Insolvency refers to a situation where a company or an individual can’t pay their debts. In other words, insolvency is when someone has more liabilities than assets. Where a company is insolvent, it’s the directors’ duty to identify this.
Insolvency is a term that can apply to both individuals and companies. Meanwhile, bankruptcy only applies to individuals and doesn’t apply to limited companies or partnerships.
There are other types of personal insolvency apart from bankruptcy, such as individual voluntary arrangements (IVAs) or debt relief orders.
Sole traders, unlike company directors, are personally responsible for their business’ debts.
Sole traders must apply for bankruptcy or enter an Individual Voluntary Arrangement (IVA). An IVA is a legal agreement to repay debts over a period of time.
Depending on the aim of the company, different options are available.
The cheapest way for an insolvent company to save its business is to negotiate payment terms with its major creditors to, for example, delay payment. This doesn’t involve any insolvency procedures. However, it may be difficult for all the necessary creditors to reach an agreement at the same time.
An alternative to reaching a consensual agreement is making formal arrangements with creditors. This option is efficient since it overcomes the hurdle of one creditor vetoing the agreement. Once the voting requirement has been satisfied within a class of creditors, it binds all of them. There are two possible arrangements: the Scheme of Arrangement and the Company Voluntary Arrangement (CVA).
Where the business can still be rescued but the company requires protection from hostile creditor actions, administration is the appropriate option. Companies tend to enter administration first followed by formal arrangements or liquidation.
The distinct features of administration are as follows:
the suspension of creditors’ right to take specific actions without the administrator’s or court’s consent (known as a ‘moratorium’)
the appointment of an administrator who takes over the management of the company
Lastly, where the business can’t be saved, it’ll wind up through the liquidation process. This is usually the last resort for most companies. Its primary function is to realise the company’s assets for cash to repay the debt owed to each creditor. There are two types of liquidation: compulsory liquidation and voluntary liquidation.
The main difference between administration and liquidation is their objectives.
Administration aims to help the company get out of debt to stay in business while liquidation results in closing down the company.
Where the administrator believes that the business can’t be rescued, they must ensure that this process achieves a better result for creditors than liquidation. As such, their role is to maximise the value for creditors by selling business assets. A liquidator’s role, on the other hand, is to generate cash quickly to repay creditors.
A Scheme of Arrangement is an agreement between the company and its creditors that has been approved by the court. It can be used to implement a broad variety of restructuring measures (eg delaying repayment or exchanging debts for shares). Once approved by creditors and the court the Scheme becomes binding on the relevant creditors, including secured creditors.
A CVA is an agreement between a company and its creditors to put in place a timetable for repayment of debts. This allows the company to attempt to trade itself out of financial difficulty. Where this isn’t possible, it’s used to achieve a better result for creditors than if the company was winded up. This option is less costly because it doesn’t involve the court, however, it’s less effective since it’s often only binding on unsecured creditors.
The CIGA reformed insolvency law, introducing new restructuring tools and protection for companies undergoing the insolvency or restructuring process.
The moratorium acts as a payment holiday for specific pre- and post-moratorium debts that fall due during this period. This provides companies with breathing space to develop a business rescue plan by temporarily relieving them from the pressure of creditors.
During this period, directors will remain in charge of the management of the company but will be supervised by a ‘monitor’ (a licensed insolvency practitioner). The monitor is responsible for ensuring that the creditors’ interests are protected. Certain transactions, eg the grant of new security, require the monitor’s approval.
The restructuring plan is a new way for companies in financial difficulties to reach a compromise with their creditors. It is similar to a Scheme of Arrangement, except it’s binding on all creditors including those that voted against it (known as a ‘cram down’).
Suppliers aren’t allowed to end their contracts on the basis that the other party has entered into a formal insolvency procedure, the new moratorium or the new restructuring plan process.
Furthermore, once a company has entered into an insolvency procedure, suppliers can’t exercise their termination rights that arose from events that took place before the start of the insolvency process.
Suppliers can only terminate the contract if they obtained:
consent from the company
consent from the court
consent from the administrator, liquidator or administrative receiver
Some supply contracts are excluded from the prohibition.