Insolvency occurs when a business can no longer pay its debts. It is illegal for directors of a business to continue operations and incur further debt when their business is insolvent. Insolvency can be the result of either mismanagement or simple misfortune so it is important for all business owners to understand their options if insolvency becomes likely.
What can a business do when it is heading towards insolvency?
If a business is facing difficulties and it is becoming (or may become) insolvent, it can enter formal administration. There are a few types of formal administration:
Liquidation (also known as 'winding up')
Voluntary Administration or Deed of Company Arrangement
Businesses may voluntarily appoint an administrator when they enter insolvency or believe it is a likely outcome, or they may be forced into administration by the courts after a creditor takes legal action.
What is the difference between the different forms of administration?
a Liquidator is appointed to 'wind the company up', which means its assets are sold to pay outstanding debts to creditors. Subsequently, the company is deregistered and ceases to exist entirely. The most common types of liquidations for insolvent companies are court liquidation and creditors' voluntary liquidation.
(possibly leading to a Deed of Company Arrangement): in voluntary administration, the administrator looks deeply into the company's financial position and its history. The administrator then makes a recommendation to the creditors about how to proceed. The
creditors can decide whether to adopt a Deed of Company Arrangement (if the directors propose one) or else they can either liquidate the company or return control back to the directors.
A Deed of Company Arrangement:
permits a company to make an arrangement which is binding on creditors. This is usually a compromise which allows the company to continue operation, subject to the terms of the arrangement.
a company enters receivership when a secured creditor appoints a receiver (or a receiver and manager together) who releases the assets for the benefits of the secured creditors. This can occur at the same time that the company is in liquidation or voluntary administration, or it can occur separately.
In all types of administration, the person appointed must be a registered Insolvency Practitioner.
What is the purpose of insolvency law?
The laws that regulate insolvency and administration are designed to protect creditors and help them recoup bad debts. When a business is structured as a company its directors are not personally liable for company debts, therefore without these protections there would be no way for creditors to recover their money. This would discourage offering credit to businesses, which would prevent businesses from operating effectively. With these protections, there is a degree of certainty and a contingency plan if things go south.
The laws also give options to businesses that have fallen on hard times and can no longer meet their obligations. Depending on their company history and the relationship of the directors with their creditors, it is often possible for a company to save itself through administration.