A company is considered to be insolvent under English law if it is unable to pay its debts.
There are two tests for corporate insolvency:
- the cash-flow test: is the company currently, or will it in the future, be unable to pay its debts as and when they fall due for payment?
- the balance sheet test: is the value of the company's assets less than the amount of its liabilities, taking into account as-yet uncertain and future liabilities?
If the evidence proves that the answer to either of these questions is yes on the balance of probabilities, then the company is deemed insolvent under English law. Furthermore a company is deemed unable to pay its debts, and therefore insolvent, if:
- a creditor who is owed more than £750 has served a formal demand for an undisputed sum at the company's registered office and the debt has not been paid for three weeks; or
- a judgement or other court order has not yet been satisfied.
What are the consequences of a company's insolvency?
Depending on the facts of a given case, the following consequences of corporate insolvency may apply:
- increased risk of personal claims and directors' disqualification. The directors of an insolvent company have a duty to put the interests of creditors ahead of all other interests. If they continue to trade the company's business beyond the point when insolvent liquidation becomes unavoidable they risk serious personal and professional consequences;
- heightened risk of formal insolvency procedure - see below;
- a winding-up petition may be issued against the company by a creditor who has served a statutory demand for payment in the circumstances described above. This may result in the company being placed into compulsory liquidation;
- any disposal of assets will be void once a winding-up petition has been presented. If a company wishes to sell goods or make payments for supplies while a winding-up petition is in progress, it must first obtain authorisation from the court;
- default under banking facilities. Insolvency and the instigation of a formal insolvency procedure will almost certainly be considered an event of default under any banking facilities held by the company, and will entitle the lender to take steps to enforce any security it holds;
- withdrawal of support from suppliers and customers. Insolvency may also be a trigger event, entitling suppliers and customers to take protective measures under contracts with the company. This can include termination of contracts and other enforcement measures;
- transactions can be reviewed and reversed. If an insolvent company is subsequently placed into liquidation or administration, any transactions the company entered into for a period of up to two years before the insolvency procedure began can be reviewed on application by the appointed insolvency practitioner, and reversed if the company was insolvent at the time and the transaction took place for either less than the market value or gave certain creditors priority over others. Fraudulent transactions are also reviewable without time limit.
What are the available insolvency procedures?
A company can be placed into a formal insolvency procedure by its directors, shareholders, creditors or the court. How it is done will depend on the facts of each case and the procedure involved. There are a limited number of UK corporate insolvency procedures, each of which is run under the control of an appointed insolvency practitioner (IP) who is professionally qualified and licensed.
Administration - this is a collective corporate rescue procedure run for the benefit of all creditors, under which the company's assets are protected by virtue of a statutory 'moratorium', or stoppage, of any forms of creditor action. Administrators have the power to trade on the insolvent business and may look to find a buyer for it. Administrations are commonly associated with 'pre-packaged' insolvency. For more information, please see our separate OUT-LAW Guide to Pre-packaged insolvency sales.
Administrative receivership – this is a process under which the holder of a floating charge against the company which pre-dates 15 September 2003 appoints a receiver-manager to sell the company's assets for maximum value in order to pay off its secured debt. The floating charge holder will usually be a bank. This procedure has been largely superseded by administration as a result of changes in the law.
Administrative receivers have no authority to pay unsecured creditors. Doing this will usually require a subsequent liquidation, although administrators can also make such payments with court approval.
Company Voluntary Arrangement (CVA) - this is a binding form of agreement between a company and its creditors which is legally regulated. Under a CVA, creditors will typically agree to a reduced or rescheduled debt arrangement which will allow the company to survive. CVAs are sometimes used in conjunction with the administration procedure.
Scheme of arrangement – this is a compromise or arrangement between a company and its creditors or members. It is similar to a CVA in many respects, although it must be approved by a court. The process is more complicated than a CVA, and will usually only be used for large companies and those with a significant number of classes of creditor or shareholder.
Whether unsecured creditors can be repaid where a company enters into a CVA or scheme of arrangement will be determined by the related documentation. These arrangements rarely interfere with secured creditors' rights.
Liquidation – this is the collective process by which a company is ended by converting all of its assets into their cash value and distributing them to shareholders if the company is solvent or creditors if the company is insolvent. The liquidator must also examine the directors' conduct, and take action if appropriate.
When a company is placed into administration or liquidation, creditors are repaid in the following descending order of priority depending on the amount of cash available:
- secured creditors' claims (fixed charge realisations);
- expenses relating to the administration or liquidation;
- Insolvency Practitioners' fees;
- preferential creditors' claims, including employee claims;
- prescribed part (see below);
- secured creditors (floating charge realisations);
- unsecured creditors' claims – usually distributed by a liquidator;
- shareholders – very unusual, otherwise the company would not be insolvent.
The 'prescribed part' included above is an amount which must be set aside by the administrator or liquidator for the benefit of unsecured creditors. It is calculated as a proportion of the amount of assets which are subject to any floating charge created after 15 September 2003. The size of the fund will depend on the value of the assets, but can be up to a maximum of £600,000.