Trading while Insolvent: What are the Legal Consequences Directors can Face?
No one sets out in business expecting the company to become insolvent. However, in an increasingly challenging trading environment, many companies will unfortunately experience issues with cash flow, increased costs of doing business, and changing consumer preferences, all of which have the potential to threaten the ongoing viability of the business. If the situation continues, a financially challenging situation can quickly escalate to one of insolvency.
An insolvent company is not necessarily doomed to failure. Insolvency is not always permanent and there are a range of formal rescue and recovery options available which can facilitate a successful turnaround of a financially distressed business. However, if a company is insolvent, expert advice must be sought in order to protect the company, its directors, and its creditors as a matter of urgency.
If advice is not taken and the company continues to trade despite being insolvent, this is a fundamental breach of several areas of the Insolvency Act 1986 and the repercussions can be severe.
Defining corporate insolvency
The first step, is to understand what is meant by ‘insolvent’. In corporate insolvency, there are two main tests which are used to determine whether a company is indeed insolvent: the balance sheet test and the cash flow test.
- Balance sheet insolvent – A company can be said to be balance sheet insolvent if its liabilities outweigh its assets.
- Cash flow insolvent – A company is cash flow insolvent if it is unable to meet its liabilities, debts, and other overheads as and when they fall due.
A company can be balance sheet insolvent, cash flow insolvent, or both. If either test suggests the company is insolvent, professional advice should be sought as a matter of urgency with consideration given as to whether the company should immediately cease trading.
Company insolvency: A directors’ legal duties
Once a company director knows – or ought to know – that their company is insolvent, they have a legal duty to place the interests of the company’s creditors above those of themselves and any fellow directors or shareholders. In practical terms this means not taking any additional credit you know you are unlikely to be able to repay, nor should a company accept customer deposits for goods or services the company is unlikely to be able to fulfil.
In many cases tipping over into an insolvent position will mean ceasing trade immediately in order to shield creditors from any further losses.
In some instances, however, it may be possible – and even advisable – for the company to continue to trade even when it is technically insolvent. This may be the case where continuing to trade in order to fulfil a certain contract would result in better overall returns for the body of creditors. Alternatively, where the company is going into administration and there is the potential for it to be sold as a going concern, continuing to trade while this deal is finalised is likely to preserve the company’s value, likewise resulting in a better return for creditors as a whole.
What is key here, is that the decision to continue to trade while technically insolvent needs to be made by a licensed insolvency practitioner and not the company directors or shareholders. Company insolvency is a hugely complex area and falling foul of the laws and regulations surrounding it can have serious consequences for company directors.
Liquidation and wrongful trading
It is when a company’s financial situation takes it past the point of rescue that the issue of trading while insolvent can have serious repercussions on the company’s directors personally.
Once a company enters liquidation, either voluntarily or by order of the court, the appointed insolvency practitioner or Official Receiver is statutorily obliged to carry out an investigation into the events leading up to the company becoming insolvent. This includes an investigation into the conduct of the directors which will typically cover a period of three years prior to the liquidation. If there is evidence that the directors were aware that the company was insolvent yet continued to trade as normal, and thereby potentially worsening the position of creditors, then this will be classed as wrongful trading.
The insolvency practitioner or Official Receiver will report their findings of wrongful trading to the Secretary of State who will then decide whether further action is required. Wrongful trading is covered by Section 214 of the Insolvency Act 1986 and is punishable by the following:
- Personal liability for company debts: In some instances of wrongful trading, directors can be held personally liable for some or all the company’s debts. While a limited company is a separate legal entity from that of its directors meaning they will not ordinarily be held responsible for debts of the company, if a director is found guilty of wrongful trading, this limited liability protection can be removed.
Depending on the financial position of the director, this could have a serious impact on their personal situation. An inability to repay the liabilities they become personally responsible for could mean their financial situation is compromised to the extent that personal insolvency options such as an IVA or even bankruptcy need to be considered in order to deal with the debt.
- Director Disqualification Order: Directors found guilty of trading while knowingly insolvent can be disqualified from acting as a director for a period of between 2 to 15 years. A disqualification order also prevents an individual from being directly or indirectly involved with the incorporation, management, or promotion of a limited company or LLP during the length of the order.
It may be possible for the director to agree to a voluntary disqualification undertaken as an alternative to a disqualification order. While a disqualification undertaking imposes the same restrictions and limitations on the director as a disqualification order, it will avoid court action and the associated costs.
Wrongful trading vs Fraudulent trading
It is also possible for directors to be found guilty of fraudulent trading if a court determines that trade continued past the point of insolvency with a clear intention to defraud creditors. Fraudulent trading is covered by Section 213 of the Insolvency Act 1986.
Unlike wrongful trading which is a civil matter, fraudulent trading is both a civil and criminal offence and the potential consequences reflect this. As well as being made personally liable for the debts of the insolvent company, those found guilty of fraudulent trading can face a possible prison sentence.
Entering into transactions while insolvent
When a company is insolvent, extreme care should be taken when making a payment to creditors or otherwise entering into a transaction with another party. Favouring one creditor over another, or disposing of company assets for less than market value, are strictly prohibited once a company is insolvent. These are known as antecedent transactions and can be overturned by the appointed licensed insolvency practitioner should the company later enter into formal insolvency proceedings such as liquidation.
- Preference Payments (Section 239 Insolvency Act 1986) – A preference payment occurs when an insolvent company pays a particular creditor ahead of others thereby putting the recipient into a better position than they otherwise would have been had the payment not been made. This is often done when repaying money owed to a connected party such as a friend or relative, paying a key supplier in order to maintain an ongoing business relationship, or repaying a loan a director has personally guaranteed. By making these payments the director is reducing the total amount available to the body of creditors as a whole, therefore breaching their fiduciary duties.
- Transactions at Undervalue (Section 238 Insolvency Act 1986) – A transaction at undervalue occurs when a business asset is sold or transferred to another party for nil consideration or for a consideration significantly lower than its true market value. An example of this would be selling a vehicle owned by the company to the director’s spouse for a nominal amount.
If an antecedent transaction is discovered as part of the liquidator’s investigations, they can bring a claim to have these transactions made void and reversed, restoring the company back into the position it would have been in had the transaction not been made.
Directors can be made personally liable for repaying a compensatory amount back to the company to cover the antecedent transaction should it not be possible for the transaction to be reversed. Directors also face a disqualification order for up to 15 years if found guilty of either of these types of antecedent transactions.
How to avoid trading while insolvent
While many instances of insolvency are unavoidable, there are things a director can do to protect themselves, their company, and their creditors when dealing with a distressed limited company:
- Be aware of the warning signs of impending insolvency – These can include cash flow issues, decreased sales, creditor’s threatening legal action, and the inability to obtain credit.
- Regularly monitor the company’s financial position – Regular monitoring can allow for financial issues to be highlighted at an early stage. The sooner action is taken to stem a potentially ruinous situation, the more options are available when it comes to putting a rescue strategy in place.
- Seek insolvency advice early – Swift insolvency advice will not only improve the chances of the company being able to effect a turnaround of its fortunes, it also demonstrates the desire for directors and shareholders to adhere to their legal responsibilities as the director of an insolvent company by taking action to minimise creditor losses.
- Make transactions with care – Do not dispose of company assets, make preference payments, or be tempted to enter into a transaction at undervalue while the company is knowingly insolvent. While these may provide short-term relief, any subsequent investigation by an insolvency practitioner will see these antecedent transactions made void and directors will be opening themselves up to allegations of wrongful or even fraudulent trading.
Article written by Karl Hodson, UK Business Finance. Karl is responsible for helping businesses across the UK raise funding for a variety of purposes such as working capital, expansion and capital equipment. He has specialist knowledge of raising finance through invoice and asset-based lending, crowdfunding, loan and equity funds and Government schemes.