Corporate Insolvency Overview

  Background of Corporate Insolvency - the aim of introducing UK corporate insolvency laws (such as the Insolvency Act 1986 and the Enterprise Act 2002), was to replicate the legal principles enshrined in the Chapter 11 [1] bankruptcy laws of the USA.  Back in the 1970's, if an organisation got into financial debt problems, its Company Directors could apply for Chapter 11 to keep creditors at arms length, while debt restructuring solutions were attempted to save the company.  For larger multinationals this typically involved a debt to equity swap. Chapter 11 prompted the Cork Committee [2] to recommend changes into the legislative handling of UK corporate insolvency; hence the Insolvency Act 1986 was conceived and made law.  Its fundamental aim is that of corporate rescue; to save struggling businesses from liquidation or receivership.  

The UK Insolvency framework remains a relatively new regime, aimed at the rescue of companies 'in court', as well as facilitating stakeholder negotiation out of court.  It also provides protection against aggressive actions taken on behalf of creditors.  The stress, cost and expense of a legal dispute between a company and its creditors is one neither side usually wishes. Unfortunately, by the time a company if forced to resorting to legal measures implemented via a court, it is usually too late for the company to be turned around and saved.  At that point, the focus in court situations tends to shift towards to carving up the diminishing company assets between creditors, as opposed to bringing in expert management help or re-financing.

Small Business Debt - In the context of a small business, (typically with Sole Trader or Limited Liability Company status), Shareholders or Directors that have accumulated unwanted spiralling debt, may be reliant on bank loans and overdrafts. Usually banks ask for tangible security (a personal guarantee).  As the business is sometimes the sole source of income for its owner, if business debt cannot be repaid, they may lose their personal assets i.e. their house or car.  In situations where these debts simply cannot be repaid, business owners may find no financial means off keeping the business alive as a going concern .As a director of a limited company that might be in trouble, it is your legal duty to make sure that the business is not a trading insolvently. Under the Companies Act 2006, Directors have to "consider or act in the interests of creditors of the company. (172[3]).   It is therefore vital for a Director to judge and document, when professional external advice should be called in, to ensure creditors cannot also blame individual Directors for business failure.

When is My Business Insolvent? - In the context of insolvency for businesses, it is broadly similar to that of individual insolvency. There are two simple accounting based tests to determine whether or not a business is insolvent.  The first is the 'Cash Flow Test'. This is the inability to repay business debt when the debt is due. Trade creditors would need to demonstrate to a UK court that they are owed more than £750 pounds and a fall statutory demand was issued and not repaid. The statutory time 'period' on the formal invoice / demand for repayment is 21 days. If the business of has reached this level of the insolvency then bankruptcy would normally follow.   Secondly, there is the the 'Balance Sheet Test'.  This is the point at which liabilities of the business are greater than the value of its assets. A successful and solvent business runs its balance sheet on a 'going concern' basis (in accordance with formal small business accounting procedures). However the balance sheet of a business that is going through one of the various for more insolvency procedures (details which are listed below), is prepared on a 'breakup' basis. In other words, the value of assets such as property, machinery and equipment is based on the value they would expect to achieve at an auction.  This is likely to be at a massively reduced rate compared to market value. If trade creditors are aware a business is going through some kind of formal insolvency procedure, it is highly probable they are unlikely to extend their credit facilities in the future, adding more cash flow worries and ultimately making business failure more probable.

Is there Light at the End of the Tunnel? - of course, not all businesses that have cash flow problems fail. Many survive, adapt and continue through difficult economic periods. Small business survival depends as much upon the attitude, character, energy, determination and experience of the owner, as it does having the best strategy, products or loyal customers.  Company Directors has a moral and legal duty not to abandon a company in financial distress, but attempt to save it on behalf of the company and its creditors.  There are penalties such as wrongful trading which can lead towards personal liability or disqualification.  It is always best to seek legal advice and ensure a full audit trail is available.  Even it it appears inevitable that the company cannot be saved, Directors are best placed with a good historic knowledge of the problems to assist external parties in minimising losses for creditors and shareholders.  If you require professional advice and information regarding debt management options, there are a range of organisations to choose from.   These these include:- free debt counselling helpline services, commercial debt management companies, financial advisors, accountancy firms and legal specialists.

External Links and References

1. Chapter 11 - from US Courts site (Reorganization Under the Bankruptcy Code)

2. Cork Committee - summary from the Official Documents Archive website

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