As the UK economy begins, in late 2009, to recover from the harshest recession in 75 years, insolvency is becoming somewhat more prevalent than has been the long term experience of most of us. The few high profile administrations such as Lehman and Woolworths are likely to be followed by many ordinary smaller businesses encountering formal insolvency procedures. Formal insolvencies tend to lag on economic recovery because of reluctance to invoke them and the time it can sometimes take to do so.

Now is therefore an ideal time to remind you about corporate insolvency and this is the first of a series of posts to do so.

Definitions

The word insolvency can be used either in a general sense to identify a company’s illiquidity or over-indebtedness (technical insolvency), or more specifically to identify a company subject to a formal insolvency procedure (formal insolvency).

Technical insolvency is most simply identified using the terms of s123 Insolvency Act 1986 ("IA86"):

• ‘the company is unable to pay its debts as they fall due’ (illiquid – the cashflow test); or
• ‘the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’ (over-indebted – the balance sheet test).

Classic evidence of the cashflow test being failed includes creditors having issued writs or statutory demands and late payment of PAYE and VAT.

Realisation that the balance sheet test includes contingent and prospective liabilities often puzzles directors because so many companies do fail that test, but it is the case that prospective and contingent liabilities are taken into account when assessing a company’s technical insolvency.

Of course, failure of one of the two tests does not immediately lead to adverse practical consequences or penalties. This is in contrast to some jurisdictions, such as Germany, where it is a criminal offence for directors not to instigate formal insolvency proceedings within three weeks of failing similar illiquidity and over- indebtedness tests. In the UK it is more helpful to consider the concept of the ‘zone of insolvency’.

A distressed company may move into insolvency but with a ‘reasonable prospect of avoiding insolvent liquidation’.

This paraphrase of part of s214 IA86 (the section that deals with wrongful trading) allows for the taking of a somewhat longer view than under the German system. It is not, however, a view without risk. Even if there had been a long period during which there was a reasonable prospect of avoiding insolvent liquidation, followed by a calamity that caused liquidation, the company will have been technically insolvent from the moment it failed either the cashflow test or the balance sheet test.

One consequence of technical insolvency is that it determines whether transactions entered into by the company are at risk of being overturned under insolvency legislation relating to antecedent transactions such as transactions at an undervalue (s238 IA86) and preferences (s239). In order for an administrator or a liquidator to be able realistically to take court action to overturn a transaction at an undervalue or a preference, the company must have been in the zone of insolvency at the time of the transaction.

However, the section that more clearly focuses directors’ minds on the zone of insolvency is s214. Wrongful trading – incurring losses when a director ‘knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation’ can lead to the court declaring that the director is personally liable for the amount the court orders to be paid. That amount is likely to reflect the losses suffered by creditors during the period of wrongful trading.

The practicalities of technical insolvency are that:

•  it can lead to formal insolvency;
• it introduces additional risks, notably for the directors personally, at a time when the company is already stressed; and
• the onset of technical insolvency is an ideal time – perhaps even the best time – for a company to take specialist insolvency advice.

Case Study

In July 2007 I was consulted by an AIM listed company whose directors where concerned about its financial position. Since then I have advised the board many times about the risks they face and whether they have a reasonable prospect of avoiding insolvent liquidation. At times there has been a gap of several months between consultations and at times we have spoken every few days. The company remains in the zone of insolvency but it currently has a reasonable prospect of avoiding insolvent liquidation and it is less illiquid and less over-indebted than when I was first consulted. It has achieved this through enhancing its profitability and attracting investment. As a start-up company in a relatively new sector it has already become a market leader although it has yet to break even. If it were to stumble and fall into formal insolvency, it seems to me unlikely that the directors would be at significant risk of a wrongful trading action. Also, for the last two years they have been aware that any transactions at an undervalue or preferences could be overturned in the event of formal insolvency – but I am not aware of there having been any such transactions!

Look out for Part 2, which will explain how best to avoid formal insolvency despite failing the technical insolvency tests.

Chris Laughton is a partner at Mercer & Hole. The views given in this blog are personal to the author.

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When is an administrator not an administrator?

The facts:

An administrator appointed by a qualifying floating charge holder discovers that the purportedly qualifying floating charge is "invalid" under s245 Insolvency Act 1986, in that the consideration for the charge was given by the creditor before the charge was created, at which time the company was unable to pay its debts within the meaning of s123.

The questions:

(a) Is the administrator's appointment therefore invalid and (b) what should he do?

The issues:

(a) Since s245(2) is triggered retrospectively by the definitions of "relevant time" (s245(3)) and "onset of insolvency" (s245(5)), and the onset of insolvency in this case is the appointment of the administrator, there is a "scintalla of time" argument that the charge does not become invalid until the administrator is appointed, by which time he has been appointed under a (then) valid charge, his appointment was therefore valid and it remains unaffected by the charge's subsequent invalidity.

Alternatively, and on the face of it more pragmatically, there could never be a valid administration appointment within the 12 month (or two year) relevant time period because that was the clear intention of the legislation, an appointment by a floating charge holder that was not a "qualifying" floating charge holder by reason of the charge's invalidity is itself invalid, and an invalid appointment is sufficient to trigger the relevant time and to give the administrator the locus to apply for directions.

(b) Should the administrator plough on, seek directions or just walk away from the nullity?

Some answers:

1. the administrator's appointment is invalid and he should seek directions, which might include a declaration from the court declaring the appointment to be invalid and an order that the administrator be indemnified by the appointor. This is arguably the safest route for the administrator and a proper course to bring the matter to the court's attention. Since the whole matter is uncertain, it must be right for the (purported) administrator as (or in case he is) an officer of the court to bring the matter to the court's attention in this way. A separate administration application can then be made, possibly retrospectively to the time of the original, invalid appointment; or  
2. on the scintilla of time argument, the administrator's appointment was valid at the time he was appointed and he should just carry on. This might avoid a creditor or the directors having to make a fresh administration application, but there is a risk that someone might view the position differently and challenge the administrator's actions. If the court is not wholly persuaded by the scintilla of time argument, such a challenge might find favour with the court, with adverse cost and liability implications for the administrator; or
3. the whole appointment was a nullity and the purported administrator is not in a position to do anything, even make an application to the court, as the company is not subject to any insolvency proceedings.

Observations:

I have recently followed answer (1) in an unreported case, but I am aware of other cases where different Counsel advised along the lines of each of answers (2) and (3).

What is your view? Is it useful to have a precedent of seeking directions or is it preferable to retain the flexibility of being able to plough on in cases where there is little prospect of challenge? Is there a real prospect of the court declining to entertain a directions application from an administrator in these circumstances?

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The time limits within which transactions at an undervalue can be upset under sections 238 and 339 of the Insolvency Act 1986 are reasonably well understood: 2 years for companies and 5 years for individuals.

Section 423, which deals with transactions at an undervalue that were intended to defraud creditors, is less straightforward. It requires proof of intention - a much more difficult hurdle than simple proof of facts - to upset a transaction successfully. And although there is no statutory time limit, historically the courts were reluctant to extend its reach too far. The recent case Sands v Clitheroe [2006] BPIR 1000 revisits these issues and great care is now required to avoid falling foul of s423.

The facts in the Sands case were that Mr Clitheroe, a practicing solicitor, gifted his interest in his home to his wife. At the time he was solvent and a partner in a fairly secure practice, but he effected the transfer in order to protect the family home in the event of the financial collapse of the partnership. After being made bankrupt 15 years later, and despite all of his creditors being "new", the court upset the transaction.

The court decided that where the intent of the transaction had been to put assets beyond creditors' reach, even though the debtor was not engaging in "risky business" and none of the bankruptcy debts existed at the time, the transaction fell within Section 423, for which there is no time limit. Notably, Section 423 applies equally to companies as to individuals.

The case shows that if a transaction is for full value or the reasons for the transaction are other than to put assets beyond the reach of creditors, it will be safe from attack under Section 423, regardless of how long ago the transaction occurred. It is, therefore, imperative that the reasons for a transaction are fully documented rather than leaving a court to assume it was to avoid creditors. The case also highlights that, where there could be a dispute as to value, it would be wise to retain evidence of the basis of valuation well beyond the appropriate statute of limitations period.

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As revealed in Insolvency reform - Bank Law Blog, the Insolvency Service has issued a consultation paper setting out its proposals to modernise and streamline the law governing insolvency procedure.

The broad aims are to bring insolvency law up to date with our current ability to communicate electronically, to move some decision-making process to insolvency practitioners and to remove some unnecessary burdens from insolvency practitioners. Replies to the consultation must be with the Insolvency Service by 10 December 2007.

The document's full title is:

"A consultation document on changes to the Insolvency Act 1986 and the Company Directors Disqualification Act 1986 to be made by a Legislative Reform Order for the modernisation and streamlining of insolvency procedures".

It is:

 "A Consultation Paper issued by The Insolvency Service on behalf of the Minister of State for Employment Relations and Postal Affairs"

and it is available for download (from the Insolvency Service website) here.

There are eight proposals, detailed below:

1. To modernise and make more flexible the means of communication, and the exchange of information, between insolvency office-holders and creditors (and others who send or receive information) in insolvency cases by:

1.Introducing a provision requiring creditors to “opt-in” if they wish to receive information issued by the insolvency office-holder during the conduct of the proceedings and/or who wish to participate in the insolvency process.
2.Updating insolvency legislation to make it explicit that communication can be effected electronically where the legislation requires it to be “in writing”.
3.Enabling insolvency office-holders to provide information by sending a link to a website on which information is posted.
4.Providing a legislative framework that will allow insolvency office-holders to hold meetings required to be held as part of their conduct of insolvency cases through media other than meetings held at a physical venue.

2. To remove a requirement that is imposed upon liquidators and trustees in bankruptcy requiring them to obtain sanction for certain actions they propose to take as part of their conduct of the case.

3. Moving to allow discretionary advertising of the appointment of a voluntary liquidator and to remove restrictions on the form any such advertisement can take.

4. Removing a requirement imposed upon liquidators to summon annual meetings of members and/or creditors for the purpose of laying an account of their acts and dealings and of the conduct of the winding up during the preceding year.

5. Removing the requirement for any document in insolvency proceedings to be sworn by affidavit and to replace it with a less burdensome requirement for such documents to be verified by a statement of truth in accordance with the Civil Procedure Rules 1998.

6. To remove the requirement for an insolvency practitioner, acting as liquidator, to submit a report to the Secretary of State on the conduct of the directors of a company if he has already submitted such a report as administrator of the same company.

7. To remove a requirement that exists for the Insolvency Services Account (“ISA”) kept by the Secretary of State to be held with the Bank of England.

8. To remove the power of the court to order that a person owing monies to a company in liquidation pay those monies into an account, in the liquidator’s name, at the Bank of England.

As an IP, I have to say that on first reading the proposals make good sense.

Comment below, or respond directly to the Insolvency Service on Annex B of the document.

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Section 216 of the Insolvency Act 1986 restricts the use by a Phoenix company or successor business of a similar name or trading style to that of a company in insolvent liquidation.

That is well known, as are the exceptions ñ or are they?

The Exceptions

S216 works by making any director of the insolvent company who is involved in managing the successor, unless he has leave of the court and subject to the exceptions in rules 4.228 to 4.230 Insolvency Rules 1986, both liable to criminal prosecution and personally liable (under s217) for the debts of the successor.

• The first exception, giving notice to creditors (rule 4.228), will rarely be available, contrary to widely adopted practice, because the notice must be given before the relevant director is involved with the successor, as the Court of Appeal made clear recentlyin Churchill & Churchill v First Independent Factors and Finance Ltd ([2006] EWCA Civ 1623).


• The second exception, a six week grace period following an application for leave made to the court no later than 7 days after the date of liquidation (rule 4.229), may be more common but requires an application anyway.


• The third exception, when the successor company has been known by the prohibited name for 12 months prior to the liquidation (rule 4.230), will also not assist most directors who wish to acquire and continue a business from an insolvent company.

Consequences

The first exception does not work in the way many people have thought. Notice to creditors is ineffective if the director is already a director, shadow director or de facto director of the successor business (but the notice cannot be given until the transaction has occurred).

What s216 therefore requires in most cases is an application to court for permission to be involved with a similarly named business, as a recent article ìRe-use of company names: the efficacy of the notice procedure called into questionî points out (Recovery, Summer 2006, p25).

Unless the application is made before the end of the first week of liquidation, making use of the second exception, there may be a period of several weeks during which the business cannot be transferred, pending the hearing.

Since the criminal and civil liabilities that result from breaching s216 are strict and automatic, and the court will actively consider whether approval is appropriate, and the court is unlikely to give retrospective permission (following Arden LJ in ESS Production Ltd v Sully [2005] EWCA Civ 554), a director would be ill-advised to rely on seeking permission after the event.

Sales by administrators

There are most likely to be unforeseen difficulties when the business was sold to the director by an administrator, administrative receiver or voluntary arrangement supervisor some time before the company went into liquidation. S216 will apply if the vendor company goes into insolvent liquidation at any time during the 12 months after it stopped being known by the prohibited name being used by the purchaser.

The only way for a director to avoid liability in these circumstances is to apply to court under s216. The application should be made before liquidation ñ although there is some doubt as to whether this would be valid ñ or within 7 days afterwards (making use of the six week period within which the application can be heard without liability attaching from the date of liquidation, provided the application is successful).

Addressing the problem

The situation is clearly unsatisfactory as MBO directors cannot wholly avoid the risk of liability and the Insolvency Service is therefore considering an urgent, albeit not retrospective, rule change.

In the meantime, directors involved in purchasing a business from an administrator may seek to agree with the officeholder that he avoids using insolvent liquidation as an exit mechanism. They are also likely to want him to avoid the vendor company being known by the prohibited name from the date of sale.

For those who have already breached s216 following an insolvency sale, in the mistaken belief that notice to creditors when the director was already involved with the successor was adequate, an application under s216 now would at least offer the prospect of relief from personal liability for the successor companyís future debts. Otherwise the director, whilst he remains involved in management of the successor company, will continue to be personally liable for all the successor companyís debts for up to 5 years after the liquidation of the vendor company.

Phoenixes beware!

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