What is Insolvency?

To be the director of an insolvent business is to enter a different world where your duties and responsibilities have radically changed, and one where you may be at risk of personal liability. This article looks at the legal definition of insolvent, the tests that apply, the impact that it has on your position as a director, and where to go for insolvency help.

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Why insolvency matters

In normal circumstances the duty of the directors of a company are to act in the interests of the company and its owners, the shareholders. When a company is insolvent those duties change so that the director’s main duty is then to protect the interests of creditors. This has important implications for how the directors should then act in running the company and failure to do so correctly can leave directors open to the risks of both personal liability and disqualification.

Some people believe that the directors of a company have to cease trading as soon as the business is insolvent. This is not actually the case as the directors can quite legitimately look to trade out of their difficulties.

However if they choose to try to do so they have to be very careful and demonstrate that they had a reasonable prospect of managing to do so in order to avoid any potential risk of Wrongful Trading under Section 214 of the Insolvency Act 1986 where if you continue to trade beyond the point where you should have known to stop, because there was no reasonable prospect of avoiding an insolvent liquidation, then you can be held personally liable for the additional loss suffered by creditors from that point.

In addition, once a company has gone into liquidation, its transactions in the period leading up to the insolvency will be scrutinised and may be subject to challenge as being a Transaction at an Undervalue (where you sold assets at below their true value) or a Preference (where you acted to put certain creditors in a better position than they would otherwise have) under Sections 238 and 239 of the Insolvency Act 1986 respectively.

These are all also matters that the Liquidator may include in his director’s conduct report which may then be taken into consideration in deciding whether to seek your disqualification as a director.

The Insolvency Tests

Section 123 Insolvency Act 1986 sets out the statutory tests for insolvency which are that either the company is unable to pay its debts as they fall due (often referred to as the ‘cash flow test’), or that its assets are less than its liabilities (often referred to as the ‘balance sheet test’).

Failure to have dealt with a valid statutory demand within the specified timescale or to have satisfied a Court judgement are deemed to be specific evidence that a company is unable to pay its debts and sufficient on their own for a creditor to present a winding up petition.

From a director’s point of view, the cash flow test is to simply ask yourself whether the company can pay its debts when they fall due for payment. So if you are having to paying your suppliers after their due dates for cash flow reasons, or if you are not paying over to HMR&C income tax and national insurance deductions on the 19th of the month, then your company could well be insolvent.

The balance sheet test asks whether the company owes more to its creditors than the value of what it owns in assets. However just looking at the balance sheet will not be enough to check this as the test also has to include contingent and prospective liabilities which could inflate the liabilities value significantly. Meanwhile, if the balance sheet has not been fully adjusted for obsolete stock or plant and equipment, or the provision for bad debts is insufficient, then the value of the assets on the balance sheet may be overstated. It is also true to say that accounts are normally prepared on an assumption of a going concern basis and in the event of a failure the realisable value of assets is often well below going concern book values. Having taken these into account, if the company’s liabilities are greater than its assets then the company could be insolvent.

Don’t panic, but do act

If you think that your company fails any of the above tests then as a director you need to take action quickly. As already discussed you do not have to immediately cease trading. Indeed developing and implementing a turnaround plan with which to trade through and out of difficulties, or to raise new investment, may well be the appropriate course of action for a responsible board of directors to take. But what you as a board do have to do is to think very carefully about what your responsibilities now are and whether you should continue to trade.

Remember that from this point on your duty is to protect the interests of the creditors and not the shareholders. You should therefore prepare forecasts showing how you are expecting trading to perform under your plan, paying particular attention to how you expect this to affect the position of the company’s creditors.

You should carefully minute all your discussions and the basis of your decisions and monitor your actual performance closely against this plan as you go forwards. And critically, you should also obtain appropriate professional advice by speaking to an appropriately qualified insolvency practitioner, insolvency solicitor or an accredited turnaround professional as early as possible in the process so you can ensure you protect your position.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and you should always seek appropriate professional advice on your own particular circumstances before taking any action. Follow us on Twitter here: