Insolvency poses significant legal and financial challenges for both individuals and companies. When a party becomes insolvent and is unable to meet its financial obligations, it triggers a range of legal processes that significantly affect creditors' ability to claim debts. This article delves deeper into the key types of insolvency processes and examines their implications.
Corporate Insolvency
A company is insolvent if it has insufficient assets to discharge its debts and liabilities. There are different tests to determine insolvency, most commonly where: (1) a company is unable to pay its debts as they fall due (the cash flow test), or (2) the value of the company’s assets is less than its liabilities, taking into account contingent and prospective liabilities (the balance sheet test).
Where a company is or is likely to become unable to pay its debts, it may be placed into a corporate insolvency process. There are two principal processes in England & Wales:
Administration
There are three statutory objectives of administration: (1) rescuing the company as a going concern, (2) achieving a better result for the creditors as a whole than would be likely if the company were wound up, and (3) realising property for secured or preferential creditors.
During an administration, the company’s affairs are overseen by an administrator, who assumes control with the intent to restructure or sell the business. The administrator has several key duties, primarily focused on maximising the value of the company's assets for the benefit of creditors. This includes assessing the company's financial situation, preparing a report on its viability and formulating a plan for either restructuring the business or facilitating its sale (known as the Administrator’s Proposals).
During administration, the powers of the company’s directors are curtailed. Although directors remain in office, they lose control of the company’s affairs, and the administrator takes over. This is to ensure that the administrator can act in the best interest of creditors without interference from management that may have previously contributed to the company's distress.
Administration affords a critical respite from legal actions against the firm through a moratorium. This moratorium halts any ongoing legal actions against the company, including claims from creditors and winding-up petitions. This is crucial as it allows the administrator to stabilise the company’s operations without the pressure of litigation or demands for immediate payment from creditors.
However, it's important to note that the moratorium does not alter the substantive rights of a party against a company in administration but simply suspends the exercise of those rights during the administration. Once the administration concludes, any claims that were pending prior to the administration may be reactivated, unless specifically addressed in the administration process. This ensures that creditors can still seek redress once the company exits administration, assuming their claims are valid.
A successful administration often involves a plan for rescuing the company as a going concern, often though not always, by a sale of the business (potentially by way of a pre-pack arrangement). This can lead to a new arrangement with creditors, where debts may be rescheduled, reduced or settled in some manner. Successful negotiations can restore the business's viability and help it emerge from administration, allowing it to continue operations and ideally return to profitability.
On the other hand, if a deal cannot be reached, the situation may lead to the company being sold off piecemeal to achieve the second of the administrator’s objectives or being wound up voluntarily or on a compulsory basis to achieve the third objective. This will ultimately result in the closure of the business if it’s determined that no viable path forward exists.
Liquidation
Liquidation typically signifies the end of the company, with creditors receiving whatever funds can be generated from asset sales, usually at a fraction of the value of their claims. This process involves the sale of a company's assets to satisfy its debts. Liquidation may be either voluntary or compulsory.
A voluntary liquidation is typically started by directors and/or shareholders who have chosen to wind-up their company, often because it is, or is becoming, insolvent and cannot pay its debts.
There are two types of voluntary liquidation: (1) a creditors’ voluntary liquidation (CVL), or (2) a members’ voluntary liquidation (MVL). A CVL is a voluntary process, but one that is typically only instigated when the directors conclude that their business is no longer able to trade and is, in fact, insolvent. An MVL is when the directors and shareholders of a solvent company decide to liquidate the company. This is usually when business owners retire/sell up and the company is left with a balance of cash to distribute to shareholders after all liabilities have been paid in full.
Unlike administration or a compulsory liquidation, there is no moratorium for a company involved in a voluntary liquidation, though it may be possible to apply to Court for a stay of any proceedings.
Conversely, a compulsory liquidation is stated by an unpaid creditor (who is owed more than £750) filing a winding-up petition. Upon filing a petition, which is then publicly advertised, the court will hold a hearing to establish whether the company is insolvent and, if it is, will issue a winding-up order placing the debtor company into liquidation.
Compulsory liquidation also results in a stay of proceedings. For claims filed before the winding-up order, the court may exercise its discretion to grant a stay of other proceedings upon application by the company, any creditor, or contributory. For claims filed after, an automatic stay is imposed. Any party wishing to initiate or continue legal action must seek permission from the court or the office holder.
Whether in a voluntary or compulsory liquidation, creditors are classified into different categories of priorities for receiving distributions from the assets of the liquidated company: broadly, secured creditors, preferential creditors, unsecured creditors, and shareholders. Secured creditors typically have the first claim on the assets of the insolvent entity, while unsecured creditors might receive little to nothing after higher-priority claims are settled.
Individual Insolvency
The primary procedures available for individual insolvency include:
Bankruptcy
A petition is typically presented either by a creditor or creditors (owed, individually or collectively, £5,000). Alternatively, the debtor may seek a bankruptcy order by applying to the Insolvency Service with that application determined by an adjudicator. If a bankruptcy order is made, the individual’s assets are administered by the Official Receiver (a civil servant appointed by the Insolvency Service), or a trustee (appointed by a majority of creditors by value). The trustee's statutory function is to get in, realise and distribute the bankrupt's estate to repay creditors.
The presentation of a bankruptcy petition has no legal effect on ongoing proceedings in which the debtor a party. However, once a debtor has been declared bankrupt and a trustee appointed, most causes of action the bankrupt had an interest in vest in the trustee to pursue, settle, or discontinue depending on what is in the best interests of the creditors as a whole. Where the debtor is a defendant, and has been made bankrupt, proceedings continue unless stayed by order of the court.
Individual Voluntary Arrangement (IVA)
An IVA is a formal agreement between an individual and their creditors to pay back a percentage of their debts over a set period. Creditors bound by an IVA will almost certainly be prevented from bringing, or continuing with, any claim against the individual debtor.
Debt Relief Orders (DROs)
Designed for individuals with low income and minimal assets, a DRO provides a legal solution for those unable to pay their debts, effectively freezing claims against the debtor for a period of time.
Comment
In order to protect their interests, creditors must understand their rights in relation to insolvency proceedings, including the right to vote in meetings, rights to receive periodic updates, rights concerning the administration of the estate, and, importantly, how those proceedings affect their rights of recovery.
Insolvency can be a challenging experience for all involved, often leading to significant uncertainty and financial loss. We regularly act for creditors in insolvency proceedings. If you would like to discuss any of the above in more detail or have any specific queries, please do get in touch with Leigh Callaway and Dani Hertz.
