How to deal with insolvency

When a business is facing solvency issues, the scope of options available decreases as financial distress increases. Directors need to consider the options available and whether continuing to trade is in the best interests of the company and its creditors.

Acting early can increase the probability of a turnaround and lessen the likelihood of more extreme measures later.

Directors should address solvency issues early by undertaking a realistic assessment of the business’ ability to recover. Early action can help reduce risk to creditors and the board.

Directors may be optimistic about the future but they may be putting themselves and others at risk.

By trading while insolvent, a company is effectively trading with creditor’s funding which is being put at risk. New creditors may also be exposed to loss that they would not have been if the company had liquidated earlier. If the company fails, its creditors may go unpaid and may become insolvent themselves.

Directors should also be mindful of breaching their statutory duties which may lead to personal liability.

The director duties under the Companies Act that are most relevant to insolvency scenarios are:

1. Act in good faith and in the best interests of the company.
2. Not allow the company to trade in a manner likely to create substantial risk of serious loss to the company’s creditors (i.e. trade while insolvent).
3. Not incur an obligation unless they believe the company will be able to perform the obligation when required to do so.
4. Exercise their powers/duties with the care, diligence and skill that a reasonable director would exercise in their circumstances.

The most common breach of these duties that leads to personal liability is allowing a company to trade while it is insolvent in circumstances where it would not be objectively reasonable to continue trading.

The fine line between commerical risk taking and reckless trading - what is required is an assessment of the company's prospects.

When a company enters troubled waters its directors should carry out a sober assessment as to the company’s actual and prospective financial position and performance, and the potential for remedying the insolvency. This assessment is not a one-off exercise and instead requires consistent and regular monitoring of whether the company is financially viable and:

1. Whether continuing to trade is in the best interests of the company and its creditors.
2. Whether the company has the ability to trade out of its distressed position.

If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of the Companies Act, absent an agreement with creditors through a formal or informal restructuring process.

Directors should seek advice from a suitably qualified legal advisor and/or insolvency practitioner that addresses their specific circumstances and provides a view on what options should be considered.

Read the Solvency Guidance report in full.  

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