A company is insolvent when it cannot pay its debts. Insolvency law provides procedures for dealing with companies that are in financial difficulty, balancing the interests of creditors with the possibility of rescuing viable businesses. The key insolvency procedures are liquidation, administration, and company voluntary arrangement.
A company is insolvent if it cannot pay its debts as they fall due. This is the cash flow test - looking at whether the company has sufficient cash or liquid assets to meet debts when they become payable. It considers both present and future liabilities. Even if the company has substantial assets, it may be insolvent on a cash flow basis if those assets cannot be readily converted to cash.
A company is insolvent if its assets are less than its liabilities, including contingent and prospective liabilities. This is the balance sheet test - comparing the value of all company assets (including intangible assets) against all debts owed. Under s.123 Insolvency Act 1986, a company is also deemed insolvent if its net assets are less than the called-up share capital.
A company is deemed unable to pay its debts if: (1) a creditor for £750+ has served a statutory demand which is not paid, secured, or compounded within 3 weeks; (2) execution or process returned unsatisfied; or (3) it is proved to the court that the company cannot pay its debts (cash flow or balance sheet test).
For certain purposes (such as wrongful trading), if a company is being wound up, it is presumed to have been insolvent in the 12 months before winding up unless the contrary is shown. This places the burden on directors to prove the company was solvent throughout this period.
Liquidation (or winding up) is the process by which a company's existence is brought to an end. Assets are collected, realised, and distributed to creditors and shareholders according to statutory priorities. After liquidation, the company is dissolved and ceases to exist. The main types are: members' voluntary liquidation (solvent), creditors' voluntary liquidation (insolvent), and compulsory liquidation (court-ordered).
| Type | When Used | Key Features |
|---|---|---|
| Members' Voluntary (MVL) | Company is SOLVENT | Declaration of solvency, directors appoint liquidator, members' control |
| Creditors' Voluntary (CVL) | Company is INSOLVENT | Creditors' meeting, creditors appoint or approve liquidator |
| Compulsory | Court order (usually creditor petition) | Official Receiver becomes liquidator, court controls process |
Members' voluntary liquidation is used when the company is solvent and able to pay its debts in full within 12 months. Common scenarios include: a business that has served its purpose and is no longer needed, retirement of shareholders, or restructuring of a group of companies.
Before MVL commences, directors must make a statutory declaration of solvency stating that the company can pay its debts in full within 12 months. The declaration must be made within 5 weeks before passing the winding-up resolution and include a statement of assets and liabilities.
Creditors' voluntary liquidation is the most common insolvency procedure for companies that cannot continue trading. It is initiated by the company itself (voluntary) but gives creditors control over the process. Used when directors recognise the company is insolvent and should cease trading.
Once CVL commences, the company's business ceases (except as beneficial for winding up). Employees are dismissed. The liquidator investigates the company's affairs and may report wrongful trading, fraudulent trading, or misconduct to the Insolvency Service. Directors may face personal liability or disqualification.
Under s.122 IA 1986, the court may make a winding-up order if: the company has passed a special resolution for winding up; the company is unable to pay its debts; the court is satisfied it is just and equitable to wind up (e.g., deadlock in management, loss of substratum); or the company is an "old public company" that has re-registered as private.
Winding-up proceedings begin with a petition to court. Petitioners can include: creditors, shareholders, the Secretary of State, the Official Receiver, or in some cases, the company itself. A petitioning creditor must typically be owed at least £750 and may need to show that a statutory demand has been served and not complied with.
After a winding-up petition is presented (but before order): a floating charge created without court approval is void; and any execution, attachment, or distress is void unless the court leaves it in force. This prevents depletion of assets before liquidation.
The court may order winding up as "just and equitable" in various circumstances: management deadlock, loss of substratum (company's purpose no longer exists), breakdown of mutual trust in quasi-partnerships, or regulatory action. This ground gives the court flexibility to order winding up where there is no other remedy.
Administration is a rescue procedure designed to: (1) rescue the company as a going concern, or if that is not possible, (2) achieve a better result for creditors than winding up, or if neither is possible, (3) realise property and distribute to secured or preferential creditors. An administrator manages the company's affairs with a moratorium on creditor actions.
Once administration begins, a statutory moratorium takes effect. This prevents creditors from taking legal action, enforcing security, or petitioning for winding up without the court's leave or administrator's consent. This breathing space allows the administrator to formulate proposals without immediate pressure from creditors.
Within 8 weeks of appointment, the administrator must convene a creditors' meeting and submit proposals for achieving the administration objectives. Creditors vote on the proposals. The administrator then implements the approved proposals, which may include selling the business as a going concern, restructuring debt, or ultimately moving to liquidation.
A Company Voluntary Arrangement is a legally binding agreement between a company and its creditors. It allows the company to compromise its debts - typically paying less than 100p in the pound over time, or rescheduling payments. If approved, it binds all creditors who were notified, including those who voted against.
A CVA allows the company to continue trading while repaying debts on affordable terms. It provides certainty for creditors who receive more than in liquidation. Directors typically remain in control. It can be used to restructure the business and return to profitability.
When a company is insolvent, or likely to become insolvent, directors' duties shift from acting in the best interests of the company (primarily shareholders) to acting in the best interests of creditors as a whole. This means directors must take creditor interests into account when making decisions, as creditors are effectively the residual claimants on the company's assets.
Directors are personally liable for company debts incurred after they knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation or administration. Liability is for the shortfall in assets that would have been available to creditors if the company had ceased trading earlier. Directors can avoid liability if they took every step to minimise loss to creditors.
A director can avoid liability for wrongful trading if they can show that after the point of no reasonable prospect of avoiding insolvent liquidation, they took every step with a view to minimising the potential loss to creditors. This may include: seeking professional advice, considering all options including administration or CVA, not incurring further unnecessary credit, and promptly ceasing trading if appropriate.
Fraudulent trading occurs when the company carries on business with intent to defraud creditors or for any fraudulent purpose. Unlike wrongful trading, fraudulent trading requires dishonest intent. Liability extends to anyone who was knowingly a party to the fraud. The court may order such persons to contribute to the company's assets. Criminal penalties may also apply.
Where a company goes into insolvent liquidation, the former directors must provide a statement of affairs showing assets, debts, and liabilities. Failure to comply without reasonable excuse is a criminal offence. This helps the liquidator understand the company's position and identify potential recovery actions.
When a company becomes insolvent, the liquidator or administrator can review and potentially set aside certain transactions made before insolvency. This prevents companies from depleting assets or preferring certain creditors in the period leading up to insolvency, ensuring fair treatment for all creditors.
A preference occurs when the company does something that puts one creditor in a better position than they would have been in insolvency. Examples include repaying one creditor in full while leaving others unpaid, or granting security for previously unsecured debts. The liquidator can recover preferences made within 2 years before insolvency (6 months if the preference is to a connected person).
A transaction at undervalue occurs when the company gives an asset away or sells it significantly below market value. The liquidator can recover such transactions made within 2 years before insolvency. This prevents directors from transferring assets out of the company before it fails. Gift transactions to connected persons are recoverable regardless of intention to prefer.
Floating charges created within 12 months before insolvency are invalid except to the extent of new money advanced at the time. For transactions with connected persons, the 12-month period is extended to 2 years. This prevents companies from granting security over remaining assets just before insolvency, which would give the secured creditor priority over other creditors.
A company has a defence to a transaction at undervalue claim if it can show that the transaction was: (a) for the purposes of carrying on its business, and (b) at the time it was entered into, the company was able to pay its debts and had reasonable grounds for believing it would continue to be able to do so.
Creditors with fixed charges have security over specific assets (e.g., property, machinery). In insolvency, they can enforce their security and recover the value of the secured asset. If the proceeds exceed the debt, the surplus goes to the company for other creditors. If there is a shortfall, the creditor becomes an unsecured creditor for the balance.
Floating charges attach to changing assets (e.g., stock, receivables, cash). In insolvency, floating charges "crystallise" and become fixed. However, since 2003, floating charge holders must share the proceeds with unsecured creditors through the "prescribed part" - a portion ring-fenced for unsecured creditors. The remainder goes to the floating charge holder.
Where a company is subject to a floating charge, a prescribed part of the company's net property is distributed to unsecured creditors (excluding preferential creditors) instead of the floating charge holder. The prescribed part is 50% of the first £10,000 plus 20% of the remainder, up to a maximum of £600,000.
Certain creditors have preferential status and are paid ahead of floating charge holders and unsecured creditors. Preferential creditors include: employee wages (up to £800 per employee for 4 months), holiday pay, and certain pension contributions. These debts are paid from floating charge asset realisations before the floating charge holder is paid.
Unsecured creditors have no security and are paid last, after all secured and preferential creditors have been paid. They include trade creditors, landlords, and customers with claims. In most insolvencies, unsecured creditors receive only a small percentage of what they are owed, and often nothing at all.
Under the Company Directors Disqualification Act 1986, directors can be disqualified from being a director or involved in company management for a specified period if the court finds them unfit. In insolvency, the Insolvency Service conducts investigations and may bring disqualification proceedings against directors of failed companies.
Minimum periods: 2 years for unfit conduct in voluntary liquidation; 3 years for unfit conduct in compulsory liquidation; Maximum period: 15 years for the most serious cases. Disqualification orders are made by the court following a complaint by the Insolvency Service.
Directors can accept a disqualification undertaking instead of going to court. This is an administrative procedure where the director agrees to be disqualified for a specified period. The periods are typically shorter than court orders (2-5 years for most cases, up to 10 years for serious misconduct). Undertakings avoid the time and cost of court proceedings.
Breaching a disqualification order or undertaking is a criminal offence. A disqualified person who acts as a director or shadows a director may face imprisonment, a fine, or both. Any transactions entered into while disqualified may be voidable, and the person may be personally liable for company debts incurred during the breach.