Trading while insolvent
Trading while insolvent is unlawful in a number of legal systems, and may result in the directors becoming personally liable for a company's debts.
- Wrongful trading – Section 214
- Transaction at an undervalue – Section 238
- Preferences – Section 239
- Extortionate credit transactions – Section 244
A limited company becomes insolvent when it can no longer pay its bills when due, or its liabilities—including contingent liabilities such as redundancy payments—outweigh the company’s assets. This is a critical point in the lifespan of a company as it denotes when the directors responsibilities change from the shareholders to the creditors. It also means that the directors need to be extremely careful when considering whether to continue to trade, or not. Any director who knows that the company is insolvent and makes the decision to continue to trade, and in doing so increases the debts of the company can be made liable for the company debts.
Company voluntary arrangement
An insolvent company can enter into a company voluntary arrangement (CVA). The CVA is a form of composition, similar to the personal IVA (individual voluntary arrangement), where an insolvency procedure allows a company with debt problems or that is insolvent to reach a voluntary agreement with its business creditors regarding repayment of all, or part of its corporate debts over an agreed period of time. The application for a CVA can be made by the agreement of all directors of the company, the legal administrators of the company, or the appointed company liquidator.
A company voluntary arrangement can only be implemented by an insolvency practitioner who will draft a proposal for the creditors. A meeting of creditors is held to see if the CVA is accepted. As long as 75% (by debt value) of the creditors who vote agree then the CVA is accepted. All the company creditors are then bound to the terms of the proposal whether or not they voted. Creditors are also unable to take further legal actions as long as the terms are adhered to, and existing legal action such as a winding-up order ceases.
During the CVA, payments are made in a single monthly amount paid to the insolvency practitioner. The fees charged by the insolvency practitioner will be deducted from these payments. The company is not required to fund any further costs.
Companies can benefit from a CVA in a numerous way:
- Improves cash flow, quickly.
- Stops pressure from tax while the CVA is being prepared.
- Stops a winding up petition and gets it adjourned.
- Can rapidly cut costs.
- Can terminate employment, leases and onerous supply contracts.
- Terminates property lease obligations.
- Terminates directors and/or managers contracts.
- Removes employees with no redundancy payments of lieu of notice costs.
- Terminates onerous customer/supplier contracts.
- Board and shareholders generally remain in control of the company.
- Has much lower costs than administration and is not publicly announced like administration is.
- Is a good deal for creditors as they retain the customer and receive some of their debt back over time.
Within a CVA, directors retain control of the business.
Directors have a legal duty to act properly and responsibly and to prioritise the interests of their creditors. The risks of liquidating a business may include disqualification from acting as a director of other companies and also personal reputation as a director. In an extreme case directors can be found personally liable to contribute towards the shortfall in payments to creditors. However, as a Company Voluntary Arrangement is in the best interests of creditors, there is no investigation into the director’s conduct.
Under a Company Voluntary Arrangement directors are not personally liable for the company’s debts, unless they have given a personal guarantee. Even if a director has provided a guarantee, a CVA will mean a director is only liable if the company cannot pay and by continuing in business there is a retained a source of income.
In most legal systems, the liability in respect of other transactions only extends for a certain period of time prior to the company going into liquidation. In the UK, directors are exposed in respect of transaction at an undervalue, preferences, and extortionate credit transactions if the transaction occurred: a) while the company was insolvent; and b) within 2 years before the onset of liquidation if the transaction was with a connected person, and 6 months if the transaction was with an unconnected person.
Directors who continue to trade while insolvent may face disqualification under the Company Directors Disqualification Act 1986. Under the provision of this act, when a company goes into liquidation, the liquidator must make a report to the Disqualification Unit of the The Department for Business, Innovation and Skills (BIS) on the conduct of all directors. If the liquidator has come across conduct which makes the director unfit to be involved in the management of a company in the future (which things would include trading while insolvent) the Department for Business, Innovation and Skills will apply to the Court for an order disqualifying the director or directors from acting as a company director for a certain period.
Many other countries have similar laws, often referred to as 'insolvent trading' or wrongful trading.
- "Insolvency Act 1986" (PDF). Insolvency.gov.uk. UK Statutes Crown. Retrieved 29 July 2014.
- "How to use Company Voluntary Arrangements to save your business" (PDF). Africa News. Retrieved 29 July 2014.
- "Company Directors Disqualification Act 1986". legislation.gov.uk. Crown. Retrieved 30 July 2014.