Company directors have exceedingly responsible jobs – they are duty-bound to act in the best interests of the company and, if the company is listed on the stock exchange, are accountable to its shareholders. They routinely have to make difficult and important decisions that affect the profitability and growth of a business and ensure that the company is financially stable.
If a company runs into financial difficulties by taking on too much debt, a director must decide whether to continue to trade and for how long, or whether the company should declare insolvency. Directors who fail to acknowledge insolvency can be liable, personally, for company debts.
Insolvency arises when a company has insufficient assets to cover their debts or cannot pay their debts on time. But it’s not always easy to identify the exact time when insolvency should be declared. Some companies operate on the brink before finally pulling through and becoming profitable again.
More information about the laws and regulations surrounding the insolvency process can be found on the government website here.
When company directors have concerns about the solvency of the business, it’s their duty to monitor and examine the financial records regularly and try to rectify the problem. The decisions they make must be carefully considered, as they can significantly impact on their employees and those the company owes money to.
Here, Dakota Murphey, working alongside law firm George Ide who were consulted for some of the information in this article, gives 3 main indicators that determine whether a company should declare insolvency:
- Cashflow Test
Here, a director must ask himself if the company can pay its debts when they fall due after studying the company accounts. One sign of a business that may be on the brink of insolvency is if they’re unable to pay their suppliers on time and have requested an extended credit period. Similarly, if one or more debtors cannot pay a company on time, this can have a substantial impact on the business which could lead to its insolvency.
- Balance Sheet Test
The Balance Sheet Test reveals whether a company’s assets exceed all of its liabilities. Directors are legally required to present up-to-date accounts and must ensure that that the company has sufficient assets to cover all liabilities. If they cannot do so, they’re obliged to consider whether they should continue to trade or declare insolvency. Directors must ensure that the risk to creditors is minimised and that unlawful trading is avoided.
- Litigation Test
It’s vital that directors consider the Litigation Test. Recently, the level of debt required to present a bankruptcy petition against an individual was increased to £5,000, but a creditor who is owed more than £750 by a company can make a written demand in respect of that unpaid debt. Thereafter, a company who’s been served with a formal written demand has just 21 days to pay, and if they don’t, the creditor can lodge a petition for the company to be wound up.
At the same time, directors of companies who are unable to pay creditors and are constantly receiving threats of litigation, should as a matter of course investigate, in detail, the solvency, or otherwise, of the company, by applying the Balance Sheet Test and Cashflow Test as explained above.
It’s interesting to note that in the event of a company insolvency, the law in the UK grants the greatest protection to banks and other parties that contract for a ‘security interest’. For example, if, say, a large industrial machine is secured by means of a ‘security interest’, then the holder of the security interest is entitled to seize and, if required, sell the equipment in order to discharge the debt that the security interest secures. The company providing the security is thus given priority over other creditors, including the company’s own employees, and other businesses that may have traded with the insolvent company.
Head in the sand?
Rather than sticking their heads in the sand ostrich-like, directors who think their company may be teetering on the brink of insolvency should not turn a blind eye but face the consequences and make some tough decisions. The situation does not necessarily mean that it’s the end of the road – many companies who’ve been declared insolvent have started up again and become successful.
If it can be proved that a director has been negligently trading a company that should have been declared insolvent, they can be sued for a breach of duty, or disqualified from holding directorships. The earlier a director accepts there’s a problem and that the company needs help and takes the necessary steps to rescue it, the better. There are options available and with the assistance of a specialist insolvency solicitor, or a professional like an insolvency practitioner, insolvency can sometimes be avoided.