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When is a company deemed solvent or insolvent?
A company is insolvent if it is unable to pay its debts as and when they fall due.
There are two tests which the courts will apply to determine whether a company is insolvent at a particular point in time; the ‘Balance Sheet Test’ and the ‘Liquidity Test’.
Both tests basically say that a company is insolvent when the value of its liabilities/debts outweighs the value of its assets/cash at bank. The tests are not really separate or distinct.
It is important to note that a court will also only look at these retrospectively should there be an issue raised after a company has entered liquidation. It is therefore important that directors know of their duties at the time a company may be insolvent so as not to fall foul of any breach of duties leading to potential personal liability to a company’s creditors or to the company itself.
What are the practical implications when a company makes the transition from solvency to insolvency?
When a company is solvent, the directors owe a duty to the company and its shareholders to manage the company for the benefit of its shareholders. However, as soon as the line is crossed into insolvency, this duty changes into an obligation to protect a company’s creditors. A director can no longer favour the interests of shareholders over creditors of the company.
Directors’ options and protecting the company
- Trading on – trading an insolvent company with the intention to cheat creditors is both a crime (s993 Companies Act 2006) - trading fraudulently whilst insolvent, and a civil wrong (s213 Insolvency Act 1986 (“IA”) - wrongful trading. Directors could also be pursued for breach of duty/misfeasance (S.212 IA) and could be subject to disqualification proceedings.
- Consider funding, take corrective action and prioritise payments – consider all funding options, and take action with the aim of alleviating the company’s cash shortage
- Downsizing/asset realisations – strategy can be used to reduce overheads and/or generate cash. Also consider arranging a sale or merger with a third party
- Exploiting rescue procedures – consider informal or voluntary arrangement or appointment of administrator, administrative receiver or liquidator and follow formal procedures.
Advice should be taken as early as possible once the directors become aware of any financial concerns.