Business Law and Practice Part 4: Insolvency

Insolvency Overview

Insolvency is one of the less loved parts of the Business Law and Practice module.

It is a complicated area, taught in a relatively small amount of time towards the end of the course. As a result, many students struggle to understand insolvency before their exams, which is not surprising.

My second training contract seat was in insolvency, and I can assure you that what you learn on the BLP is only the tip of the iceberg. It is also far more interesting in practice.

Insolvency lawyers, even those who have practised in the area for many years, carry copies of the Insolvency Act 1986 and the Insolvency Rules with them to refer to. You should be doing the same. Do not try to memorise the law, as you will come unstuck.

The first thing to understand is that insolvency law is a practice area. It has its own laws, rules and procedures, and fully understanding it within the short time allocated in BLP is virtually impossible. Aim to grasp the motivations and consequences behind the procedures at a high level.

Secondly, remember that you are being taught insolvency within the business module. Always remind yourself that you are looking at it from a business perspective, not necessarily a purely legal one.

Finally, insolvency lawyers, even the most experienced, frequently double-check the legislation because the rules are so specific. You should do the same.

I am not going to reiterate the law here. You will need to refer to the statute in the exam, so I will not repeat it or provide a step-by-step guide to making someone insolvent. Instead, I hope to give you some ideas about the reasons for choosing insolvency routes.

Being able to explain the legal procedures is one thing, but advising a client on the advantages and disadvantages of administration, for example, will help you significantly in the exam.

Types of Insolvency Procedures

There are four main types of insolvency procedure: voluntary arrangements, bankruptcy, administration and winding up.

Personal insolvency may involve a voluntary arrangement or bankruptcy. Corporate insolvency may involve a voluntary arrangement, administration or winding up.

Lenders, often banks, who have taken security such as a mortgage, charge or debenture, are likely to have powers conferred by the security documents in the event of insolvency or default. These powers may include the ability to repossess a mortgaged property. Similarly, landlords usually have the right to forfeit a lease on insolvency.

Voluntary Arrangements

Voluntary arrangements are voluntary agreements with creditors. They can be useful, allowing a debtor to repay a certain amount over time, divided between creditors. However, they are becoming less common in corporate insolvency.

Often the second largest creditor of a business, after banks and lenders, is the landlord. Landlords have historically been disadvantaged under voluntary arrangements. Many are now reluctant to enter into them, and without the landlord agreeing not to forfeit the lease, the arrangement is difficult to set up.

The Impact of Insolvency

Insolvency, especially for businesses, is a major event.

Currently, insolvency is widespread. Many high street names are in administration, and debt consolidation or insolvency solutions are widely advertised. It is easy to forget how devastating insolvency can be for a trading company.

The consequences of a winding up petition can be severe. Even if the company was not insolvent before, a petition can push it over the edge. Most trading companies rely heavily on cash flow to pay staff, buy stock and cover overheads. Credit rating agencies monitor winding up petition advertisements and flag them immediately. These alerts are sent to major lenders and banks, which then freeze the company’s accounts. Without access to funds, the company quickly collapses. Staff are unpaid and refuse to work, suppliers stop delivering, deadlines are missed, and contracts are cancelled. A business can be destroyed within weeks, all over a petition for as little as seven hundred and fifty pounds.

Insolvency as Debt Collection

This may sound counterintuitive. Why make someone insolvent to collect a debt? Most creditors will not receive the full amount they are owed, and if there are preferential creditors, they may receive nothing at all.

Why not simply sue?

The answer is that insolvency is far more intimidating than litigation and has additional benefits. Statutory demands are cheaper, quicker and often enough to make a debtor pay. You do not need to show mitigation of loss or go to court. However, the debt must be undisputed. Disputed debts should be pursued through litigation, not insolvency.

If a statutory demand does not work, the next step is a bankruptcy or winding up petition.

This is a more extreme scare tactic and is expensive. You must pay a deposit to the Official Receiver plus a court fee. The deposit is refunded if the petition is withdrawn because the debtor pays, but the court fee is not. For large debts or large clients, this may be a loss they are willing to bear.

Insolvency as Rescue

Administration, including voluntary arrangements, is designed to rescue the business or achieve the best outcome for creditors. Winding up petitions damage reputations and often devalue assets or goodwill.

If part of the business is still viable, for example the online and wholesale arm of a clothing company, it can be separated from the loss-making part and sold. This is what happens in a pre-pack.

Administration can also give companies time to pay unexpectedly great demands, such as damages or tax bills. If continued trading would achieve a better price for assets, administration is a good option.

One of the key benefits of administration is the moratorium. This is a period during which no legal action may be taken against the company. Litigation is stayed, and crucially, no winding up petitions can be presented.

This moratorium can prevent the advertisement of a petition, protecting the company from collapse.

Insolvency as a Contractual Trigger

Insolvency is often a contractual trigger.

Starting an insolvency procedure can activate clauses relating to forfeiture in leases, receivership and possession in charges and mortgages, retention of title in supply contracts and default in most contracts. These consequences are important when advising clients.

Forfeiture, receivership and some contract cancellations are considered legal steps and cannot be taken during a moratorium. This is another reason administration may be attractive. Retention of title clauses are usually respected by administrators.

Insolvency as a Last Resort

Bankruptcy and winding up are last resort options when financial problems have gone too far.

They allow debts to be written off so individuals or companies can eventually start again. Unsecured creditors rarely receive a good return, but sometimes a small amount is better than nothing.

It is crucial to remember the criminal offences that directors can commit. If a company reaches the point of no return, it must cease trading to avoid incurring further debt. Continuing to trade can lead to criminal prosecution. At this stage, insolvency is often the only lawful option.

There is also a key professional conduct issue. The interests of directors may conflict with the interests of the company. Directors may need independent legal advice if their actions leading up to insolvency are in question.

Exam Preparation

For the exam, prepare a timeline of the procedures, detailing what must be done and shown at each stage. The procedures are complicated, and a timeline is a helpful way to summarise the information.

When advising a client, put yourself in their position. Consider what they want to achieve, what they are worried about and whether their business would suffer if their reputation were damaged.

It is also useful to list what an insolvent company or individual can and cannot do, such as giving away assets, granting security or making preferential payments.

Overall, remember that insolvency is only a small part of the module. Do not spend too long trying to memorise legislation. If you understand why a business might face insolvency and the advantages and disadvantages of each process, the legislation will fall into place.