When is a company deemed insolvent? Important information for company directors

As a director of a limited company, it is important to stay on top of the company’s financial position and monitor its solvency on an ongoing basis.

Allowing a company to continue trading whilst insolvent exposes a director to potential personal liabilities and other consequences. As soon as you suspect that your company may be on the verge of facing financial difficulty, it is best to seek external professional advice at the earliest opportunity.

So, how does a director ascertain when a company is insolvent (or headed in that direction)? This is a deceptively simple question that has seen plenty of litigation in courts (which in turn has spawned many different tests to determine insolvency, depending on the context).

Knowing when exactly your company enters an insolvent state is essential, not just to the future of the company. This knowledge is crucial to determining:

• when your duty as a director to minimise the loss to creditors arises, failing which you may be at risk of incurring personal liability or committing an offence
• at what stage you must decide to cease trading, and if so, which insolvency procedure the company should enter.

When your business is struggling to stay afloat, it is understandably difficult to determine when and whether the company has reached a point where it is considered “insolvent” in the legal context, and you can no longer realistically see “light at the end of the tunnel” to justify continued trading.

The law – when is a company insolvent?

Under the provisions of Section 123 of the Insolvency Act 1986, a company is deemed “unable to pay its debts” (the concept used to describe “insolvency”) where:

• a statutory demand requiring the company to pay the sum due has been served, and the company has, for three weeks or more, neglected to pay, secure or compound the debt
• a creditor has attempted execution or another enforcement process against the company in respect of a debt without success
• it is proven to the satisfaction of the court that the company is unable to pay its debts as they fall due (the cash flow test)
  • even if a company is able to pay the debts that are due at present, it will still fail the cash flow test if it does not (or will not) have the resources to discharge debts that will fall due in the “reasonably near future”
• it is proven to the satisfaction of the court that the value of the company’s current assets is less than the amount of its present and future liabilities (the balance sheet test)
  • this is not a strictly mathematical test, nor is it a simple subjective question of whether a company has reached “the point of no return”. Instead, the test requires a detailed consideration of the particular circumstances of the company as well as the prospective or contingent liabilities in question.

The courts have further confirmed that passing one test won’t exempt the company from passing another, i.e. a company that is solvent on a cash flow basis will not escape being deemed unable to pay its debts if it is insolvent on a balance sheet basis, and vice versa.

Given the above, it is clear that a company should always strive to maintain up-to-date financial information at all times. Company directors should closely monitor a company’s ability to service financial commitments (both present and future).

The risks – what happens if your company is unable to pay its debts?

Although a company may have reached the point of being considered insolvent pursuant to the above-described test/criteria, there may still be a chance for the business to survive. Professional advice should be sought urgently to consider rescue options such as informal arrangements with creditors, formal ‘Time To Pay’ arrangements with HMRC (TTP), Company Voluntary Arrangements (CVA) or Administration.

If the company cannot be rescued, then it should be placed into liquidation (either through the courts, which is known as ‘compulsory liquidation’ or through ‘creditors’ voluntary liquidation (CVL)’ which is a process initiated by the directors but with creditors having the decision-making power.

A company verging on or having descended into insolvency triggers additional responsibilities on company directors. Acting in the best interest of the creditors of the company becomes paramount and should be considered before the best interests of the company.

A director acting in breach of his duties as a director may face subsequent action with consequences potentially including personal liability for losses suffered by the company and being disqualified from being a director of a limited company.

Don’t wait – get advice ASAP

It is safe to say that timing is crucial in insolvency: a director of a company that is no longer able to pay its debts (or is on the brink of insolvency) should seek professional advice at the earliest opportunity.

Contact our Restructuring and Insolvency solicitors today

If you need legal assistance in relation to insolvency, corporate recovery and restructuring, please do not hesitate to get in touch with a member of our Insolvency team or complete this online enquiry form, and we will be happy to assist you with your enquiry.