Insolvency – a director’s dilemma

When a company is in financial difficulties it is essential that the directors seek and obtain competent and professional advice.

Once the prospect looms that the company may fail and that the directors may be called on to fulfil obligations under personal guarantees, it becomes more difficult for directors to make rational judgements on the business they are running.

The most difficult decision for any director is whether the company should stop trading and, if so, when.

Here we look at a situation from the point of view of a fictional company director.

When is a company insolvent?

There is no precise legal definition of insolvency and it is still a largely a matter of judgement. It is therefore arguable as to the exact moment when a company becomes insolvent. A firm is normally regarded as insolvent on two counts:

• n When its liabilities exceed its assets.
• n When it is unable to meet its liabilities as they fall due.

When should I act?

In view of the problem in determining precisely when a company is insolvent, directors should seek advice and be extremely careful about the liabilities their company incurs, once they are aware that financial problems exist. Directors, particularly those controlling and possibly owning smaller family businesses, often fail to appreciate the alternative courses of action open to them, and the consequences of these both for the company and for themselves.

What are the options and how do they protect me?

The options are:

• Take corrective action within the existing company with the aim of alleviating its cash shortage.
• It may be possible to arrange a sale or merger with a third party that has greater financial resources to assist the firm with its difficulties.
• If the cash position is so critical that continued trading is no longer possible, the directors will have to either come to an informal or voluntary arrangement with creditors in an attempt to resolve the company’s difficulties or take steps to arrange for the appointment of an administrative receiver, an administrator or a liquidator and follow the appropriate formal insolvency procedure.

What steps can I take now to futureproof the problems?

The directors’ duty is to preserve the status quo for the benefit of creditors and shareholders until the company’s future is determined

A common feature of firms that experience financial difficulties is that accounts are poorly maintained. Accurate and up-to-date accounting records are never more vital and necessary than when a company is running out of money.

Although up-to-date information will not of itself necessarily alter the ultimate decision, its presence allows alternative options to be considered, thus giving the directors the opportunity to determine the company’s future, rather than having a solution imposed.

When would I be liable if I continue trading in the face of financial difficulties?

If there is a real risk that creditors may not be paid and trade is allowed to continue, however well intentioned the decision may have been, any bills incurred during this period and not subsequently paid may be held to be the personal responsibility of the directors.

The directors’ duty is to preserve the status quo for the benefit of creditors and shareholders until the firm’s future is determined.

How can I foster a sympathetic hearing from creditors?

This is more likely to be the case if the proposals are presented and supported by an insolvency practitioner. Throughout this period, the directors must have regard to the potential penalties of being found guilty of either wrongful trading or trading fraudulently while insolvent.

Although efforts will be concentrated on the resolution of the short-term cashflow difficulties, the directors should not forget to consider the viability of their company in the longer term. If the decision is made that the company should continue to trade, there must be clear evidence of a real prospect that all creditors will ultimately be paid.

If there is no such prospect, apart from the possible conversion of work in progress into finished stock (assuming finished stock can be sold for a price that will cover the cost of completion), trading may have to cease immediately.