What is Insolvency?

Insolvency is a core business concept that has profound implications for those who experience it.

In this article we’ll explore what it means, how to know if you’ve reached it, and what directors should do next.

What is Insolvency?

Insolvency is a state of financial distress where either an individual or a limited company can no longer pay debts when due. Another way of defining this is where liabilities exceed assets (including cash).

When not addressed it can lead to insolvency proceedings which are legal actions designed to prompt the insolvent entity to either pay what it owes to creditors or be closed down.

While insolvency can refer to personal finances, it is more commonly used to refer to business distress in the UK, particularly limited companies or partnerships. For individuals, bankruptcy is the preferably used.

In both these cases, directors cease their responsibilities to shareholders at the point of insolvency, and assume a primary responsibility to maximise creditor returns.

How to Check if a Company is Insolvent?

A company may be considered insolvent if it fails one of these two tests:

• Cash Flow Insolvency Test – Does your company have enough cash to pay it’s bills right now? Answering no may place you in the state of insolvency.
• Balance Sheet Insolvency Test – List your assets (including cash) in one column of a spreadsheet, and your liabilities (debts) in the second. If column A is less than Column B, you are insolvent.

Examples of Insolvency

Typical examples of how a company could become insolvent include:

• cashflow problems caused by late paying customers
• loss of a key business contract which negatively affects cash flow
• shifting market forces render your key product or service less useful
• a lawsuit or other unexpected liability

What’s the Key Insolvency Legislation in the UK?

They key UK insolvency legislation for England and Wales is the Insolvency Act 1986 and The Insolvency (England and Wales) Rules 2016.

In Scotland, the correct insolvency legislation is The Insolvency (Scotland) (Company Voluntary Arrangements and Administration) Rules 2018, and The Insolvency (Scotland) (Receivership and Winding up) Rules 2018.

The main insolvency legislation for Northern Ireland is The Insolvency (Northern Ireland) Order 1989and The Insolvency (Northern Ireland) Rules 1991.

How Can We Avoid Insolvency?

It’s important to understand the warning signs of insolvency as early as possible. For the company director, the warning signs are cash flow problems, and an increasing sense of constant firefighting within the business. Perhaps key staff members leave, or a major business contract is lost. When combined with an overall lack of awareness of the company’s financial situation, including vital sales forecast documents, things can quickly spiral out of control.

This is where sound financial management, in conjunction with an accredited bookkeeper can spell the difference between success and failure. While directors may be superb at the core service of their business, it is the challenge of running a company effectively, and especially the working capital cycle, which causes many to slip into insolvency despite an overall viable business model.

How Can We Save a Business from Insolvency?

It is possible to save a business from insolvency via a process known as company rescue. Business rescue, which is a core part of the skills of an insolvency practitioner, may include restructuring the business via a process such as administration, or negotiating a structured repayment plan with creditors such as a company voluntary arrangement.

It is also possible to secure business finance to aid the company through a tight spot, to renegotiate terms with suppliers, or even sell assets which are no longer needed.

These kind of decisions require immense business savvy, but many company’s do survive balance sheet insolvency to emerge with a leaner, more profitable business on the other side.

What’s the Insolvency Process?

When a company in the UK becomes insolvent, it must work with a licensed Insolvency Practitioner (IP) or, in some cases, an Official Receiver. The process depends on whether the insolvency is voluntary or compulsory.

• Voluntary Insolvency: If a business recognises financial distress, it can approach an IP to assess its situation. The IP may recommend either a rescue process (such as administration or a Company Voluntary Arrangement) or a Creditors’ Voluntary Liquidation (CVL), which involves closing the company in an orderly manner.
• Compulsory Liquidation: If a creditor takes legal action due to unpaid debts, the court may order the company’s closure. In this case, an Official Receiver, an officer of the Insolvency Service, is appointed to handle the liquidation process.

Regardless of the route taken, the goal is to either restructure the company’s debts and operations to enable recovery or to close it down while ensuring creditors are treated fairly.

If the company has been liquidated and closed down, it is struck off the register at Companies House. As long as the liquidator’s investigation has found no wrongdoing, directors are free to become directors of another company if they wish, whether in the same or a completely unrelated field. There are restrictions on setting up a new company with the same or a similar name, however, and your insolvency practitioner will be able to advise you further on this.

The Role of an Insolvency Practitioner

An Insolvency Practitioner (IP) is a licensed and regulated professional, often an accountant, responsible for overseeing insolvency proceedings.

The main purpose of an insolvency practitioner is to provide advice to both individuals and businesses to guide them towards the best possible outcome.

Their role includes:

• Assessing Financial Viability: Evaluating whether a company can be saved or if liquidation is the best option.
• Implementing Rescue Strategies: If possible, they may arrange administration or a Company Voluntary Arrangement (CVA) to help businesses recover.
• Managing Liquidation: In cases where closure is necessary, they oversee asset sales and distribute funds to creditors.
• Acting in the Best Interests of Creditors: Ensuring fair distribution of assets and compliance with insolvency laws.

IPs are closely regulated by professional bodies and the Insolvency Service to ensure ethical and legal compliance in handling distressed businesses.

Is an Insolvency Practitioner the Same as a Liquidator?

An insolvency practitioner and a liquidator are related but distinct roles within the field of insolvency.

An insolvency practitioner is a broad term for a qualified individual authorised to deal with insolvency cases. They can act in various capacities depending on the specific circumstances of the insolvency. .

A liquidator, on the other hand, is a specific type of insolvency practitioner appointed exclusively to oversee the process of liquidation – the winding up of a company. In this role, the liquidator is responsible for selling the company’s assets, distributing the proceeds to creditors, and concluding the company’s affairs.

Therefore, while all liquidators are insolvency practitioners, not all insolvency practitioners act as liquidators. Their role varies based on the insolvency process they are managing.

How Much Does an Insolvency Practitioner Cost?

The cost of an insolvency practitioner depends on the complexity of the insolvency situation and the type of procedure undertaken. For simpler processes like a Creditors’ Voluntary Liquidation (CVL) or a Members’ Voluntary Liquidation (MVL), fees can start from around £4,000, but this can vary. More complex procedures like Company Voluntary Arrangements (CVAs) or company administrations typically incur higher fees due to their increased complexity and duration. In CVAs, there’s also an ongoing fee for supervising the arrangement, which is usually taken from the payments made to creditors.

The payment for these services generally comes from the assets of the insolvent company. However, in cases where assets are insufficient, such as in some CVLs, directors might need to cover the costs personally or find alternative funding sources.

Liability for Debts

Director Liability

In most cases, directors of a limited company are not personally liable for business debts. A limited company is a separate legal entity, meaning its liabilities remain distinct from those of its directors and shareholders. If the company becomes insolvent and cannot pay its debts, creditors generally have no claim against the directors’ personal assets. However, there are circumstances where directors can be held personally responsible.

1. Personal Guarantees: Directors who have signed personal guarantees for loans, leases, or supplier agreements remain personally liable if the company cannot meet these obligations. This means creditors can pursue the director’s personal assets, including property or savings, to recover outstanding debts.
2. Wrongful Trading: If a director continues trading while knowing the company is insolvent and unlikely to recover, they could be held liable for increasing creditor losses. Under the Insolvency Act 1986, wrongful trading can result in personal financial liability if the company enters liquidation.
3. Fraudulent Trading: Deliberately misleading creditors, taking on debt without intention to repay, or transferring assets to avoid obligations can lead to personal liability and even criminal prosecution. This is a serious offence and can result in fines, disqualification, or imprisonment.
4. Overdrawn Director’s Loan Accounts: If a director has borrowed money from the company that hasn’t been repaid before insolvency, they may need to repay the outstanding amount, as this is considered a company asset.
5. Misuse of Company Funds: Using company funds for personal expenses or moving assets below market value before insolvency can be classed as misfeasance, potentially making directors personally liable.

Consequences for Director Liability

The consequences of a director becoming personally liable for company debts can be severe, ranging from financial hardship and reputational damage to the loss of career opportunities. These consequences can be categorized into the following, in order of decreasing severity:

1. Financial Liability: The most immediate and direct impact is the obligation to repay the company’s debts from the director’s personal assets, which can lead to severe financial strain and even personal bankruptcy.
2. Disqualification from Directorship: A court order barring the director from holding any directorship or managing a company for a specified period can have a significant impact on their professional career and limit their future business endeavours.
3. Legal Proceedings and Litigation: Directors facing personal liability may be subjected to legal actions and litigation, which can be costly, time-consuming, and emotionally draining. The potential for additional legal penalties or fines further aggravates this aspect.
4. Reputational Damage: The tarnished reputation associated with personal liability can hinder business relationships, limit future investment opportunities, and erode the trust of stakeholders, severely impacting the director’s professional standing.
5. Increased Scrutiny in Future Roles: Even after resolving the initial issues, directors with a history of personal liability may face increased scrutiny and scepticism in future business engagements. Securing directorship positions or obtaining credit might become challenging, affecting their long-term career prospects.

Shareholder Liability

Similar to directors, shareholders of a limited company are generally not liable for its debts if the business becomes insolvent. Shareholders’ financial risk is typically limited to the value of their shares, which could become worthless if the company fails. However, there are certain situations where shareholders may face financial consequences.

1. Unpaid Shares: If a shareholder has agreed to purchase shares but has not fully paid for them, they may be required to contribute the outstanding amount when the company is liquidated.
2. Personal Guarantees: Although shareholders are usually not responsible for company debts, those who are also directors may have signed personal guarantees for loans, leases, or supplier agreements. In such cases, they can be held personally liable for those specific debts.
3. Fraudulent or Wrongful Activity: If a shareholder is also involved in the management of the company and has engaged in fraudulent trading, asset stripping, or misfeasance, they could be held personally responsible for losses caused to creditors. This is more relevant if the shareholder is actively involved in decision-making rather than a passive investor.

Consequences for Shareholder Liability

While shareholders in a limited company are typically protected from personal liability for the company’s debts, certain circumstances can lead to financial and legal consequences if the company goes insolvent. Shareholder liability for company debts is generally limited to the amount unpaid on their shares, but there are exceptions where liability can extend beyond this protection.

1. Loss of Investment: If the company is liquidated, shareholders are the last to receive any remaining assets, and in many cases, there may be nothing left after creditors are paid. This can lead to significant financial loss, particularly if the shareholder has invested substantial sums into the business.
2. Personal Liability in Specific Situations: In certain cases, shareholders may become personally liable for the company’s debts. For example, if a shareholder also acts as a director and is found guilty of wrongful or fraudulent trading, they may be personally liable for the company’s debts. Additionally, shareholders who have provided personal guarantees for company loans or other financial obligations can face direct liability if the company defaults.
3. Reputational Impact: If a shareholder is also involved in the company’s management, stakeholders may perceive them as having contributed to its financial difficulties, which could damage their credibility and future business opportunities.
4. Legal Actions and Liabilities for Unpaid Shares: If a shareholder has not fully paid for their shares, they may be liable for the outstanding amount.
5. Potential Future Scrutiny: Shareholders with a history of investing in or holding shares in insolvent companies may face increased scrutiny in future business ventures. Investors, lenders, or potential partners may be cautious about engaging with them, particularly if the insolvency results from poor management or failure to meet financial obligations.

Trading While Insolvent

Trading while insolvent means a company continues to operate as normal despite being unable to pay debts or where corporate liabilities outweigh assets.

UK company law makes it clear that, after insolvency, a director’s responsibilities are to creditors, not shareholders. As such, any actions taken after becoming aware of the company’s financial situation must be in accordance with this.

If you suspect the company is insolvent, you should seek professional advice immediately. Don’t pay anyone, including yourself, or dispose of any assets. It would be wise to document all actions taken, including your justification for your actions.

If the company goes into liquidation, the Official Receiver or Insolvency Practitioner handling the case has a duty to investigate the actions of directors in the period preceding insolvency. Part of their responsibility to creditors is to check for any evidence of wrongful or fraudulent trading on behalf of directors.

Wrongful Trading

Wrongful trading means that a director continued to trade with the result of failing to minimise the loss to company creditors when they should have done so.

The regulations around Wrongful Trading are laid out in Section 214 of the Insolvency Act 1986.

Section 214 defines wrongful trading as trading when a director “knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation.”

So, while trading insolvent could happen when the company is merely technically insolvent, but easily able to solve that when a big invoice is paid, wrongful trading means the situation is permanent, and the director knows this.

Consequences of Trading Whilst Insolvent

The IP’s investigation will examine:

• whether the director acted responsibly before the company went into liquidation
• whether the director took responsible steps to minimise losses for creditors

Where evidence of wrongful trading can be substantiated, directors can be held personally liable for company debts. This is obviously a more serious situation than mere insolvency, in which a director’s assets would be traditionally protected by the corporate veil.

In serious cases, the Insolvency Service can even issue a director’s disqualification, meaning a ban of up to 15 years from serving as a director.

What To Do If You’re Trading Whilst Insolvent

If your company is insolvent, act immediately by seeking advice from a licensed insolvency practitioner. They will assess your options, whether that’s restructuring or entering a formal insolvency process.

Avoid making payments or selling assets without professional guidance, as this could lead to personal liability. Keep clear records of all decisions to show you’re acting responsibly.

Do not withdraw funds, favour certain creditors, or accept payments for work you can’t complete—this could be seen as misconduct. Taking the right steps early can help protect you and ensure compliance with insolvency laws.

Do You Need Free Limited Company Insolvency Advice?

For a free, no-obligation and confidential discussion with a licensed insolvency practitioner, please do not hesitate to get in touch with our team.

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