Insolvency advice

When a company is in financial difficulties, it is essential the directors obtain competent and professional advice. Once the prospect looms that the business could fail and the directors might be called upon to fulfil obligations under personal guarantees, it becomes more difficult for them to make rational judgments with regard to the business they are running.

The most difficult decision for any director is whether the company should stop trading and, if so, when. Here are some of the questions often asked.

When is a company insolvent?

There is no precise legal definition of insolvency and it is largely a matter of judgement. It is therefore arguable as to the exact moment when a company becomes insolvent. A firm is normally regarded as insolvent on two counts:

• When its liabilities exceed its assets, after taking into account its contingent and prospective liabilities.
• When it is unable to meet its liabilities as they fall due.

When should a director act?

In view of the problem in determining precisely when a company is insolvent, directors should seek advice and be extremely careful about the liabilities their company incurs once they are aware financial problems exist.

It is at this time that directors, particularly those controlling and possibly owning smaller family businesses, often fail to appreciate fully the alternative courses of action open to them, and the consequences of these both for the company and for themselves.

What are those options and how do they protect directors?

These may be summarised as follows:

• To take corrective action within the existing business with the aim of alleviating the firm's cash shortage. However, very often there is little room for manoeuvre as the bank overdraft is fully extended and creditors may be pressing for payment, while debtors can be slow to settle accounts.
• It might be possible to arrange a sale or merger with a third party with greater financial resources to assist the company over its difficulties.
• If the cash position is so critical that continued trading is no longer possible, then the directors will have to either come to an informal or voluntary arrangement with creditors in an attempt to resolve the company's difficulties or take steps to arrange for the appointment of an administrative receiver, an administrator or a liquidator and follow the appropriate formal insolvency procedure.

What steps can I take now to futureproof my firm?

A very common feature of companies that experience financial difficulties is that the accounting records are poorly maintained, with the result that the financial information available to management is inadequate. Accurate and up-to-date accounting records are never more vital and necessary then when a company is running out of money.

This cannot be emphasised too strongly. Without accurate financial data neither the directors nor their advisers can hope to make the right decisions: whether it be the elimination of loss-making activities or products, an injection of funds to correct a shortage of working capital, or an effort to reduce stocks and trade debtors to improve the company's cashflow.

Although up-to-date information will not of itself necessarily alter the ultimate decision, its presence allows alternative options to be considered, giving the directors the opportunity to determine the company's future rather than having a solution imposed from without.

Short-term profit forecasts and cashflow projections must be reviewed so that the benefit of future trading can be evaluated, together with the likely outcome of any company reorganisation or refinancing proposals.

When would I be liable if I keep trading in the face of financial difficulties?

If there is a real risk that creditors might not be paid and trade is allowed to continue, however well-intentioned the decision may have been, any bills incurred during this period not subsequently paid might be held to be the personal responsibility of the directors. The directors' duty is to preserve the status quo for the benefit of creditors and shareholders until the company's future is determined.

The directors should take advice as to whether trading should continue, and if plans for the future are realistic. If it is possible to formulate a rescue plan that is regarded as achievable, it will probably be important to inform creditors, as far as possible, of the company's financial position and the intentions for the settlement of outstanding accounts.

Very often, creditors will be receptive to sensible deferred payment terms, providing current purchases are paid for in cash or on normal credit terms.

How can I maximise the chances of a creditors' agreement occurring?

This is more likely to be the case if the proposals are presented and supported by an insolvency practitioner. Throughout this period the directors must have regard to the potential penalties of being found guilty of either wrongful trading or trading fraudulently while insolvent.

Although efforts will be concentrated on the resolution of the short-term cashflow difficulties, the directors must not forget to consider the viability of their company in the longer term.

If the decision is made that the firm should continue to trade, there must be clear evidence of a real prospect that all creditors will ultimately be paid. If there is no such prospect, then apart from the possible conversion of work in progress into finished stock (assuming that the finished stock can be sold for a price that will cover the cost of completion), trading may well have to cease immediately.

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