, in another guise, preserving the jobs of employees. Pre-packs are, however, often controversial.

In such sad situations there are always losers and a bitter taste left in the mouth. For directors, such situations mean particularly choppy waters to navigate.

Definition of insolvency

Jamie Leader, a partner and head of Insolvency and Restructuring Disputes at Enyo Law, thinks that it’s important to understand what insolvency really means.

He explains that there are two forms of insolvency recognised by English law: an inability to pay debts when they fall due, often referred to as cashflow insolvency, and an excess of total liabilities over total assets, referred to as balance sheet insolvency. 

As he points out: “A company is technically insolvent if it meets either test. So, a company which has a balance sheet surplus may nonetheless be cashflow insolvent if its assets are illiquid, and a company that currently has sufficient cash to pay its debts when due may be balance sheet insolvent on a longer term view.”

Paul Taylor, a partner in the corporate department of Fox Williams, adds more flesh to the bone. He explains that while the technical wording of insolvency is set out in the Insolvency Act 1985, a company will also “be deemed to be unable to pay its debts by a court if it fails to comply with a statutory demand, or satisfy enforcement of a court judgement debt awarded against it”.

And Adrian Furniss, senior insolvency administrator at BRI, echoes the same, referring specifically to Section 123 of The Insolvency Act. He says that the act makes no distinction between ‘inadvertent’, ‘technical’ or ‘actual’ insolvency. Those terms “do not form part of the criteria used by an insolvency practitioner when assessing a company’s predicament.” As a result, it doesn’t matter what the reason, a company either is or is not solvent.

Interestingly, Taylor adds that the definition of insolvency is also relevant to certain company procedures, such as reductions of capital, which require directors to make statements of solvency.

Occasionally firms seek to enter into a time to pay (TTP) arrangement, suggesting that the debtor is cashflow insolvent. However, Leader sees TTP as “a crucial tool in overcoming short term cashflow difficulties without the need for formal insolvency proceedings.”

Taylor is of the same opinion. He holds TTP as a simple reconfiguring of payment deadlines, “meaning that the company will have more time to repay the debt, allowing it an opportunity to ensure it has sufficient assets to repay the debt when it eventually becomes due”. His point is that TTP is not necessarily a bad thing.

Regardless, though, he notes that “there is no inflexible rule that a company should go into liquidation immediately upon the directors deciding that it is insolvent”. Rather, he says that “it is up to the directors to consider all the available options and to decide which will best protect the interests of creditors”.

Director’s duties when a firm heads for the buffers

When business is upbeat, the primary duty of directors according to Taylor is to “promote the success of the company for the benefit of the shareholders and other stakeholders”. However, when storm clouds appear, with the potential for insolvency, he warns that “the primary duty of the directors is to minimise the losses of the company’s creditors”. As a result, directors should “not do anything in the course of trading that would be deemed disadvantageous to creditors”.

In this situation Leader’s advice is clear: directors need to consider their actions very carefully, particularly in regard to the effect of their decisions on creditors. He says this because if directors “don’t take proper account of the interests of creditors, they will be at risk of personal liability if the company does fail”.

Good corporate governance is critical. However informal management may have been in the past, once a company encounters financial distress it should hold regular board meetings and prepare detailed minutes to record the reasons for the directors’ decisions. Such evidence, in Leader’s view, will be invaluable in defending against any future allegations of breach of duty.

And Furniss backs this line. He highly recommends keeping “contemporaneous notes of all key financial decisions and the rationale behind them, and avoiding doing anything that may worsen the financial position”. By this he means not incurring further debts or continuing to trade when there are no reasonable prospects of recovery, while also not paying selected creditors over others, or selling assets at less than market rates.

It goes without saying that if directors are in any doubt about what to do, they should seek professional advice – at the earliest opportunity. Here Furniss suggests that once a director becomes aware of serious financial problems, they should speak to the company accountant who may then refer them to an insolvency practitioner. He adds that “directors are, of course, at liberty to contact an insolvency practitioner IP for advice independently”.

But as to where else to turn for guidance, Taylor mentions the Business Advice Centre and the Federation of Small Businesses which offer help to struggling firms. He adds that “the company’s bank or lenders can also provide options to relieve, at least for a short time, cashflow issues”.

Continuance of business

The obvious question at this juncture is whether an insolvent company can continue to trade. Here Leader says that they can “in appropriate circumstances, but it is risky”.

And Taylor agrees, stating that “the risks of continuing to trade include wrongful or fraudulent trading, and/or misfeasance, which is where a director is found guilty of breaching their fiduciary duties”.

He thinks it critical that directors recognise that the actions they take while the company is insolvent will be fully scrutinised by a liquidator or administrator.

He cites section 214 of the Insolvency Act 1986, and says that “a director can be personally liable to pay towards the assets of a company if the director allows the company to continue trading at a time, when the director knew (or ought to have known) that there was no reasonable prospect of the company avoiding insolvent liquidation – this is known as ‘wrongful trading’.” He adds that if this is proven, directors can be held liable to “pay compensation equivalent to the estimated loss incurred by the company, calculated from the point that the directors knew, or ought to have concluded, the insolvency of the company to the point of formal insolvency.”

However, Leader reckons that where directors have good reason to believe that a period of cashflow insolvency is only temporary, it may be in everyone’s interests that the company trades on to restore itself to solvency. In fact, he reckons that “to liquidate the company in those circumstances might be highly value-destructive for all stakeholders. However, directors should ensure that their projections are realistic and, if they are not sure or if the problems are not merely temporary, they speak to an insolvency practitioner so as to decide how to proceed.”

Likewise, Furniss sees no reason why an insolvent company can’t continue to trade “providing that they have a recovery plan in place and business forecasts that support the recovery plan showing that the position is forecast to improve”. To reiterate, without good advice, and where precautions are not taken, if a company subsequently enters liquidation (voluntary or compulsory), he says the “directors may be culpable of misconduct and be the subject of a disqualification order of up to 15 years. In addition, the liquidator may take recovery actions against them personally”.

On a tangent, Leader cautions firms looking to raise funds that asset sales are a particular area of risk. This is because, as he details, “in the event of an insolvency, any sales of substantial assets that took place in the period before the company collapsed will inevitably be closely scrutinised and may be challenged”.

Taylor expands on this, saying that selling or transferring assets at an undervalue is prohibited by the Insolvency Act: “If a liquidator believes that the assets have been transferred or sold at an undervalue, to the disadvantage of creditors, they can apply to the court to void the transaction.”

Furniss recommends that tangible assets be valued by an independent valuation agent prior to sale. This is to avoid any culpability which may result in disqualification and/or recovery actions against the director’s personal assets in the event of liquidation.

CVAs as an option

Even so, Taylor offers up a number of options if directors for directors when a company becomes insolvent. He says that directors can put the company into administration, or liquidate it which entails ‘winding-up’ – this results in the company being closed down and its assets sold/distributed to creditors.

They can also contact the company’s creditors to see if they can meet an informal agreement, or enter the company into a company voluntary agreement (CVA).

And this isn’t such a bad move per se says Leader as “it can be a useful tool for managing financial distress and achieving a better outcome for all stakeholders”.

He explains that a CVA allows a struggling company to make a proposal to its creditors to restructure its liabilities that include delaying payments and/or reducing the amounts due. If a majority of the creditors accept the proposal, it becomes binding on all of them. For him “the process promotes the interests of creditors as a body and reduces the risk of individual creditors seeking to hold the restructuring to ransom in order to get a better deal for themselves.”

It’s relevant that, as Taylor comments, CVAs are good for directors who want to remain in full control as “the terms of the agreement will be agreed by the directors themselves, subject to creditors agreeing to the terms. Further, CVAs are a cheaper alternative compared to other insolvency processes such as pre-pack administration – they allow more cash to remain in the company and avoids large up-front payments”.

He continues: “But by agreeing to a CVA, creditors will essentially ‘give up’ their right to be able to pursue legal action against the company for the debts, as long as the directors comply with all the terms of the CVA.” By definition creditors are more likely to see a return on their debts as the business continues to trade.

However, for Furniss, while a CVA may be an appropriate method of addressing an insolvent company’s situation if there is a strong chance of recovery, “the key to a successful CVA is whether or not the underlying business is viable. If it isn’t, a CVA will fail”.

There are a number of important consequences of a CVA which Taylor outlines. These include new creditors not being bound by the CVA which means that they could take legal action against the company including a winding-up petition; entering into a CVA also negatively impacts the company’s credit score; and CVAs can be burdensome for directors to comply with as agreements often run for years rather than weeks or months. 

To get a CVA off the ground, 50% or more shareholders and 75% or more creditors must agree to the terms, and secured creditors will not be bound by the terms of the CVA.

Even so, Leader says that CVA’s aren’t perfect and don’t always succeed. This is because when preparing a proposal, it can be hard to strike the right balance between cutting hard enough to address the company’s financial difficulties and proposing terms that most creditors will support. As a result, he says that approved proposals still see some companies fail later on. Nonetheless, he reckons that “CVAs are an invaluable part of the insolvency practitioner’s toolkit and, when used well, can deliver excellent results”.

Removing an insolvent company from the register

Some directors may think that removing – striking off – their company from the Companies House register will remove their personal risk. However, as a general rule Leader thinks that although it may be the only practical option for very small companies, “the better approach in most cases will be to use a formal insolvency process so to ensure that the company’s affairs are properly dealt with”.

In fact, he’s of the view that “directors who use dissolution to seek to avoid engaging with the company’s creditors are likely to increase their risks of personal liability or disqualification”. Worse, if they intentionally avoid notifying creditors of the dissolution process, they could even commit a criminal offence.

Indeed, Taylor points out an essential requirement of voluntary strike off: that the company must be under no threat of liquidation; anything otherwise “could result in the director being found guilty of misconduct and could result in them being held personally liable for the debts of the company”.

That said, Furniss advises that if the correct procedure is followed, directors can voluntarily strike off their business by filing a DS01 form. It costs £8 to submit online or £10 by post and “after three months, if no objections are received from creditors, the company will be removed from the register and shut down”.

Helping an insolvent business recover

But just because a firm is in trouble, that doesn’t mean that it’s doomed. As Leader highlights, a specialist advisor can help the board understand and implement the options available. He adds that “even if there is no way to rescue the company and avoid formal insolvency proceedings, the taking and acting on professional advice will generally provide directors with significant protection against personal liability for their subsequent actions”.

One part of the recovery process involves seeking a financial breathing space. Taylor’s tack would involve talking to the banks and lenders, and assessing the company’s financial situation looking for options in relation to loan repayments. “This,” he says, “may include a longer repayment period or a pause in payments to provide the company with some ‘respite’ while it gets its finances back in order.” It follows that this will heavily depend on the extent of the company’s financial difficulties.

Allied to this, if the company has missed a tax deadline or knows it will not be able to pay tax on time, it can approach HMRC with an application for a ‘payment plan’ to pay in instalments. This too will help with cashflow.

He notes also that “directors have a duty to act in the best interests of the company, which under company law includes acting in creditors interests”. He takes this to mean that “directors should communicate any indication of the company being in financial difficulty to creditors as soon as possible.”

Leader doesn’t disagree, but warns that “actions that improve the position of particular creditors at the expense of others could expose directors to risk; such transactions could be set aside”.

It shouldn’t be forgotten that a problem shared may lead to an alternative – and better outcome. This is what Furniss advocates when he says that “an insolvency practitioner –experienced in dealing with a diverse range of businesses – will carefully listen to the background of the situation and use their professional judgement to arrive at the most appropriate actions to take with the aim of recovery.” 

However, it needs to be remembered that, as Furniss says: “Where assets are purchased from an insolvent company, either by the former directors/employees, management, or by an unconnected party, it will generally not be well received by creditors. However, what creditors do not always acknowledge and/or understand is that an ‘in-situ’ sale or a sale to a connected party will realise more than if the assets were uplifted and sold at auction.”

Advice for creditors

Creditors are a key part of this story, and their rights in relation to a restructuring or insolvency process will depend very much on the circumstances. 

If no formal insolvency process has been commenced - say the directors are trying to achieve some form of informal restructuring – then as Leader notes, “a creditor may well be able to exert significant control by, for example, threatening to present a winding-up petition”.

However, if formal proceedings are already underway, he explains that the scope to influence proceedings will be more limited. The problem is, he says, “as a general rule, the law gives a certain amount of power to the general body of creditors, but much less to individual creditors. That said, creditors may be able to raise objections or challenges, in appropriate circumstances”.

Where creditors have concerns Furniss’ advice is to discuss them with the appointed insolvency practitioner with a view to submitting a complaint. He adds that “if the creditor remains dissatisfied, they could complain to the practitioner’s governing body and/or seek legal advice which may recommend an application being made to the appropriate court.”

And for Taylor? His advice to creditors who do not agree to a restructuring process is to “make demands for payment or start formal insolvency proceedings” as this may have the effect of invalidating the restructuring agreement that was reached with other creditors.

Summary

Business failures happen. That’s life. However, directors of afflicted firms must not ignore the law and act incorrectly. If they do, they risk personal liability and possible disqualification from being involved in the management of a company for quite some time.

Taking and acting on good advice, and by following good corporate governance procedures, will clearly reduce the risks.

And for creditors? Their salvation depends on incorporating robust systems to check on those that they’re trading with while keeping a watchful eye on payment trends.