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What you should know about insolvency - Part 1

As the UK economy begins, in late 2009, to recover from the harshest recession in 75 years, insolvency is becoming somewhat more prevalent than has been the long term experience of most of us. The few high profile administrations such as Lehman and Woolworths are likely to be followed by many ordinary smaller businesses encountering formal insolvency procedures. Formal insolvencies tend to lag on economic recovery because of reluctance to invoke them and the time it can sometimes take to do so.

Now is therefore an ideal time to remind you about corporate insolvency and this is the first of a series of posts to do so.

Definitions

The word insolvency can be used either in a general sense to identify a company’s illiquidity or over-indebtedness (technical insolvency), or more specifically to identify a company subject to a formal insolvency procedure (formal insolvency).

Technical insolvency is most simply identified using the terms of s123 Insolvency Act 1986 ("IA86"):

  • ‘the company is unable to pay its debts as they fall due’ (illiquid – the cashflow test); or
  • ‘the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’ (over-indebted – the balance sheet test).

Classic evidence of the cashflow test being failed includes creditors having issued writs or statutory demands and late payment of PAYE and VAT.

Realisation that the balance sheet test includes contingent and prospective liabilities often puzzles directors because so many companies do fail that test, but it is the case that prospective and contingent liabilities are taken into account when assessing a company’s technical insolvency.

Of course, failure of one of the two tests does not immediately lead to adverse practical consequences or penalties. This is in contrast to some jurisdictions, such as Germany, where it is a criminal offence for directors not to instigate formal insolvency proceedings within three weeks of failing similar illiquidity and over- indebtedness tests. In the UK it is more helpful to consider the concept of the ‘zone of insolvency’.

A distressed company may move into insolvency but with a ‘reasonable prospect of avoiding insolvent liquidation’.

This paraphrase of part of s214 IA86 (the section that deals with wrongful trading) allows for the taking of a somewhat longer view than under the German system. It is not, however, a view without risk. Even if there had been a long period during which there was a reasonable prospect of avoiding insolvent liquidation, followed by a calamity that caused liquidation, the company will have been technically insolvent from the moment it failed either the cashflow test or the balance sheet test.

One consequence of technical insolvency is that it determines whether transactions entered into by the company are at risk of being overturned under insolvency legislation relating to antecedent transactions such as transactions at an undervalue (s238 IA86) and preferences (s239). In order for an administrator or a liquidator to be able realistically to take court action to overturn a transaction at an undervalue or a preference, the company must have been in the zone of insolvency at the time of the transaction.

However, the section that more clearly focuses directors’ minds on the zone of insolvency is s214. Wrongful trading – incurring losses when a director ‘knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation’ can lead to the court declaring that the director is personally liable for the amount the court orders to be paid. That amount is likely to reflect the losses suffered by creditors during the period of wrongful trading.

The practicalities of technical insolvency are that:

  •  it can lead to formal insolvency;
  • it introduces additional risks, notably for the directors personally, at a time when the company is already stressed; and
  • the onset of technical insolvency is an ideal time – perhaps even the best time – for a company to take specialist insolvency advice.

Case Study

In July 2007 I was consulted by an AIM listed company whose directors where concerned about its financial position. Since then I have advised the board many times about the risks they face and whether they have a reasonable prospect of avoiding insolvent liquidation. At times there has been a gap of several months between consultations and at times we have spoken every few days. The company remains in the zone of insolvency but it currently has a reasonable prospect of avoiding insolvent liquidation and it is less illiquid and less over-indebted than when I was first consulted. It has achieved this through enhancing its profitability and attracting investment. As a start-up company in a relatively new sector it has already become a market leader although it has yet to break even. If it were to stumble and fall into formal insolvency, it seems to me unlikely that the directors would be at significant risk of a wrongful trading action. Also, for the last two years they have been aware that any transactions at an undervalue or preferences could be overturned in the event of formal insolvency – but I am not aware of there having been any such transactions!

Look out for Part 2, which will explain how best to avoid formal insolvency despite failing the technical insolvency tests.

 

 

Date: 15th September, 2009
Author: Chris Laughton

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