Insolvency: When is it time to accept the inevitable?

Insolvency: When is it time to accept the inevitable?

What are the risks of trading when in financial difficulty? Nathanael Young of SA Law explores the legal implications of continuing to trade even though insolvency appears inevitable

Even when it is obvious that a company is in financial difficulty, it can be difficult to advise the directors. Most of the time, they will believe they can trade through the difficulties, perhaps with a little forbearance on the part of their creditors, or a new line of credit or two. But when is enough enough? And what happens if they make the wrong call?

On a practical level, there comes a point when the creditors will decide this for themselves, whether by stopping the flow of credit, enforcing security or starting insolvency proceedings. The instinct of most directors is to stave off the creditors as long as possible, and to treat that as averting insolvency. Unfortunately, that normally involves trading on long after the law would regard the company as insolvent, which is a particular concern for directors.

Based on the legal definition, a company is insolvent when it is unable to pay its debts. This can occur in one of two ways.

  1. Cash flow insolvency exists when a company is unable to pay its debts as and when they fall due, regardless of its assets.
  2. Balance sheet insolvency occurs when the liabilities of the company exceed its assets, even if it has no difficulty paying debts due now.

In reality, as the Supreme Court has recently clarified, the two tests are not entirely distinct. The balance sheet test simply takes a longer-term view of the liabilities ahead, and whether the company’s assets are sufficient to meet them, whereas the cash flow test looks at the short-term picture.

These criteria are quite strict – on one measure or another a large number of SMEs have been insolvent at some stage. It is certainly not the case that companies are expected to stop trading simply because they are insolvent in the legal sense. However, trading when the company is insolvent does mean the directors run a much greater risk of personal liability than would normally be the case.

Most advisers are aware that directors can be personal liable for wrongful trading – often referred to as trading while insolvent. However, this is not necessarily the most dangerous type of claim. In reality, successful wrongful trading claims are rare.

This is largely because wrongful trading will only occur if the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. Things must be very bad indeed before there is no reasonable prospect of avoiding insolvent liquidation, so directors can usually say that they believed things would get better, or “that the clouds will roll away and the sunshine of prosperity will shine upon them again”, as one judge memorably put it.

A more significant risk for directors is that liquidation will involve examination of a director’s transactions with a company.

The obvious things that liquidators will be looking out for is evidence that the company’s assets have been sold to the directors at an undervalue. Where a director is a creditor of the company, they will be looking for evidence that the director’s loan account was repaid in preference to other creditors. While preference actions in particular can be difficult to bring against third parties, the fact a director will be a “connected party” for the purpose of such claims means that the technical criteria are relaxed. Ironically, it is often directors that have put their own money into a company who end up falling foul of the preference rules.

However, arguably the most dangerous area for directors and accountants is in relation to directors’ remuneration. In owner-managed companies, there is a tendency for directors to pay themselves first, then account for the payments later. Where the same individuals are shareholders and directors, they rarely need to worry about the duties they owe to the company. Even if they breach them, there is no one to sue.

This changes radically once a company is insolvent in the legal sense – or even of doubtful solvency. Then the directors must also consider the position of the creditors of the company, and not merely their own interests. If they do not, and the company subsequently goes into liquidation, the liquidator can bring a claim against the directors for misfeasance.

This means that all financial transactions between directors and the company will come under scrutiny, stretching back to the point at which the company was first in financial difficulty. In most cases, that will be well before the onset of any formal insolvency procedure, and the liquidator can look for evidence of unpaid invoices and arrangements with creditors to argue for the earliest possible date. In carrying out that scrutiny, although it would be for the liquidator to show that any sums in issue were paid to the directors in question, the burden is on the directors to explain why payments made to them by the company were proper and to justify credit entries on any director’s loan account.

If a company has been managed in an informal way, this often means a large number of unexplained transactions between the director and the company, and in turn can mean a substantial personal liability on the part of the director.

While this is not an exhaustive guide to the risks of trading when in financial difficulty, it does highlight some of the pitfalls. It does not mean that companies cannot trade through their difficulties, but it does mean that the directors need to take much greater care than they would in better times. They have to be conscious that all their actions – and certainly all their financial transactions – will be under scrutiny. They should maintain records of their decisions, explain their reasoning, and take professional advice. If the directors feel they are walking a tightrope, this reflects the risks they are running. When financial difficulties continue over an extended period, it may indeed be better to accept the inevitable.

Nathanael Young is a senior associate at SA Law and leads the firm’s insolvency practice area.

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