When a company becomes insolvent, directors have a duty to keep losses to creditors as low as possible and should not continue to trade if (as a result of trading) the company’s debts will increase.
If the company is insolvent and the directors do continue to trade the Directors can be held personally liable for the company’s debt.
Is my company insolvent?
It is not always easy to determine whether the company is “insolvent” and so, whether as director, the decision should be made to cease trading.
The definition under section 123 of the Insolvency Act 1986 sets out that a company is considered to be insolvent when it can no longer meet its liabilities
There are two ways to determine whether a company has become insolvent:
1. The “balance sheet” test: If on the company’s balance sheet the liabilities outweigh the assets it is likely the company is insolvent.
2. The cash flow test: The main question for the cash flow test is whether the company is able to pay its liabilities as they fall due.
Cash flow issues are of course very common, even when a company has a healthy level of business; such problems will often be caused by a major customer failing to pay on time, causing short term cash flow problems. However, the difference with an insolvent company is that the amount owing is so high that the company is unlikely to ever be able to pay its debts.
What is wrongful trading?
Wrongful trading is when the directors knew, or should have reasonably known, that the company was insolvent (or that there was no reasonable chance that the company would not become insolvent) but decided to continue trading.
Wrongful trading is a serious matter and directors should be cautious of not increasing the company’s debt and worsening the position of their existing creditors, especially when they do not have a plan of how they are going to get the company out of its financial difficulty.
When directors become aware that the company may be in difficulty they should seek professional advice as they have a duty to put the creditors first and have to limit incurring additional debt.
What is fraudulent trading?
Fraudulent trading occurs when directors attempt to deliberately avoid paying the company’s liabilities, usually by trying to deceive creditors and / or customers.
What are the consequences?
When a company becomes insolvent, there may be an investigation into the conduct of the directors to ensure they tried to mitigate the loss of their creditors. If it comes to light that the directors have not acted responsibly they could be held personally liable for the company debt. Being found guilty could also result in an individual being disqualified from being a company director for up to 15 years.
Fraudulent trading carries the same consequence as wrongful trading but with the addition of a potential prison sentence as fraudulent trading is also a criminal offence.
Examples of trading whilst insolvent
Examples include but are not limited to:
- accepting credit from a supplier knowing the company cannot make repayments;
- continuing to take orders that you know cannot be fulfilled;
- selling assets belonging to the company below the market value;
- taking money out of the company to fund personal expenses;
- collecting an unreasonably high salary that the company cannot afford; and
- paying one creditor in preference of another
Directors can be found culpable for trading a company whilst it is insolvent (most commonly wrongful trading) if they continue to trade when it is unlikely that the company will be able to recover from its financial difficulties. There are potentially serious consequences for directors as they can be held to be personally liable for company debts and can be banned from being a director in the future.
If you think your company may be insolvent or would like further advice on wrongful or fraudulent trading please don’t hesitate to contact a member of our Dispute Resolution team.