Exam focus
This is relevant to students taking the UK variant of the exam only.
Insolvency will not appear in every exam.
The Insolvency Act 1986 has been updated by the Insolvency Rules 2016. The rules apply in England and Wales and a parallel project to modernise the Scottish insolvency rules is in progress.
The regulations are not significantly different. The rules have been updated to reflect modern business practice and to make the insolvency process more efficient. Changes include:
Enabling electronic communications with creditors
Removing the automatic requirement to hold physical creditors meetings, although creditors will be able to request meetings
Enabling creditors to opt out of further correspondence and for small dividends to be paid by the office holder without requiring a formal claim from creditors
As a result of the slight differences, the examining team will accept answers based on both sets of guidance.
This reflects the requirements of the Insolvency Act 1986.
Insolvency
There are two tests for insolvency:
- If assets are exceeded by liabilities, or
- If a company is failing to discharge its debts as and when they fall due. If a company meets either criteria then it is technically insolvent.
1 Voluntary liquidation
Introduction
Liquidation is the process of terminating a company, thus ending its life. The assets of the company are physically liquidated, i.e. they are sold, so that cash can be used to pay off company creditors and equity holders.
There are two forms of voluntary liquidation:
Members’ voluntary liquidation Creditors’ voluntary liquidation.
Members’ voluntary liquidation
This form of liquidation is used when a company is solvent (i.e. has assets greater than its liabilities). In order to facilitate this, the members must pass one of two resolutions:
An ordinary resolution, where the articles provide for liquidation on the expiry of a fixed date or a specific event, or
A special resolution, for any other reason.
Once this has been passed the directors must make a declaration of solvency stating that they are of the opinion that the company will be able to pay its debts within twelve months. A false declaration would constitute a criminal offence.
The company will then appoint a named insolvency practitioner to act as the liquidator. They will realise the company’s assets and distribute the proceeds accordingly.
Once the liquidation process is complete the liquidator presents a report at the final meeting of the members, which is then submitted to the registrar of companies. The company will be dissolved three months later.
Creditor’s voluntary liquidation
This form of liquidation is used if a company intends to liquidate voluntarily but is insolvent. Once again a resolution of members must be passed (as with a members’ voluntary liquidation). However, no declaration of solvency can be made.
Instead a meeting of creditors must be held within fourteen days of passing the resolution. At least seven days written notice must be given for this meeting. During the meeting the directors must present a full statement of the company’s affairs and a list of all creditors and amounts owed to them.
Both the members and the creditors are entitled to appoint a liquidator.
However, the creditors’ choice must prevail over the members’ choice.
In addition the creditors may appoint up to five people to sit on a liquidation committee.
The liquidator will realise the company’s assets and distribute the proceeds accordingly. Once the liquidation process is complete the liquidator presents a report at the final meeting of the members, which is then submitted to the registrar of companies. The company will then be dissolved.
2 Compulsory liquidation
Introduction
Companies may be obliged to liquidate if a winding up order is presented to a court, usually by a creditor or member. Such a petition may be made for a number of reasons, which include:
The company being unable to pay its debts
It is just and equitable to wind up the company.
If a member petitions on the latter basis this will only be considered if the company is solvent and the member has been a registered shareholder for at least six of the prior eighteen months.
Consequences
If successful, the court will appoint an official receiver (an officer of the courts) as liquidator. They may be replaced by a practitioner at a later date. The receiver investigates the company’s affairs and the cause of its failure. The petition also has the following effects:
All actions for the recovery of debt against the company are stopped.
Any floating charges crystallise.
All legal proceedings against the company are halted and none may start unless the courts grant permission.
The company must cease trading activity, unless it is necessary to complete the liquidation, e.g. completing work-in-progress.
The directors relinquish power and authority to the liquidator, although they may remain in office.
Employees are automatically made redundant. The liquidator may choose to re-employ them to help complete the liquidation process.
Procedures
Within twelve weeks of being appointed the official receiver will call a meeting of creditors in order to agree the appointment of a licensed insolvency practitioner and to appoint a liquidation committee.
The liquidator will realise the company’s assets and distribute the proceeds accordingly. Once the liquidation process is complete the liquidator presents a report at the final meeting of the members, which is then submitted to the registrar of companies. The company will then be dissolved.
3 Allocation of company assets
Liquidators in a compulsory liquidation must pay debts in the following order:
Fixed charge holders
Expenses of liquidation, including liquidator’s remuneration
Preferential creditors, including employee’s wages and accrued holiday pay
Prescribed part set aside for unsecured creditors* Floating charge holders
Unsecured creditors (ranked equally)
Preference shareholders
Members.
It is likely that liquidators will also adhere to these principles in a voluntary liquidation as well.
*Prescribed part
The prescribed part is an amount set aside to give unsecured creditors some protection. In many liquidations, if the prescribed part was not in place, the unsecured creditors would be unlikely to receive anything as it is likely that fixed charge holders, liquidation fees, preferential creditors and floating charge holders would receive any monies crystallised.
The calculation is based on the ‘net property’ of the company. This is the amount of assets remaining after paying fixed charge holders, liquidator’s fees and preferential creditors.
If the net property is less than £10,000, the prescribed part won’t apply and any remaining monies will be paid to the floating charge holders.
The prescribed part is calculated as:
- 50% of the first £10,000 of the net property figure
- 20% of £2,985,000 less £10,000
- Subject to a maximum of £600,000.
If net property is less than £2,985,000 the calculation at step 2 should use the figure of net property remaining.
Example – prescribed part
| Assets | £6,000,000 |
| Fixed charge creditors | £2,500,000 |
| Floating charge creditors | £750,000 |
| Preferential creditors | £650,000 |
| Unsecured creditors | £8,000,000 |
| Ordinary share capital | £20,000,000 |
| Liquidators costs | £200,000 |
| Net property calculation: | |
| Assets | 6,000,000 |
| Less fixed charge creditors | (2,500,000) |
| Less liquidator’s costs | (200,000) |
| Less preferential creditors | (650,000) |
| Net property | 2,650,000 |
Prescribed part calculation (applicable as net property > £10,000)
| 50% | × £10,000 | 5,000 |
| 20% | × (2,650,000 – 10,000) | 528,000 |
| Prescribed part | 533,000 | |
4 Administration
Introduction
Administration is the process whereby an insolvency practitioner is appointed to manage the affairs of a business (Enterprise Act 2002). It is often used as an alternative to liquidation with a view to:
Rescuing a company in financial difficulty
Achieving better results for creditors than could be achieved through liquidation
Realising property to pay off secured creditors.
Appointment
Administrators can be appointed by any one of the following:
The courts, in response to a petition
The holder of a qualifying floating charge over company assets
Members or directors, providing that liquidation has not already begun.
Courts will only appoint an administrator if the company is, or is likely to become, unable to pay its debts and if it feels that administration will help meet the objectives listed above.
Consequences
The administrator takes over control of the management of the company. They must follow any proposals approved at any meeting of creditors or dictated by the courts. However, particular powers include:
Removal or appointment of directors
Calling meetings of creditors and/or members
Making payments to secured or preferential creditors
Making payments to unsecured creditors, if it is felt that this will assist the objectives of the administration
Presenting or defending a petition for liquidating the company.
Upon appointing an administrator certain protections are afforded to the company, namely:
The rights of creditors to enforce security over the company’s assets are suspended
Petitions for liquidation are dismissed
No resolutions to wind up the company may be passed
The directors continue in office, although their powers are suspended.
Advantages of administration over liquidation
Administration provides time to develop an alternative plan for survival. Liquidation results in the cessation of the company and therefore any future benefits that might have been generated will be lost.
Members are less likely to lose their investment.
Creditors are more likely to be paid. In a liquidation, unsecured creditors are likely to receive nothing.
Creditors will still be able to trade with the company if the administration is successful. If the company is liquidated, the creditor loses a customer.
5 Alternatives to winding up
Introduction
Often businesses have no alternative but to face up to administration or, in the worst case scenario, liquidation. However, there are alternatives that exist to help both incorporated and unincorporated businesses survive, namely:
Individual voluntary arrangements
Reconstructions.
Individual Voluntary Arrangements (IVAs)
An IVA is an arrangement available to individuals, sole traders and partnerships to help them reach a compromise with creditors with the aim of avoiding the closure of their business and, perhaps, bankruptcy.
Such an arrangement usually facilitates lower payments of debt over an extended period, usually five years.
Once an individual (or their insolvency practitioner) submits a proposal to the courts for an interim order creditors may no longer take action against the individual (referred to as a moratorium on actions). A creditors meeting must be held within fourteen days of the order to include the proposals made by the individual with regard to their debt. The creditors may accept the proposals with a 75% majority (by value of creditors present) vote.
The main benefit is obviously that the individual may continue in business and work towards the payment of their debt in a more flexible manner.
They are also not penalised by bankruptcy laws, such as restrictions on becoming a director.
Creditors also benefit as it is likely that they will receive more under the terms of an IVA than they would if liquidation was enforced upon a company that is potentially insolvent anyway.
Reconstructions
It may be possible for companies facing problems to survive by taking up new contracts or exploiting market opportunities. However, such ventures usually require cash injections and when faced with liquidity problems this can pose a problem, not least because such businesses may not appear attractive to external investment.
Typical traits of such companies include:
Accumulated losses
Debenture interest arrears
Cumulative preference shares dividend arrears No payment of ordinary dividends
Share price below nominal value Share price decline.
To become more attractive to investment the company could reorganise or reconstruct.
Permitted reconstructions
Capital structures protect stakeholders’ interests. Therefore changes to these structures are restricted by company law. However, under various mechanisms of the Companies Act 2006 companies are able to:
Write off unpaid share capital
Write off share capital which is not represented by available assets
Write off paid up share capital which is in excess of requirements Write off debenture interest arrears
Replace existing debentures with a lower interest debenture Write off preference dividend arrears
Write off amounts owing to trade creditors.
By altering the capital structure of the business and by removing some of the debt of the business, companies may be able to reduce their accumulated losses to the point that they have profits available to begin paying debts and dividends in the future. The reduction in the debt burden also frees up resources for investment in future opportunities and new growth.
To do this the company must ask its stakeholders to surrender some or all of their existing rights and amounts due. They do this in exchange for new rights under a new or reformed company and a share of the benefits that could arise due to future investment. This may be more appealing than the alternatives, which include:
To remain as they are, with the prospect of no return from their investment and no growth in their investment, or
To accept whatever return they could be given in a liquidation.
6 Wrongful and fraudulent trading
Fraudulent trading
Fraudulent trading is where a company carries on a business with the intention of defrauding creditors or for any other fraudulent purposes. This would include a situation where the director(s) of a company continue to trade whilst insolvent, and enter into debts knowing that the company will not be in a position to repay those debts.
Fraudulent trading is also a criminal offence under the Companies Act 2006.
Wrongful trading
Wrongful trading is when the director(s) of a company have continued to trade when they: “knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation“.
A director can defend an action of wrongful trading if they can prove that they have taken sufficient steps to minimise the potential loss to creditors.
Wrongful trading is an action that can be taken only by a company’s liquidator, once it has gone into insolvent liquidation (either voluntary or compulsory liquidation).
Wrongful trading needs no finding of ‘intent to defraud’, unlike fraudulent trading.
Wrongful trading is a civil offence (fraudulent trading is a criminal offence),
it only needs to be proven “on the balance of probabilities” (i.e. it is more likely than not that the director(s) are guilty of wrongful trading).
Fraudulent trading needs to be proven “beyond reasonable doubt” (i.e. it is almost certain that the director(s) are guilty of fraudulent trading).
For these reasons, wrongful trading is more common than fraudulent trading.
Penalties
Fraudulent trading
Directors can be made personally liable for the debts of the company (a civil liability under the Insolvency Act)
Disqualified as a director for between two and 15 years
Imprisoned for up to ten years.
Wrongful trading
Directors can be made personally liable for the debts of the company
Disqualified as a director for between two and 15 years.
Test your understanding 1
- Explain the procedures involved in placing a company into
compulsory liquidation. (10 marks)
- Explain the consequences of compulsory liquidation for a
company’s creditors, employees and shareholders. (5 marks)
(Total: 15 marks)
Test your understanding 2
Tommy Co is in compulsory liquidation. The insolvency practitioner has liquidated the company’s assets and has £1.125 million available for distribution. The following points are relevant:
The company has an issued share capital of 2.5 million £1 shares.
The directors declared, but have not paid, a dividend of 10 pence per share six months ago.
The insolvency practitioner’s costs total £50,000.
Tommy Co’s bank has a floating charge over the company’s stock, which has now crystallised. The value is £400,000.
The company’s employees have been paid, with the exception of £275,000 of accrued holiday pay.
Unsecured creditors total £500,000.
Required:
Identify and explain how the available funds will be distributed to the
stakeholders of Tommy Co by the insolvency practitioner. (5 marks)
Test your understanding 3
Compare and contrast the characteristics of a members’ voluntary
winding up and a creditors’ voluntary winding up. (5 marks)
Test your understanding 4
Poppy and Rosie registered their pet food business as a private limited company, Wag Ltd, in January 20W9. They injected £1,000 of share capital of £1,000 into Wag Ltd, and appointed themselves as directors of Wag Ltd.
Wag Ltd made a small profit in its first few years of trading, after the salaries paid to Poppy and Rosie. However, following difficult economic conditions, Wag Ltd made a loss of £15,000 in the year ended
31 December 20X2.
In early 20X3, Poppy said she thought the company should cease trading and be wound up. Rosie, however, insisted that the company would be profitable in the long-term so they agreed to carry on the business. Poppy was no longer involved in the day-to-day running of the business and stopped drawing a salary (although she retained her position as company director).
During 20X3 and 20X4, Rosie falsified Wag Ltd’s accounts to disguise the fact that the company had continued to suffer losses, until it became obvious that they could no longer hide the company’s debts and that it would have to go into insolvent liquidation, with debts of £75,000.
Required:
Advise Poppy and Rosie as to any potential liability they might face in respect of:
Fraudulent trading, and Wrongful trading.
(8 marks)
Test your understanding 1
- A company is usually placed into compulsory liquidation by a creditor, who uses compulsory liquidation as a means to recover monies owed by the company. The creditor must petition the court and the petition is advertised in the London Gazette. There are various grounds for a petition to be made for compulsory liquidation.
The most common ground is that the company is unable to pay its debts. In this case the creditor must show that he or she is owed more than £750 by the company and has served on the company at its registered office, a written demand for payment. This is called a statutory demand. If the company fails to pay the statutory demand in 21 days and does not dispute the debt, then the creditor may present a winding up petition at court.
The application for a winding up order will be granted at a court hearing where it can be proven to the court’s satisfaction that the debt is undisputed, attempts to recover have been undertaken and the company has neglected to pay the amount owed.
On a compulsory winding up the court will appoint an Official Receiver, who is an officer of the court. Within a few days of the winding up order being granted by the court, the Official Receiver must inform the company directors of the situation. The court order is also advertised in the London Gazette.
The Official Receiver takes over the control of the company and usually begins to close it down. The company’s directors are asked to prepare a statement of affairs. The Official Receiver must also investigate the causes of the failure of the company.
The liquidation is deemed to have started at the date of the presentation of the winding up petition.
At the end of the winding up of the company, a final meeting with creditors is held, and a final return is filed with the court and the Registrar. At this point the company is dissolved.
Tutorial note: Credit will be awarded to candidates who explain other, less common, means by which a company may face a compulsory liquidation:
A shareholder may serve a petition for compulsory liquidation. The grounds for doing so would normally be based on the fact that that the shareholder is dissatisfied with the management of the company, and that it is therefore just and equitable to wind up the company. This action by the shareholder is only allowed if the company is solvent and if the shareholder has been a shareholder for at least six months prior to the petition.
Very occasionally, if the Crown believes that a company is contravening legislation such as the Trading Standards legislation or is acting against the public or government interest, it is possible for the company to be liquidated compulsorily. This is very serious action to take and is not used very regularly.
- Creditors – The role of the Official Receiver (or Insolvency Practitioner, if appointed), is to realise the company’s assets, and to distribute the proceeds in a prescribed order. Depending on the amount of cash available for distribution, and whether the debt is secured or unsecured, creditors may receive some, all, or none of the amount owed to them.
Employees – All employees of the company are automatically dismissed. A prescribed amount of unpaid employee’s wages, accrued holiday pay, and contributions to an occupational pension fund rank as preferential debts, and will be paid before creditors of the company.
Shareholders – Any surplus that remains after the payment of all other amounts owed by the company is distributed to the shareholders. In most liquidations the shareholders receive nothing.
Test your understanding 2
The stakeholders of Tommy Co will be paid in the following order:
- Liquidator’s costs of £50,000.
- Preferential creditors: i.e. the employee’s accrued holiday pay of £275,000.
- Floating charge holders i.e. the bank’s debt of £400,000.
- Unsecured creditors of £400,000.
At this point, £1.125 million is fully allocated. The unsecured creditors must forfeit the other £100,000 owed to them.
The members’ declared but not paid dividends rank below the above stakeholders and will therefore not be paid. Likewise there will be no residual assets left to distribute to the members, who will receive nothing at all upon the liquidation of Tommy Co.
Test your understanding 3
A voluntary winding up takes place when the company resolves by special resolution to be wound up for any cause whatsoever, or by ordinary resolution where the articles provide for liquidation on the expiry of a fixed date or a specific event.
In the case of a members’ voluntary winding up, the directors make a declaration of solvency stating that after full inquiry into the company’s affairs they are of the opinion that the company will be able to pay its debts within twelve months of the commencement of the winding up.
In a creditors’ voluntary winding up, such a declaration is not possible owing to the circumstances leading to the winding up.
In a members’ voluntary winding up, the liquidator is appointed by the members and is accountable to them.
In a creditors’ voluntary winding up, both members and creditors have the right to nominate a liquidator and, in the event of dispute, subject to the right of appeal to the courts, the creditors’ nominee prevails. Here the liquidator is primarily accountable to the creditors.
In a creditors’ voluntary winding up, the resolution is followed by a creditors’ meeting where it is possible for a liquidation committee to be appointed. Such meetings form no part of a members’ voluntary winding up.
Test your understanding 4
Fraudulent trading occurs where, in the course of a winding up, it appears that the business of a company has been carried on with intent to defraud creditors, or for any fraudulent purpose.
In such cases, the court, may declare that any persons who were knowingly parties to such carrying on of the business are liable to make such contributions (if any) to the company’s assets as the court thinks proper. There is a high burden of proof involved in proving dishonesty on the part of the person against whom it is alleged.
It should be noted that there is a criminal offence of fraudulent trading under the Companies Act 2006, which applies to anyone who has been party to the carrying on of the business of a company with intent to defraud creditors or any other person, or for any other fraudulent purpose.
Given that it is stated that Rosie hid the fact that Wag Ltd was insolvent it is possible that she might be liable under the fraudulent trading provisions both civil and criminal. As a consequence she may well be liable for a maximum prison sentence of 10 years and may have to contribute to the assets of the company to cover any loss sustained by creditors as a result of her actions.
There is no to support either action against Poppy.
Wrongful trading does not involve dishonesty but it still makes particular individuals potentially liable for the debts of their companies. Where a company is being wound up and it appears that, at some time before the start of the winding up, a director knew, or ought to have known, that there was no reasonable chance of the company avoiding insolvent liquidation, they would be guilty of wrongful trading.
In such circumstances, unless the directors took every reasonable step to minimise the potential loss to the company’s creditors, they may be liable to contribute such money to the assets of the company as the court thinks proper.
It is clearly apparent that Rosie will be personally liable for the increase in Wag Ltd’s debts from £15,000 to £75,000. However, as a director of the company Poppy will also be liable to contribute to the assets of the company.
