What is insolvency?

Despite the UK’s economic fortunes improving somewhat of late, hundreds of businesses are still falling into insolvency every month.

According to credit firm Experian’s Insolvency Index, a total of 1,491 firms became insolvent in May 2010.

Under UK business law, insolvency is defined in the Insolvency Act 1986 Section 123:

123. Definition of inability to pay debts (i.e. insolvent)

    1. A company is deemed unable to pay its debts – […]
  1. (e) If it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due. (Known as cash flow insolvency.)

  2. A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities. (Known as balance sheet insolvency.)

Liquidation
If your business becomes insolvent it may be put into liquidation. This is where the assets and property of the business are redistributed to satisfy all claims of your creditors.

The liquidation process can be instigated by the directors and shareholders of the insolvent business but the process will only be legally effective if there is a convening of a meeting of creditors where they can appoint a liquidator of their choice – known as creditors voluntary liquidation (CVL).

Alternatively, a creditor can petition the court for a winding-up order which can place the insolvent business into a compulsory liquidation.

Generally, the priority of claims on the insolvent company’s assets will be determined in the following order:

  1. Firstly, the costs of the liquidation are met out of the company’s remaining assets
  2. Secondly, the preferential creditors under applicable law are paid
  3. Thirdly, in many legal systems, the claims of the holders of a floating charge will be paid; other claims may also fit into this layer
  4. Fourthly, if there is anything left, the unsecured creditors are paid out proportionally in accordance with their claims. In many jurisdictions, a portion of the assets which would otherwise be caught by a floating charge are reserved for the unsecured creditors.
  5. In the very rare instances where the unsecured creditors are repaid in full, any surplus assets are distributed between the members in accordance with their entitlements.

There are two insolvency procedures available to companies; these are Administration or a Company Voluntary Arrangement.

Administration
Administration is a procedure designed to avoid, or at least delay, liquidation. Businesses in Administration appoint an Administrator, who must be a licensed Insolvency Practitioner, to manage the company’s affairs and protect the interests of creditors while restructuring the company so that it can continue as a going concern.

One particular type of Administration is pre pack administration. This is where the Administrator immediately completes a pre-arranged sale of the business, often to its directors or owners, to enable a best price to be achieved and thus maximise the price of assets for the business’ creditors.

Company Voluntary Arrangement (CVA)
A CVA is a legal agreement between an insolvent business and its creditors where a fixed amount lower than the outstanding actual debt is paid to creditors. These payments are usually made on a monthly basis and remaining debts are written-off at the end of the agreed terms. The CVA is managed by a Supervisor who must be a licensed Insolvency Practitioner. If the CVA fails, the insolvent business is usually put into liquidation.

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