One of the most difficult and important questions for a Director of a company to answer honestly is whether their company is insolvent. For a Director of a family run company there is the additional burden of pride, the company may have been handed down through the generations and nobody wants to be in charge when insolvency looms.
In previous articles on this website the issue of a Director’s personal liability has been examined. A company Director who fails to acknowledge the insolvency of the company may well end up being personally liable for the company debts.
Ordinarily a Director is under a duty to act in the best interests of the company and its Shareholders. However, once a Director forms the view that the company is insolvent there is a duty to act primarily in the interest of the company’s creditors. A Director who allows a company to continue to trade and incur liabilities at a time when they know or ought to have known that there was no reasonable prospect of the company avoiding an insolvent liquidation (or an insolvent administration) may incur personal liability for the losses sustained by the company’s creditors in an action against them known as wrongful trading.
Often it is difficult to identify the precise point at which a Director knows or should have known that there is not a reasonable prospect of avoiding an insolvent liquidation or insolvent administration. In such situations where Directors have concerns about the solvency of their company they are well advised to monitor and review the financial state of the company on a regular basis and to consider how their decision making impacts on potential creditors.
There are still a number of companies and businesses operating on the brink of insolvency and it may well be one of those businesses which goes into insolvency and causes cash flow problems for your company, this interruption to planned cash flow may then ultimately make what was a solvent company suddenly insolvent. This is particularly the case around quarter rent days.
There are three simple key indicators which allow you to identify as a Director whether your company is insolvent.
The first test is known as a cash flow test. Essentially the question the Director needs to ask is can my company pay its debts as they fall due? An inability to pay suppliers on time, and often requesting longer credit periods, may well be a sign that the business is insolvent. Likewise, whilst your business may not be cash flow insolvent one of your debtors may well be. It is important to recognise that a request for a longer credit period or a debtor not paying on time is an indication that they may have financial issues which ultimately impact on your business.
The second test is the balance sheet test. This considers whether a company’s assets exceed all its liabilities. There is a legal requirement on Directors to present up to date accounts of the business and therefore a Director should be able to establish quite easily whether the company has sufficient assets to cover its liabilities. In the event they do not, a Director should seek advice as to whether they should continue to trade. They need to ensure that they minimise the risk to creditors with a view to ensure that unlawful trading does not occur.
Company Directors also need to consider the litigation test. Whilst the level of debt required to present a bankruptcy petition against an individual has been increased to £5,000 a creditor that is owed more than £750 by a company can serve a formal written demand in respect of that unpaid debt. It is usual for that demand to be in the form of a statutory demand and a Director whose company has been served with a statutory demand or formal written demand has a period of twenty-one days in which to settle the debt or could be faced with a creditor petitioning to wind up the company. Likewise a Director who is constantly receiving threats of litigation against the company ought to consider in detail the solvency of the company and then apply the cash flow test and balance sheet test referred to above.
If a Director believes that their company is approaching insolvency then rather than adopting the ostrich position of putting their head in the sand, they should realise that the situation does not necessarily mean that it is the end of the road for the business. There are options available to rescue companies and it is true to say that the earlier a Director intervenes to rescue a company with the assistance of a specialist insolvency solicitor and/or Insolvency Practitioner the more options there are open to that company and the better the chance of avoiding liquidation.
Mayo Wynne Baxter Solicitors are able to advise Directors as to the issues that they face as well as the appropriate course of action for their company. We have worked closely with Insolvency Practitioners in the past to implement rescue procedures for businesses which have then allowed the company to successfully continue trading.
If the above has raised any issues or concerns for you please feel free to contact Darren Stone, Head of Insolvency on 01273 775533.