A company is said to be insolvent when it defaults on due payments or has insufficient assets to cover outstanding liabilities. It is likely that in the first situation a company would enter into liquidation unless it was rescued financially. The second scenario, which is sometimes referred to as ‘balance sheet insolvency’, allows a company to avoid possible liquidation through negotiation with its creditors.
The systems and processes of insolvency law differ between countries. Broadly speaking, a country’s response to insolvency is either ‘creditor friendly’, such as in the UK, where providers of finance are protected against a debtor’s insolvency, or ‘debtor friendly’ where the debtor’s attempt to rehabilitate and stabilise a business is given priority over a creditor’s claim of repayment, which is what happens in the US under Chapter 11 of the US Bankruptcy Code. In this article, we focus on insolvency procedures in the UK.
It is the director’s responsibility to know whether a company is insolvent. If the company continues to trade in such a situation the director can be held responsible for wrongful trading, which is illegal under the UK Insolvency Act of 1986. The procedures open to an insolvent company in the UK are as follows:
This rescue procedure is designed to allow a company to carry out financial restructuring or to begin selling assets to achieve a better result for creditors than liquidation.
Company voluntary arrangements (CVAs) allow an insolvent company to restructure its debt once it has received creditor approval.
Whereas administration deals with the collective interests of creditors, a receiver is appointed by a secured creditor to look after his/her own interests.
This is a termination procedure whereby a liquidator is appointed to convert a company’s assets into cash to pay back creditors.
Order of repayment
There are various types of creditors and these have different levels of priority when it comes to distributing a company’s assets. In descending order of importance, these include:
These have a legal charge over the assets owned by a company such as land, machinery and intellectual property.
Administrators and liquidators are reimbursed for the cost incurred for carrying out their services.
This category includes employees that are owed wages, holiday pay and pension contributions from the company. It previously included tax liabilities, but the 2002 Enterprise Act abolished ‘Crown preference’ for such debts, to the benefit of unsecured creditors.
Floating charge asset holders.
A percentage of the sale of floating charge assets, such as stock, is reserved for unsecured creditors, subject to a maximum value of £600,000. This is known as the ‘prescribed part’. Any surplus funds left from this sale will be distributed to any remaining floating charge holders.
Any creditor who does not hold security.
The lowest ranking in terms of insolvency.
The primary sources for UK insolvency law are the Insolvency Act of 1986 and the Enterprise Act of 2002, which came into force on 1st April 2004. There is also a policy document that is specific to directors called the Company Directors Disqualification Act of 1986. More recently, on 23rd February 2009, the UK government introduced the Banking Act, which introduces administration and insolvency procedures for banks.
In 2002 the EU introduced the European Commission Regulation on Insolvency Proceedings, which was designed to improve the efficiency of cross-border insolvency proceedings with the EU.