Company directors should have at least a basic, general understanding of corporate insolvency law. This is particularly true when the company’s finances are under stress, as circumstances can easily arise where the directors may face personal liability for decisions they make without properly understanding their duties to creditors and the legal consequences of their action or inaction.
When a company (rather than an individual or a partnership) becomes insolvent, the law provides, in effect, for two types of outcome. One is that the company enters into a “rescue” type of proceeding, usually with the objective of enabling all or part of the company’s business to continue. The other is liquidation, whereby the company ceases to trade and is wound up.
Sometimes, an insolvent company will go through both procedures. That can happen where, for instance, an administrator is appointed and sells the company’s primary business as a going concern. Following the sale, the administration ends and the company goes into liquidation, with the liquidator distributing the sale proceeds and any other assets of the company to the company’s creditors.
When a company goes into administration , an administrator takes over management and control of the company. The administrator has extensive powers to manage the affairs of the company. Amongst other things, it can remove and appoint directors, manage the business of the company, and dispose of the company’s assets.
There are several ways that an administrator can be appointed. The directors of the company can elect to put the company into administration and appoint an administrator by filing notice with the court. The court itself can (usually on application of creditors or, in some cases, a government regulator) order the appointment of an administrator. The holder of a qualifying floating charge (who is usually a secured lender) can also appoint an administrator by notice to the court.
An administrator’s primary obligation is to rescue the company as a going concern or, if that is not possible, to achieve a return for the creditors that would be better than they would have obtained if the company were wound up with its assets sold off piecemeal.
When an administrator is appointed, there is a moratorium that takes effect at the time of appointment. This prevents creditors from taking any enforcement action, such as the appointment of a receiver (which is discussed below).
Frequently, where an insolvent company has a viable business that is capable of trading profitably if it can be relieved of its debts, the administrator will attempt to sell the business as a going concern. Such a sale is an “asset sale” rather than a “share sale”, which means that the purchaser acquires the business by purchasing a collection of assets. This means that the liabilities associated with the business are, by and large, left with the insolvent company after the sale.
The sale of a business by an administrator will frequently enable a viable business to continue to trade, which can preserve jobs for the company’s workers and may mean that the company’s creditors get the benefit of the company’s goodwill as part of the price realised for the business (which they would not have in a liquidation — see below).
In recent years, ” pre-pack ” administrations have become more popular. A “pre-pack” is a sale of an insolvent company’s business that has been agreed in advance of the appointment of the administrator. One of the justifications for a pre-pack sale is that it allows the business to avoid some of the stigma associated with insolvency. Therefore it enables the company to get a better price for the business than an administrator would have been able to achieve if it marketed the business after being appointed.
Company Voluntary Arrangement
A company voluntary arrangement (or ” CVA “) is, in effect, a debt restructuring agreement. The main features of a CVA are:
- There are no restrictions on what the company can agree with its creditors, except that the agreement cannot affect the rights of any secured creditor (usually lenders) or preferential creditor (basically, employees) without the consent of the affected secured or preferential creditor.
- The unsecured creditors are entitled to vote on a resolution approving the CVA. The CVA is binding on all unsecured creditors if approved by 75% (by value) of the unsecured creditors who vote on it, provided that no more than 50% (in number) of the unsecured creditors vote against it.
- A creditor or shareholder who objects to the CVA can raise his objection with the court during the 28 day period after the CVA is approved.
So a CVA is a flexible arrangement, but its flexibility is somewhat limited by the rights of secured and preferential creditors. In some circumstances, they may, in practice, have a veto power over the CVA. In addition, secured creditors can enforce their rights (by appointing a receiver, etc,) even though a CVA has been approved and has taken effect — there is no moratorium.
A scheme of arrangement is a mechanism similar to a CVA, which is provided for in the Companies Act 2006. It requires, however, that 75% (in value) of each class of creditors that is affected by the scheme must approve it. That may mean that the separate votes of several different classes of affected creditors are required in order to approve and implement the scheme.
Sometimes a secured creditor will take a fixed charge over a single asset (or set of assets) of a company, and will retain the right to appoint a receiver over that asset. This is a relatively limited form of receivership in which the receiver can sell the asset and use the proceeds to settle the debt owed to the secured creditor.
Another form of receivership is ” administrative receivership ,” but because of the way insolvency law has changed in recent years, administrative receiverships are not as readily available as they once were. A lender who holds a floating charge that was created before 15 September 2003 will likely have the ability to appoint an administrative receiver, but the holder of a floating charge created after that date will not. The administrative receivership process is broadly similar to administration — although with some differences in the detail.
A lender with a floating charge created after 15 September 2003 will usually have the right to the appointment of an administrator (rather than its own administrative receiver) or a fixed-charge receiver in relation to specific assets.
Liquidation is the “end game” in insolvency. A liquidator’s job is to sell or otherwise realise the assets of the company and to pay its creditors insofar as possible.
A company can be placed in liquidation voluntarily or by an order of the court. Most insolvent liquidations commence when either (i) the creditors and shareholders have, in effect, agreed that the company should be voluntarily liquidated, or (ii) a creditor (or other person with standing) has successfully petitioned the court to have the company wound up.
To obtain a compulsory winding-up order from the court, the petitioner must show that the company is insolvent. Broadly speaking, there are two tests for insolvency: the “cash flow” test and the “balance sheet” test . A company’s failure to pass either test is grounds for the issue of a winding-up order. Under the cash flow test, a company is insolvent if it is unable to pay debts as they fall due. Under the balance sheet test, a company is insolvent if its liabilities exceed its assets.
There is also a voluntary procedure known as a ” members voluntary liquidation ,” whereby the shareholders pass a resolution to liquidate the company. This is generally used for the reorganisation of a group of companies or in other circumstances where, although the company is liquidated, all of its creditors are paid in full.
Payment of Creditors
The order of priority for the payment of the creditors of an insolvent company is as follows, with each level of creditor being paid in full before anything is paid to the next level:
- Debts to holders of fixed charges (out of proceeds of disposal of fixed charge assets);
- Liquidation and administration expenses;
- “Preferential” debts (which are prescribed by statute, and are essentially amounts owed to employees);
- An amount (which can vary) that is, by statute, set aside for unsecured creditors out of amounts realised from assets that are subject to a floating charge;
- Amounts realised from assets that are subject to a floating charge, for the floating charge holder (or holders);
- Amounts due to unsecured creditors;
- The surplus (if any) to shareholders.
Where there is a question as to the solvency of a company, directors need to pay close attention to the company’s financial situation. When a company becomes insolvent, the directors’ primary duty shifts to the creditors of the company rather than its shareholders, and directors can face a variety of sanctions if they allow an insolvent company to continue to trade to the detriment of its creditors.
Certain solicitors and accountants specialise in insolvency work. Whether you are a company director seeking advice about your duties and your options, or whether you are a creditor concerned about recovering a debt from a potentially insolvent company, you should be looking to a recognised specialist for advice.
You can find solicitors specialising in insolvency in our solicitor directory here.