That a business can become insolvent is a fact of life. The well known insolvencies involving some of the country’s best known retailers and manufacturers shows how global economic decisions can affect local trading conditions, both in terms of speed and severity.
When a business becomes insolvent, the directors have to decide whether to continue to trade or cease operations. This will depend largely on the reason for the insolvent position. As an advisor to businesses, you need to be able to spot the warning signs early on, and know how best to help your client.
Technical Insolvency is; when a company is unable to pay its debts as and when they become due and/or the value of its liabilities, including contingent liabilities, exceeds the value of its assets.
Causes
There are two major causes of insolvency, which account for around 50% of all failures – loss of market share and/or loss of finance. Loss of market share is more likely to be a gradual process, whereas loss of finance is usually quite sudden.
No matter the cause, it is vital that the directors (and de facto directors) of a company recognise as early as possible that the business is about to become technically insolvent and take the appropriate steps to avoid possible personal liability or disqualification, should formal insolvency proceedings follow.
Spot the warning signs
The early warning signs are generally most apparent in terms of cash flow. Revenues are not keeping pace with current liabilities, resulting in delays in payments to creditors past their contractual dates. This does not necessarily mean that the company is heading for liquidation, but it is at this stage that the directors should assess the situation, determine the causes and formulate an action plan to mitigate it.
It may well be a temporary squeeze on cash flow which can be remedied by prudent management, so access to timely and accurate financial information is vital. However, great care should be taken to ensure that any decisions are based on reasonable information; not on blind optimism.
When would the directors be held liable?
An important question for directors of a company in trouble is if they will be held liable for its losses. I’ve explained this by way of the following example:
A company is technically insolvent but is currently negotiating a contract for new business, or a sale of part or all of the existing company, which will improve the situation and return it to solvency.
However, these negotiations fail and the company goes into liquidation. The directors knew or ought to have concluded, that there was no alternative to insolvent liquidation when the negotiations failed. But between this point and when the business finally ceased trading (and stopped incurring further losses), there was a loss to creditors and a reduction in the company’s assets. The subsequent liquidator will have to look at the extent and nature of these losses to establish whether the directors can be held personally liable.
The key word here is ‘reasonable’. In this example, while the directors may have ‘hoped’ that obtaining new business or a sale of part or all of the existing company would have returned the company to solvency, or at least resulted in a better outcome for the creditors, there has to be a ‘reasonable expectation’ that this will take place. Therefore the more documentary evidence to back up that expectation the better.
If this is not the case, the directors can be accused of wrongful trading: when a company continues trading beyond a point when the directors ought to have known it would have no alternative but to enter into insolvent liquidation and as a result the position of the creditors has worsened.
When negotiating a sale of the business, it is not unknown for a competitor company to express interest in purchasing a business and then carry out due diligence simply as a fishing expedition, or drag things out until the company’s position is so weak that a substantially reduced offer will be accepted. This is one of the reasons why some insolvent companies seek the protection of an administration order so that acts carried out in the interim period prior to a potential sale, including obtaining further credit, are sanctioned by an insolvency practitioner. Appointing an insolvency practitioner substantially removes any potential liability on the part of the directors, while the practitioner is in office.
Avoiding Personal Liability
Trading while insolvent can be extremely dangerous if the end result is formal insolvency proceedings. To help avoid allegations of wrongful trading and therefore potential personal liability, management should ensure that its decisions are well documented.
Steps to avoid personal liability
• Hold regular board meetings to discuss the company’s financial position and minute the discussions and decisions.
• Prepare profit and loss projections and review them regularly.
• Put in place cost cutting measures and effective debtor control.
• Consider all potential contracts and their effect on profit and liquidity.
• Attempt to inject/obtain further capital if there is a reasonable prospect that this will relieve the situation in the long term.
• Do not incur further credit except in the ordinary course of business.
•Most importantly, seek professional advice.
Wrongful trading is just one of the avenues open to a subsequent liquidator to hold directors personally liable. Others including the following;
• Fraudulent trading
When a company sets out to defraud creditors or HM Revenue & Customs and is used as a vehicle to obtain goods or services by deception.
• Misfeasance
This generally relates to the misapplication or misappropriation of company assets, but refers to any wrongdoings or breach of duty, including excessive drawings, payment of illegal dividends or allowing transactions at undervalue or preference to take place (defined below)
Transactions at undervalue
When a company’s assets are sold, given away or otherwise disposed of for substantially less than market value.
Preference
Preference can occur when a creditor or director is placed in a better position than would be the case under insolvency regulations. For example, if, before a company enters insolvent liquidation, it makes a payment to one particular creditor instead of another at a time when the directors knew, or ought to have known the company was insolvent and likely to go into liquidation, then that payment could be deemed to be a preference. This might occur where the creditor company is a subsidiary, or is associated with the insolvent company.
To determine, whether any offences or breaches of fiduciary duty have been committed, a liquidator will look at the nature and timing of the possible offences, and consider when the directors:
• first became aware that the company was insolvent
• had access or ought to have had access to accounts showing insolvency
• sought professional advice; and whether they followed that advice.
The liquidator will then consider if any offences have been committed, the extent of the directors’ responsibility for the failure of the company, and assess their:
• failure to provide goods and services paid for in advance
• failure to keep adequate accounting records
• retention of HMRC monies
• failure to cooperate with an office holder in the event of liquidation or administration.
If it is considered that offence has occurred, all directors may also face proceedings under the Company Directors Disqualification Act. If found guilty, they may be disqualified from taking part in promoting, forming or managing a limited company for between 2 and 15 years.
Action to be taken
Continuing to trade with knowledge of insolvency can be extremely risky. But, trading shouldn’t necessarily cease; many companies go through a period of technical insolvency and then return to solvency. However, if it is deemed beneficial to continue trading great care should be taken to protect the interests of creditors – it is vital that the position of creditors does not worsen. All steps should be taken and evidenced to show that if insolvency proceedings follow the losses to creditors have been minimised and there were sound reasons to believe that continuing trade was the best option.
When the directors become aware that the company is insolvent, they should seek professional advice at the earliest opportunity. This can include obtaining an expert overview of the company and its options, or using insolvency legislation to protect the assets of the company and its creditors’ interests while restructuring is carried out. If the company is to be sold and the proceeds are insufficient to pay the creditors in full, many purchasers prefer to buy it out of administration as it tends to negate, among other things, possible future claims for transactions at undervalue or preference.
Adrian Dante is Restructuring & Recovery Director at MHA MacIntyre Hudson