From Uncertainty to Action: Business Owners' Essential Guide to Understanding Insolvency, Financial Distress, and Recovery, With Guest Simon Haskew
So how can you, as a business owner, best equip yourself to navigate turbulent times?
The good news is knowledge is power. Understanding your responsibilities and options provides much needed clarity. That’s why we’ve dedicated this Q&A to address the critical concerns that keep entrepreneurs awake at night.
Q: So what exactly does insolvency mean, and how can I determine if my business has reached this point?
SH: Insolvency means being in a state of inability to pay one’s debts as they fall due. A company is deemed to be in this state if it fails to satisfy a statutory demand or judgment debt and also if the value of its assets is less than the amount of its present and contingent liabilities. In this sense a company can be either cash flow insolvent, balance sheet insolvent or both. The important point is that if insolvency arises, company directors’ duties can fundamentally shift from looking after the interests of the business owners/shareholders to acting in the interests of the creditors as a whole. This duty entails protecting the value of a company’s assets and mitigating liabilities and claims against it where possible.
Q: Could you shed light on the common factors that lead to insolvency, and what proactive steps can I consider to steer clear of these pitfalls?
SH: Typically, what I see is businesses that run out of cash. Some literally exhaust all cash resources and have nothing left to pay the next wage bill. Others get to the point where they can foresee not having enough cash to pay essential costs in one, two, three, or more months’ time. The back story will usually be the incidence of trading losses that have wiped out reserves. More unusual is a company that doesn’t suffer from cash flow problems (yet) but has a significantly negative balance sheet.
Being a business owner and entrepreneur means that insolvency risk goes with the territory. Having the best laid plans won’t necessarily guarantee success because there are always so many externalities or things arising beyond our direct control (who could have predicted the effects Covid 19 or invasion of Ukraine as part of their budgetary process). What is important though is be alert as early as possible to a potential cash crisis so that there is enough time to plan around it. The key is having consistently reliable up-to-date management information as a basis for decision making. Any business that operates without a detailed rolling cash-flow forecast is not best placed to navigate the inevitable difficulties that SME businesses are destined to encounter.
Q:In the event I suspect financial difficulties in my business, what are the initial steps I should consider taking to address the situation?
SH: The very first step is to share those concerns with a trusted colleague, friend, or business advisor. You need to sense-check them with someone rather than going it alone. If you’re fortunate to be able to just pick up the phone to your accountant, that’s the call I would make. That conversation in itself might resolve the issue but if not, your accountant is likely to know a specialist who can drill down further in an initial conversation with you and suggest options.
Q: When a business faces insolvency or financial distress, what are the primary options at my disposal, and how do they differ in terms of outcomes and processes?
SH: This is a massive subject area in itself. The fundamental decision concerns whether or not allowing trading to continue. As discussed above, a director’s primary duty shifts to looking after the interests of creditors when the spectre of insolvency arises. This in turn raises the question at what precise point does this duty shift occur such that the interests of the creditors must take precedence. Is it when insolvency (here in the sense of insolvent liquidation or administration) is merely a potential risk, at one end of the spectrum, or a clear certainty at the other end?
Broadly, the answer is to weigh the situation up on the balance of probabilities. If, based on the evidence before them, the directors were to conclude that it was more likely than not that the company would go into insolvent liquidation or administration, that is the point from which the interests of the creditors must be engaged. If the decision to continue trading is made following that conclusion, it must be because it is demonstrably in the interests of the creditors (because it enhances the value of the company’s assets and/or mitigates its liabilities). In these circumstances, such trading is usually tactical short-term, aimed at realising assets and/or side-stepping liabilities. In reaching their conclusion, directors need to be acting (1) in good faith and (2) reasonably. The former is a given.
My take on the latter is that acting “reasonably” means acting rationally in the face of the available evidence. Every situation will present uniquely and it’s one of the most difficult decisions a board of directors will make. If there is any doubt, there is no substitution for special independent legal advice. If the board concludes that insolvency cannot be avoided, then the options typically available will be Company Voluntary Arrangement, Administration or Voluntary Liquidation. The details behind these options would be the subject of another whole blog!
See the Supreme Court decision in BTI v Sequana for a detailed discussion about when the duty to creditors arises.
Q: As a Company Director, how might insolvency impact me personally in terms of liabilities, legal responsibilities, and potential consequences?
SH: We have already covered the main legal responsibility which is to have regard for the interests of creditors as a whole. Most directors are honest, well -meaning and keen to do “the right thing”. Unfortunately, by following their instincts on this, some directors will act unintentionally in contravention of insolvency law. A very typical example is the payment in full of a group of (usually small) creditors in priority to others, for example paying local trades people (the butcher, baker, newsagent) because this feels right. These however are classed as “preference” payments and can be clawed back by the insolvency office holder (i.e., liquidator or administrator). This is why the emphasis is on protecting the interests of the creditors as a whole. Looking after some creditors at the expense of others offends the core insolvency principle of treating all creditors equally. Of course, everyone is well aware that in an insolvency situation some creditors have priority for repayment over others. But this is a complex area and should be left for the liquidator to deal with.
Recurring themes we see where directors are liable to make a payment back to the company include repayment of overdrawn directors’ loan accounts and repayment of dividends (because at the time they were drawn the dividends were unlawful as they were not covered by sufficient cumulative profits). Preference payments made to directors themselves (often unintentionally) are also reasonably commonplace.
Additionally, directors may have given personal guarantees to various third parties and be called upon to repay those guaranteed debts, irrespective of the company’s ability to pay. These typically include guarantees given to banks and other lenders, landlords under property leases, trade supplier accounts, franchisors under franchise agreements, and counterparties under lease finance agreements.
There are other potential repercussions, for example disqualification from being a director under the Companies Director Disqualification Act and personal liability for HMRC debts in certain circumstances. But these latter examples are comparatively rare and should not trouble the vast majority of directors who, as already noted, are straightforward and honest in their business dealings.
Q: Finally, what are some tell-tale signs that suggest it’s time for me to seek professional assistance or consult with an insolvency expert to address the position?
SH: Anything which hints that that there is an insolvency threat on the horizon should be investigated quickly and assurances gained that it can be resolved. If there is any lingering doubt, make that call.
A big thank you to Simon for generously sharing your expertise and being our guest expert on this crucial subject. Your valuable insights and wealth of experience have illuminated the often complex path of insolvency, offering business owners practical, actionable steps and proactive strategies to help them navigate this challenging terrain with greater confidence and peace of mind.
Looking for more insights on the world of insolvency?
You can find out more about Simon Haskew here.
Hi, I’m Harriet, your trusted Fractional CFO , Chartered Accountant and Business Growth Specialist.
I am the founder of Below The Line Finance and my mission is to financially empowering creative entrepreneurs to build aligned businesses – with profit, purpose and healthy cashflows! With my collaborative and supportive approach, I am dedicated to guiding you to greater confidence and success with your business finances. What could you accomplish with your very own Mini CFO?
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Harriet Formby MA ACA
Small Business CFO, Below The Line Finance