Business Law and Practice Part 4: Insolvency

Insolvency is one of the less loved parts of the business law and practice module; it is a complicated area but is taught in a relatively small amount of time towards the end of the course. As a result, a lot of students struggle to get their head round insolvency before their exams, which is not surprising really! My second training contract seat was in insolvency, and I can assure you that what you learn on the BLP is the tip of the iceberg (it’s also a lot more interesting in practice!).

The first thing I would say is that insolvency law is a practice area in itself. It has its own laws, rules and procedures, and to understand it properly in the short amount of time you get in BLP is virtually impossible. I would recommend trying to grasp the motivations and consequences for the procedures, but at a relatively high level. The second thing is that you are being taught insolvency on the business module, so always remind yourself you are looking at it from a business point of view, not necessarily a legal one. And finally, the third thing to inform you is that insolvency lawyers, even the ones who have practised in the area for years, carry a copy of the Insolvency Act 1986 and the Insolvency Rules with them to refer to. The law and rules are so specific that they often double check to make sure they have got it right. You should be doing the same; don’t try to learn the law, you will come unstuck.

I am not going to reiterate the law here, you will need to refer to the statute in the exam so I am not going to repeat it or give a step by step guide to making someone insolvent. What I am going to do, hopefully, is give some ideas as to the reasons for deciding on an insolvency route – being able to explain the legal procedures is one thing but being able to advise the client on the pros and cons of administration, for example, should help you in the exam.

I will start by explaining there are four main types of insolvency procedure: voluntary arrangements, bankruptcy, administration and winding-up. Personal insolvency could involve a voluntary arrangement or bankruptcy, corporate insolvency could be a voluntary arrangement, administration or winding-up. Lenders (often banks) who have taken security (a mortgage, charge or debenture, for example) are likely to have their own powers conferred by the security documents in the case of insolvency or default on payment, such as the ability to repossess a mortgaged house, for example. Similarly landlords usually have the right to forfeit a property (end the lease) on insolvency.

Voluntary arrangements are exactly what they say on the tin, a voluntary arrangement with creditors. They can be quite useful in the sense that you enter an agreement to pay back a certain amount of debt, split between the creditors, over time (have you seen the adverts for IVAs on the TV?), but are going out of fashion, especially in corporate insolvency. Often the second largest creditor of a business (after the banks, lenders, etc.) is the landlord, and they have typically been hard done by under voluntary arrangements. As a result, many are wary of entering into voluntary arrangements with creditors and without the landlord agreeing not to forfeit, the arrangement is difficult to set up.

Currently, insolvency is all around us. So many of our high-street names are in administration, and debt consolidation or insolvency solutions are advertised everywhere. It can be easy to forget that insolvency, especially for businesses, is a big deal. Leaving individuals aside for the moment, the consequences of a winding-up petition for a trading company can be devastating; if it wasn’t insolvent before, a petition can drive it over the edge. Most trading companies rely heavily on their ability to move cash – paying staff, buying stock, covering overheads, etc. Credit rating agencies monitor winding-up petition advertisements and will put up a red flag as soon as they see one in the London Gazette. These are sent to all major lenders and banks, which immediately freeze the bank accounts of the company concerned. The company will not be able to access its money without an order from the court or the withdrawal of the petition. Without cash flow, the company is quickly crippled – staff are not paid and refuse to work, key suppliers aren’t paid so don’t deliver; the lack of staff and stock means the company misses contractual deadlines and its contracts are cancelled. The business is in tatters in a matter of weeks, all over a petition which may have been for as little as £750.

Insolvency as debt collection

This sounds a little counter-intuitive – why would you make someone insolvent to collect a debt? Most creditors are unlikely to receive the full amount they are owed on insolvency, if there are a number of preferential creditors it could be that you would get nothing at all. Why not just sue? The answer is that insolvency is much scarier than a court case and has some other benefits too. Statutory demands are cheaper than litigation, take less time and are often enough to make someone pay up. You don’t have to show mitigation of loss or go to court. Simple. There are some constraints though – the debt cannot be disputed. Disputed debts or debts with elements that are disputed should be pursued through litigation, not insolvency. However, if it is simply that you haven’t been paid, a stat dec is an effective way of scaring your debtor into paying up.

If a statutory demand doesn’t work, the next stage is a bankruptcy or winding-up petition. Using this as a scare tactic is a little more extreme but not unheard of. It is quite expensive, however – you have to pay a deposit to the official receiver (OR) for their services plus a hefty court fee. You get the OR’s deposit back if you withdraw the claim (i.e. because the debtor has paid up) but not the court fee. For large amounts of debt, or large clients, this might be loss the client is willing to bear.

Insolvency as rescue

Administration (including voluntary arrangements) is an insolvency procedure designed to rescue the business, or at the very least get the best outcome for the creditors; winding-up petitions damage the reputations of businesses and can often devalue the assets or goodwill left for creditors. If there is a part of the business that is still viable (e.g. the wholesale and Internet part of a clothes company is often profitable where as the shops are not) this can be separated from the loss making side and sold on (this is what happens in a pre-pack). Also, if it is likely the company could be traded out of difficulty, for example, if it is due to be paid a huge commission when it reaches the end of a contract, administration could achieve this. Often companies that are suddenly faced with an unexpectedly large demand (typically damages in a court case or a large tax bill) will give themselves time to pay through administration. Finally, if a better price could be achieved through continued trade to sell assets, for example, if the company has a lot of stock for example, administration is a good option.

One of the key benefits of administration is the moratorium: a period in which no further legal action may be taken against the company. All ongoing litigation is stayed and, usually the crucial aspect, no winding-up petitions can be presented. Where the aim of the administration is to save the company, the moratorium can literally be the shield that prevents collapse. As I described above, the advertisement of a winding-up petition can destroy a company. An administration moratorium can prevent the advert being placed, leaving the company intact to be able to control how news of its money troubles are spread.

Insolvency as a trigger

What is often forgotten (as it isn’t often flagged up clearly on the LPC) is that insolvency is very often a contractual trigger. If an insolvency event occurs (usually defined as starting an insolvency procedure), it triggers various clauses within contracts including forfeiture (in leases), receivership and possession (charges and mortgages), retention of title (in supply contracts – the supplier can reclaim goods bought by the insolvent party) and default (most contracts). Whilst insolvency isn’t normally used tactically to trigger one of the provisions (if a creditor can petition for insolvency, it can usually sue under its contracts) the contractual consequences are important when advising a client. Forfeiture, receivership and some contract cancellation are regarded as legal steps so cannot be taken under a moratorium (again, another motivation for administration). Retention of title clauses are usually observed by administrators.

Insolvency as last resort

Bankruptcy and winding up are the last resort when money issues have just gone too far. They allow debts to be scored under so those concerned can, after a time, get up and start again. It rarely gets a good result for unsecured creditors but in some cases, a small something is better than nothing. It is important to remember, when discussing insolvency as a last resort, the criminal offences that can be committed by directors. If a company gets to the point of no return, it should cease trading to prevent running up any more debt. Failing to do this can have serious consequences, including criminal prosecution for the directors of the company. When it gets to this stage, there is often no option but to become insolvent; to continue to trade would be illegal.

There is a key professional conduct issue surrounding insolvent companies: the interests of the directors may conflict with the interests of the company. You should be wary of this; directors may need to get independent legal advice if there is a question about their involvement leading up to insolvency.

For the exam, I would recommend preparing a time-line of the procedures, detailing what you need to do and show at each stage of the process. The procedures are quite complicated, so using a timeline in this way is a helpful method of summarising all the information you need to know. If you are advising the client around insolvency, put yourself in their shoes: what do they want to achieve and what are they worried about? Would their business suffer if their reputation were damaged? It is also useful to list the things a company or individual can and cannot do if it is insolvent – i.e. give away assets, grant security, make preferential payments to creditors.

Overall, remember that insolvency is only a very small part of the module; don’t spend too long trying to get a handle on it or remember all the legislation. If you have an idea of why a business might be facing insolvency and what the benefits and negatives are of each process, the legislation will fall into place.