In the current economic climate, the threat of company insolvency is in the forefront of many executives' thoughts. For many, however, it is uncharted territory, complete with its own jargon and procedures.
"Insolvency" - what is it?
The insolvency legislation (being primarily the Insolvency Act 1986, as amended by the Insolvency Act 2000 and the Enterprise Act 2002, and supplemented by the Insolvency Rules 1986) does not define the word "insolvency". A company can be considered insolvent based on either of two tests: first, the "cash flow" test, where it is unable to pay debts as they fall due; and, secondly, the "balance sheet" test, where its total liabilities (including contingent and prospective liabilities such as guarantees) exceed its realisable assets. A company might pass the cash flow test, yet be insolvent under the balance sheet test, or vice versa.
The various insolvency procedures have different features. Which one is chosen (or imposed) will largely depend on the prospects for rescuing the company.
Administration may be initiated by the company, the holder of a "qualifying floating charge" or by the court, normally on the application of a creditor. A statutory moratorium applies, preventing creditors enforcing security without the consent of the administrator. No proceedings, legal or insolvency, can be commenced. This procedure was designed to enable the company to be rescued from insolvency. However, in practice the company is likely be liquidated or dissolved following the administration.
Receivership is commenced by a secured lender applying to the court to enforce its security either over specific property subject to a fixed charge or over all the company's assets under a floating charge. However, receivership under a floating charge is generally no longer possible if the charge was created after 15 September 2003. Instead, lenders holding such security may, generally, appoint administrators out of court.
Company voluntary arrangement
Under a company voluntary arrangement (or "CVA"), the debtor company and its creditors come to an agreement regarding payment of the company's debts which is implemented and supervised by an insolvency practitioner. This is a "rescue". A CVA can also be used in solvent situations.
"Pre-pack" is a term used to describe a sale of business put together between the management of the company, its proposed administrators and a buyer before the company enters administration, where the sale is completed by the administrator on appointment, thereby rescuing part of the business.
Finally, liquidation (or "winding up") is generally commenced to close the company and distribute its assets among creditors. It may be voluntarily initiated by the company itself, either because it is insolvent (termed "creditors' voluntary liquidation" ("CVL")), or because its purpose has come to an end ("members' voluntary liquidation"). In both cases, the shareholders place the company into liquidation, but in the case of a CVL, the creditors vote on the liquidator's appointment. A creditor of a company can also petition the court for its winding up if it is insolvent. This is known as 'compulsory' liquidation.
Directors and the "twilight zone"
The period between the point when there is no real prospect of avoiding insolvent liquidation and the commencement of one of the insolvency procedures is often referred to as the "twilight zone". Directors and officers must be especially aware of how the company's uncertain solvency can affect their duties.
Normally, directors' duties are owed to the company, that is the shareholders as a whole. However, once a company has entered the "twilight zone", directors are under a legal duty to concentrate on protecting the interests of the creditors rather than those of the shareholders. Section 172(3) of the Companies Act 2006 states that the duty to "promote the success of the company" is subordinated to any enactment or rule of law requiring directors to consider or act in the interests of creditors of the company. By way of illustration, directors should avoid allowing the company to incur further losses or greater liabilities (such as loans), even though shareholders might wish to try and trade out of the financial difficulties. Similarly, directors should also take care to avoid disposing of company property at less than its market value or preferring one creditor unfairly over another.
Directors' conduct during this period will be carefully scrutinised by the insolvency practitioner (IP) overseeing the administration or liquidation. The IP is legally obliged to investigate the directors' conduct in the run-up to the insolvency procedure and to report to the Department for Business, Enterprise and Regulatory Reform. Breaches of duty will expose directors to statutory remedies under insolvency and company legislation, such as wrongful trading and misfeasance. Furthermore, the court can set aside or vary transactions at an undervalue and preferences which were entered into up to two years before the commencement of the liquidation or administration. Such proceedings may result in directors facing personal liability and even disqualification. A director's personal lack of awareness of the company's pending insolvency is no defence: the test for liability under wrongful trading, for example, is what is referred to as a "subjective/objective" test. This means the director will be judged both according to the standards of what a reasonably competent director ought to have known, and also with regard to any special knowledge or skills the director actually possesses (for example, accountancy skills). This can raise the courts' expectations accordingly.
Despite these concerns, neither the courts nor insolvency practioners aim to punish directors who act reasonably in protecting creditors. The following are practical considerations for directors to minimise the risk of claims.
- The financial position of the company should be monitored by preparation of regular financial statements, projections and accounts.
- Take appropriate advice from professionals. The company accountants should be asked to verify current solvency and cashflow to establish if insolvency can be avoided. Lawyers may be consulted to determine whether any proposed transactions are inappropriate. Advice from an insolvency practitioner should be sought to assess potential strategies for recovery.
- Board meetings and other more informal meetings attended by all directors should be held at regular intervals. Detailed minutes should be kept and briefing papers should be circulated in advance to promote discussion. Absent directors should ensure they are kept informed.
- Individual directors with concerns about the solvency of the company should raise them with other board members and have any concerns minuted. If a director's concerns are ignored, the director may even wish to consider obtaining independent legal advice. As a final step, he or she may wish to consider resignation. Resignation alone is not, however, a bar to liability for wrongful trading.
- Directors should consider the company's financial situation before incurring further liabilities or agreeing to large compensation or pension packages for departing management.
- Be wary, if you are a nominee director or a director of several group companies, of conflicts of interest. Duties to a parent company or appointing company do not override the duties to a subsidiary (and its creditors).
- Major creditors and investors should be kept informed, subject to advice from the company's advisers. Special considerations apply for listed companies. For example, the LSE Disclosure and Transparency Rules impose obligations on the release of information. Appropriate announcements must be made to avoid the creation of a false market in shares of listed companies.
These are challenging times for many companies, and directors of distressed companies, not unreasonably, have their attention focussed on keeping their businesses afloat. However, they must also remain aware of the extra risks that they face to avoid exposing themselves, and their insurers, to personal liabilities and claims.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.