The big three questions:
- Is the company able to pay its debts as they fall due? (‘Cashflow Test’)
- Are the company’s assets greater than its liabilities, taking into account its contingent and prospective liabilities? (‘Balance Sheet Test’)
- Is there a reasonable prospect that the company will avoid going into insolvent liquidation?
If at any time the answer to question 1 or 2 is ‘no’ then the company maybe insolvent.
Should a company be found to be insolvent the Directors should consider that their usual duties (to promote the success of the company for the benefit of the members as a whole) become subject to an overriding duty to protect the interests of creditors.
There is much legislation regarding what is expected of a director in an insolvent situation.
Directors must ensure that they act prudently and responsibly. In so acting a Director will be assumed to have the general knowledge, skill and experience that may reasonably be expected of a person in his or her position. Any special knowledge or experience will also be taken into account.
In connection with ‘question 3’ above, the language of the legislation is whether the directors “knew, or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation”. Directors will therefore be judged by a standard that has both subjective and objective elements. A Finance Director, for example, may face greater scrutiny than an Operations Director.
If any company does subsequently enter into formal insolvency, the extent to which any Director falls short of these standards of conduct will also be taken into account in connection with any disqualification proceedings. Following an insolvency, Directors can be disqualified from acting as a Director of a company for up to 15 years.
When insolvency has intervened or is foreseeable at some time in the future, the Directors must very carefully consider whether there is a reasonable prospect of survival, and they should not place creditors at risk in pursuing merely speculative and unlikely outcomes. They should regularly and carefully minute their consideration of these issues and they should take specialist insolvency advice. The key to achieving a successful outcome is to act as early as possible, and to consider alternative strategies, such as raising finance, asset disposal, business reorganisation or Company Voluntary Arrangement, before the situation becomes unmanageable.
Where the company’s survival depends upon the support of a Bank or other lender, close dialogue will be necessary as to the terms upon which any continued support will be provided. If that support is withdrawn, or if it becomes uncertain, the Directors must urgently consider what the prospects are for the Company’s recovery and survival. They should also review the alternative strategies available to them to obtain replacement finance or to reduce the company’s reliance on lender support.
Whether or not a company is presently able to pay its debts as they fall due, or it has a positive balance sheet, if at any time the answer to question 3 is ‘no’ and an insolvent liquidation is impending, perhaps because of a forecast cash crisis, then the directors run the risk of personal liability to creditors for ‘Wrongful Trading’ unless they can show that they subsequently took every step with a view to minimising the potential loss to the company’s creditors that they ought to have taken.