What is insolvency?
Technically, the law has two definitions of insolvency. ‘Cash flow insolvency’ is when a company can’t pay its debts regardless of the assets it currently owns, while ‘balance sheet insolvency’ is when a company’s liabilities outweigh its assets, even if it currently has the cash flow to pay its debts. On a more practical level, insolvency tends to occur when the failing company’s creditors take actions such as stopping credit or initiating insolvency proceedings.
What is the risk for directors?
Many directors try to manage creditors as long as possible, but this can mean trading long after the law would consider the company insolvent. The consequences can be a much greater risk of personal liability for the directors. They can be accused of ‘wrongful trading’ or ‘trading while insolvent’, which can make them personally liable to the creditors of the company for any increase in the company’s debts.
Liquidators of insolvent companies can look for inappropriate transactions such as company assets sold to directors at less than their actual value, or preferential repayment of debt owed. However, arguably the most dangerous area relates to directors’ remuneration. In owner-managed companies that have no external shareholders, there is a tendency for directors to pay themselves first. However, if the company becomes insolvent, the liquidators can bring a misfeasance claim against directors for not paying all of the creditors equally.
Further down the rabbit hole
A misfeasance claim also takes the company further down the rabbit hole. All financial transactions between directors and the company will come under scrutiny, stretching back to the point the company was first in financial difficulty. The liquidator will look for evidence of unpaid invoices and special creditor arrangements to argue the company was in financial difficulty from earliest possible date. If the company has been managed in an informal way, this often means many unexplained transactions, which can result in a substantial personal liability on the part of the directors.
How to avoid it
Financial difficulties are a fact of business life, but the possibility of insolvency highlights some important things to focus on now. Do not be tempted to adopt a business as usual approach. Take professional advice, as that is the best way to avoid liability later. Be conscious that all of your actions – and particularly financial transactions – could come under scrutiny, so keep good records of decisions and the reasons for them, and take professional advice. Finally sometimes the only sensible thing to do is call it a day, and take advice on the options for putting your business into insolvency. .