Article
Written by Alice Payne
Posted on 31/05/2016

Understanding corporate insolvency

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What is insolvency?

Insolvency is when a company can no longer meet its financial obligations to repay debts that are due. Quite simply, its liabilities exceed its assets. 

Often mistaken for bankruptcy, which is an official legal status, insolvency is instead a financial state of being and can be rectified without declaring bankruptcy. In the UK, insolvent companies have recourse to different procedures, which fall into five key categories:

  • Administrations
  • Company voluntary arrangements (CVAs)
  • Administrative receiverships
  • Compulsory liquidations
  • Creditors’ voluntary liquidations (CVLs)

The first three of these options may enable the company to be rescued, while the latter two do not. Administration is the process of gaining control of an insolvent company and protects a company from legal action. During a CVA, a financial negotiation takes place where creditors often write off part of their debt so that the company can return to solvency. Administration is usually implemented before a CVA so that the company is protected during its rescue. In administrative receivership, an insolvency practitioner is appointed by a creditor to control the company’s assets for the creditor’s benefit.

What is liquidation?

Liquidation is when a company’s assets are transferred to cash, which is then distributed to creditors (those owed money). Rather than forcing liquidation, it is often better to find a way for the company to continue trading so that its realisable value increases. While a creditor can enforce debt recovery through court action and liquidation, creditors and directors frequently try and work together to find the most acceptable solution.

In a CVL, shareholders decide to wind up the company under the supervision of a liquidator. The alternative option is compulsory liquidation. Any creditor can initiate this process, regardless of whether the company has agreed. However, it’s usually a last resort for frustrated creditors if the relationship with the company has broken down.

Areas of responsibility

In an insolvency, different parties have different responsibilities. It is the directors’ responsibility to know if a company is insolvent and still trading. If the directors continue to allow trade while insolvent, and cause avoidable losses to creditors, this is called wrongful trading and the directors can be prosecuted. However, simply being the director of an insolvent company isn’t an offence, unless there has been any misconduct, which will then be investigated. External factors rather than mismanagement can often be to blame in insolvency.

For example, during and after the global financial crisis, insolvencies and bankruptcy rose significantly as companies were forced out of business. Many of those directors have doubtless gone on to run lucrative and successful ventures, having learnt from the mistakes. Indeed, the number of corporate insolvencies continue to fall.

When it comes to responsibility for appointing receivers, liquidators and administrators, this is held by the insolvent company’s funding bodies (banks and lending organisations), creditors and directors as well as the courts.

The purpose of insolvency

Insolvency is not punitive; its purpose is to enable transparency and initiate a fair process for stakeholders – where possible attempting to rescue a company or business.
 
Being insolvent doesn’t mean a company has to stop trading immediately. Often, to recover from insolvency, it’s crucial the company continues to trade in enable a rescue. But directors need to ensure they take every step to minimise possible losses to creditors. To do this, once they realise their company is insolvent, directors will seek professional advice from an insolvency practitioner. This can help them to reduce their own liabilities and ensure the company follows correct protocol.

Selling an insolvent business

Instead of winding up a business, it can sometimes be sold as part of a rescue process. In this case, a sale of the business and its assets is negotiated. The company making the purchase may be owned by a management buy-out team, a competitor or someone entering the sector.

Employees are often transferred to the new company but other contracts aren’t, and the new company will negotiate new trade relationships. The proceeds of the sale, meanwhile, are either distributed to the creditors or to a liquidator to manage and distribute.

Insolvency pecking order

In the UK there’s a strict process outlining the order in which assets are received. Anyone holding a fixed charge over a company’s assets is at the front of the queue and is paid once those assets are sold. Preferential creditors are next in line and usually include unpaid employees. After that, the order is: creditors with a floating charge, unsecured creditors and, finally, shareholders.

Cross-border insolvencies

With the global nature of trade, many insolvencies now have a cross-border element. In Europe, each country has its own legal proceedings for insolvency which can involve considerable differences, such as the format of proceedings, the priority of different creditors and the legal rights of the various stakeholders. However, through the European Regulation on Insolvency Proceedings, there is a coordinated process for insolvency in Europe.

In 2017, a modernised Insolvency Regulation will come into effect, shifting the focus away from liquidation, making it easier for businesses to restructure and protecting creditors’ rights.

While insolvency is a complex area of corporate law and can be both costly and lengthy, there are very clear guidelines in place. With careful management and advice, falling into insolvency doesn’t have to mean the end of your business.