What is bankruptcy and is it ever a good way forward for contractors?

Now you’ve got your head around winding-up petitions and their impact on contractors, let’s look at another area that limited company contractors might not exactly rush to explore, partly because for some it may have a stigma, and partly because it’s a bit mysterious, especially to those others who’ve never entered it before -- bankruptcy, writes Gareth Wilcox, partner at Opus Restructuring & Insolvency.

And significantly, on the basis I’m often asked the following, not just what is bankruptcy but is bankruptcy ever a good way forward for contractors?

What is bankruptcy?

What is Bankruptcy? Simply put bankruptcy (in the UK) is a legal process which provides for an individual to be released from debts which they cannot afford to repay.  When a person is declared bankrupt, all their assets (apart from those which are excluded in law) immediately vest in their appointed Trustee in Bankruptcy, who has a responsibility to sell them and seek to repay the creditors using the proceeds (if possible). 

Bankruptcy usually lasts for a period of one year before an individual is discharged, although this can be extended where there has been wrongdoing, or a failure to cooperate with the appointed Trustee.

A person can either apply for bankruptcy themselves if they have concluded that they cannot afford to pay their debts, or alternatively a creditor can apply to court for an order that an individual be declared bankrupt where they are owed over £5,000.

For the purposes of this article exclusively for ContractorUK readers, I am going to focus on an individual applying for their own bankruptcy.

How does a person become bankrupt?

Bankruptcy has been heavily modernised in recent years, and now starts with a straightforward online application, for which a fee of £680 is payable. 

Various financial information is required to be submitted with the application, to show that the individual’s debts are higher than the value of their assets, such that they cannot reasonably be expected to be able to repay them.

The application is reviewed by an adjudicator who works for the Insolvency Service, and that person determines whether a bankruptcy order should be made.  If the application is successful, ‘the bankrupt’ (as they become) will receive a copy of their bankruptcy order and the formal process will start.

Will I lose my assets if declared bankrupt?

As mentioned above, once a person is declared bankrupt, their assets vest in their appointed Trustee in Bankruptcy. 

This will be the Official Receiver (a civil servant employed by the Insolvency Service) in this first instance, although they may during the process be replaced by an Insolvency Practitioner (IP) from the private sector, who would fulfil the same role and functions.

There are some limited exceptions to the rule that all assets fall into the bankruptcy estate, including:

• such tools, vehicles and other equipment as are necessary to the bankrupt for use personally in their employment, business or vocation;
• such clothing, bedding, furniture, household equipment and provisions as are necessary for satisfying the basic domestic needs of the bankrupt and their family;
• Assets held on trust for another party;

In certain circumstances, however, exempt assets (to the extent that they are of significant value) may be sold by the Trustee, and replaced with a similar asset of lower value.  This often happens with required vehicles which are of high value.

If I go bankrupt, what happens to my home?

Often the largest asset in a bankruptcy is the bankrupt’s home, and the bankrupt’s interest in any property does vest in the Trustee on their appointment. 

There are specific provisions for dealing with a residential home, including a requirement that it be dealt by the Trustee within a period of three years from the date of bankruptcy, otherwise it ceases to be part of the estate and reverts to the bankrupt.

The interest of a bankrupt which is capable of vesting in the estate is limited to their interest in the property, deducting any joint ownership interest and mortgages secured on it. In practice, the value of a bankrupt’s interest is usually calculated by ascertaining the equity available after mortgage(s) and splitting this with any spouse or other co-owner, to work out the actual value to the bankruptcy estate.

Once the value of equity is known, it may be possible for a co-owner or another third-party to make an offer to the Trustee, to buy out the bankrupt’s interest in the property, thereby avoiding the need for it to be vacated and sold. 

If no suitable agreement can be reached, a Trustee can apply for an order for possession and sale of a property, although if there is a non-bankrupt partner/spouse or dependants occupying residential property, a court will not grant an order within the first year of bankruptcy to enable alternative arrangements to be made. This delay, however, does not apply to investment properties (which can effectively be sold immediately), only residences of the bankrupt and any spouse (or former spouse).

If there is no equity after the mortgage, or the equity is minimal (under £1,000) the Trustee may conclude that there is no benefit available for the estate and conclude that they have no interest. There are also provisions for special circumstances (e.g. if accessibility adaptations have been made to a property for a child). 

The above outline is meant as a very general guide only, any parties affected by their own bankruptcy or the bankruptcy of a co-owner of property should take bespoke legal advice.

What about my pension if I’m bankrupt?

The short answer is that pension schemes are excluded from an individual’s bankruptcy estate.  This is as long as it is an ‘approved’ scheme (most are) and there are provisions protecting even those that are not.

Unfortunately, however, this is a complex area and there are numerous potential issues.  Firstly, to avoid the possibility for an individual from hiding their assets away in a pension to protect them from bankruptcy, a Trustee is able to recover contributions made into a scheme which are deemed ‘excessive’.

Secondly, if a person is already drawing down on a pension, the payments received represent income, which can be included by a Trustee considering an income payments order application (see below section ). Further, if a lump sum is drawn down on a pension, it may represent after-acquired property, which a Trustee may make a claim on.

Again, this is a complex area, and anyone affected should take specialist advice.

What about my income amid bankruptcy?

A Trustee will ask any bankrupt they are appointed over for details of their income and expenditure, to assess whether they have sufficient surplus income to make income contributions. To the extent that contributions are made, they will be paid into the estate and comprise a part of the assets which will be applied to pay bankruptcy costs, and thereafter the creditors of the bankrupt.

If an agreement can be reached between the bankrupt and their Trustee in this regard, contributions will be collected under an Income Payments Agreement, which can last for a period of up to three years (from the date of agreement). 

If no agreement can be reached, and there are often disagreements about ‘reasonableness’ of certain expenses, a Trustee can apply to court for an Income Payments Order, which forces a bankrupt to make the assessed contributions for a period of up to three years (from the making of the order).

Any windfalls or similar one-off payments (such as legacies) received during the bankruptcy will also be claimed by the Trustee as after-acquired property.

What restrictions are placed on a bankrupt?

The biggest prohibitor for contractors considering bankruptcy is that individuals are banned from acting as a director for the period of their bankruptcy (usually 12 months). 

They are also precluded from creating, managing or promoting a company, with heavy penalties potentially applying, including personal liability both for the disqualified director and any person acting on their behalf. This is designed to avoid ‘patsy’ directors taking office on behalf of banned individuals.

Undischarged bankrupts are also precluded from:

• borrowing more than £500 without telling the lender of the bankruptcy
• managing a business with a different name, without telling people you are doing business with that you’re bankrupt
• working as an insolvency practitioner (so bankruptcy would be bad news for me!)

Another consideration for contractors is that bankruptcy can have a detrimental effect on certain professional qualifications, and it may preclude you from certain roles (e.g. those in Financial Services). Bankruptcies are advertised in the London Gazette and appear on the Individual Insolvency Register, so are a matter of public record.

In addition to the above, there are several bankruptcy offences which place criminal liability on certain conduct, such as attempting to give away or hide assets which should have fallen into the estate. Additionally, a Trustee can apply to delay the discharging of a bankrupt beyond the end of the usual 12 months if the bankrupt fails to cooperate with their investigations. 

Further, if the Official Receiver finds that an individual has behaved dishonestly or recklessly, they may apply for a Bankruptcy Restrictions Order.  This would be an order of the court which, broadly speaking, extends the usual bankruptcy restrictions for a given period of 2-15 years (depending on severity). A shorter restriction period can sometimes be compromised by a bankrupt agreeing a Bankruptcy Restrictions Undertaking, which has the same effect.

What alternatives are there?

One key alternative to bankruptcy which contractors should consider is an Individual Voluntary Arrangement (IVA). This is where an individual offers income contributions to creditors in order to repay debts (in full or part) over a period of time, with the arrangement overseen by an IP. 

This avoids bankruptcy and, while it may have implications in certain professions, therefore also avoids the prohibition on the individual acting as a director. 

As mentioned above, since surplus income can be claimed by a Trustee in any event, a contractor who has ongoing income would be well-served by considering this as an option. In certain straightforward circumstances, a debt management plan may be appropriate, however, this is a less formal arrangement, and you should ensure that any advisor engaged is authorised by the Financial Conduct Authority.

In the short term, individuals facing financial pressures can apply for ‘breathing space’ of up to 60 days, during which they are protected from enforcement action, and interest payments are frozen.

Debt Relief Order

Another alternative for bankruptcy is a Debt Relief Order (DRO). This is designed for straightforward circumstances where an individual:

• owes less than £30,000
• has less than £75 a month spare income
• has less than £2,000 worth of assets
• does not own a vehicle worth £2,000 or more
• has lived or worked in England and Wales within the last three years
• has have not previously applied for a DRO within the last six years

Where a DRO is granted, however, an individual is subject to restrictions for a period of 12 months, similar to a bankruptcy. They cannot:

• borrow more than £500 without telling the lender about the DRO
• act as the director of a company
• create, manage or promote a company without the court’s permission
• manage a business without telling those you do business with about your DRO

So is bankruptcy ever the right option for a contractor?

Due to the wide-ranging consequences, bankruptcy (and indeed a DRO) should only ever be regarded as a last resort for contractors.  Since a contractor will be unable to run a company (without court permission), they are likely to find it harder to secure work going forward, particularly in the financial sector.

This being said, if a contractor’s financial situation is sufficiently serious and they have no ongoing work or income, it may be the best solution available to them. Bankruptcies do not last forever and it does allow individuals to carry on with their lives after debt. It is not a decision to take lightly, however, and any individual in financial difficulty should seek advice from a suitably qualified professional.