An insolvent company is not necessarily doomed to failure. Insolvency is not always permanent and there are a range of formal rescue and recovery options available which can facilitate a successful turnaround of a financially distressed business. However, if a company is insolvent, expert advice must be sought in order to protect the company, its directors, and its creditors as a matter of urgency. If advice is not taken and the company continues to trade despite being insolvent, this is a fundamental breach of several areas of the Insolvency Act 1986 and the repercussions can be severe. Defining corporate insolvency The first step, is to understand what is meant by ‘insolvent’. In corporate insolvency, there are two main tests which are used to determine whether a company is indeed insolvent: the balance sheet test and the cash flow test. • Balance sheet insolvent – A company can be said to be balance sheet insolvent if its liabilities outweigh its assets. • Cash flow insolvent – A company is cash flow insolvent if it is unable to meet its liabilities, debts, and other overheads as and when they fall due. A company can be balance sheet insolvent, cash flow insolvent, or both. If either test suggests the company is insolvent, professional advice should be sought as a matter of urgency with consideration given as to whether the company should immediately cease trading. Company insolvency: A directors’ legal duties Once a company director knows – or ought to know – that their company is insolvent, they have a legal duty to place the interests of the company’s creditors above those of themselves and any fellow directors or shareholders. In practical terms this means not taking any additional credit you know you are unlikely to be able to repay, nor should a company accept customer deposits for goods or services the company is unlikely to be able to fulfil. SPECIAL FEATURE 23 Special Feature No one sets out in business expecting the company to become insolvent. However, in an increasingly challenging trading environment, many companies will unfortunately experience issues with cash flow, increased costs of doing business, and changing consumer preferences, all of which have the potential to threaten the ongoing viability of the business. If the situation continues, a financially challenging situation can quickly escalate to one of insolvency. Trading while Insolvent: What are the Legal Consequences Directors can Face?
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