Company insolvency: the options and what directors must do

A company is insolvent when it cannot pay its debts. The Insolvency Service describes two ways that happens: the company cannot pay its bills when they become due, or it has debts that are larger than the value of its assets.

Insolvency is a legal and financial position, not a verdict on the business. A company can be insolvent and still be viable, which is why some of the formal options below are designed to keep it trading.

It is also different from bankruptcy, which is the term used for individuals. A limited company goes through company procedures such as administration, liquidation or a company voluntary arrangement.

You test for it in two ways, and the Insolvency Service uses the same two tests when it examines failed companies: the cash flow test and the balance sheet test. Either one failing is a warning sign.

The Insolvency Service suggests directors use the tests whenever they have concerns about solvency. A rolling cash flow forecast is the practical way to see a shortfall coming, and our guide to cash flow problems covers the early signs in more detail.

Directors must put creditors’ interests ahead of their own and the shareholders’. GOV.UK sets out what that means in practice, and it applies from the point insolvency is a possible outcome:

• Protect any assets the company has.
• Treat all creditors the same, without favouring one over another.
• Do not make creditors’ financial position worse.
• Consult an insolvency practitioner, or consider appointing one.

The law treats someone as a director if they perform a director’s duties, even if they are not formally appointed. Directors who are unsure about an action they are considering should take professional advice before they take it.

Directors are not normally personally responsible for company debts, but they can become liable if the company has been mismanaged. GOV.UK names wrongful trading, fraudulent trading, misfeasance and compensation orders as examples.

Wrongful trading is the one most directors worry about. Under section 214 of the Insolvency Act 1986, a court can order a director to contribute to the company’s assets if the company went into insolvent liquidation or administration and, before that, the director knew or ought to have concluded there was no reasonable prospect of avoiding it.

There is a defence: the court cannot make the order if the director took every step to minimise the potential loss to creditors that they ought to have taken. The test is what a reasonably diligent person with the director’s role, knowledge and experience would have done.

Separately, a director who signed a personal guarantee is liable under that agreement if the company defaults or becomes insolvent. The British Business Bank describes a personal guarantee as a legally binding agreement making the director personally liable for repaying the loan in those circumstances.

The main formal options are a company voluntary arrangement, administration and liquidation, and which one fits depends on whether the business can be rescued. An insolvency practitioner can explain the choices for your company.

We cover the first in detail in our guide to company voluntary arrangements. A creditor who holds a floating charge over the company’s assets can also appoint an administrator, so a lender’s security can shape which route is available. Our guide to the debenture explains what that security looks like.

Administration tries to rescue or sell the company, while liquidation ends it. In administration the administrator runs the business, and GOV.UK says it can end with a rescue deal, a sale of the business as a going concern, a sale of assets followed by closure, or closure if there is nothing to sell.

In liquidation the company stops doing business and employing people, and its assets are used to pay its debts. The liquidator takes control, and in a creditors’ voluntary liquidation acts in the interests of the creditors, not the directors.

A members’ voluntary liquidation is different again. It is for a solvent company that can pay its debts, for example when the owner is retiring, so it is not an insolvency option.

Once a liquidator or administrator is appointed, directors lose control of the company and must co-operate fully. They must give the office-holder the information and paperwork they ask for, attend meetings and answer questions, and a court can order a director to comply.

• The office-holder reports on the directors’ conduct to the Insolvency Service, and a director whose conduct is found unfit can be banned for 2 to 15 years or prosecuted.
• For 5 years after an insolvent liquidation, directors must not be involved in a company or business using a prohibited name, which includes the old registered name, trading names and similar names, unless an exception applies.
• Employees who are made redundant by an insolvent employer can apply to the government for redundancy pay, unpaid wages, holiday pay and notice pay, within caps and time limits set by GOV.UK.

Starting again is not wrong in itself. The Insolvency Service lists what it treats as misconduct, including abusive phoenixism, so take advice before launching a new company after a failure.

Often it can be reduced, if action is taken early. The Insolvency Service says many insolvencies each year could potentially be avoided with the right action, and lists keeping proper financial records, paying the correct tax on time, spotting early signs of distress and getting sound professional advice.

If the problem is a tax debt, HMRC Time to Pay and our guide to HMRC debt set out the options. If a creditor has already threatened court action, read about a winding-up petition without delay.

Capzy is a credit broker, not a lender, and is paid by the lender. We do not give insolvency advice and we cannot help a company that is already insolvent borrow its way out: lenders decide case by case, and some schemes, such as the Growth Guarantee Scheme, exclude borrowers in relevant insolvency proceedings.

If your business is under pressure but is still meeting its debts, you can check your funding options with a soft search that does not affect your credit score. Borrowing to cover ongoing losses only postpones the problem, so speak to an insolvency practitioner if you are not sure where you stand. You can also compare providers in our lender directory.