Being declared insolvent: What happens when a limited company goes into liquidation?

With most things in life, it’s natural to have a fear of the unknown and words like ‘insolvent’ and ‘liquidation’ can give you nightmares!

To alleviate that fear, the best place to start is with some simple definitions, writes Richard Hunt, a director at SFP Group.

So, what does ‘insolvent’ and ‘liquidation’ mean?

Insolvent

A company is insolvent when it cannot pay its debts when they fall due and / or has more liabilities than assets. 

Liquidation  

This is the process of winding up the company’s affairs and distributing any available assets to stakeholders in a prescribed order.

When we put these words together i.e. ‘Insolvent Liquidation,’ it takes us to either a Compulsory Liquidation or Creditors' Voluntary Liquidation.

The difference in these two unsurprisingly is in the title!

Compulsory Liquidation (CL)

The company is normally forced into this route (hence the ‘compulsory’ bit) by a creditor through the courts.

Creditors' Voluntary Liquidation (CVL) 

The company is wound up ‘voluntarily’ with the director formally instructing a licensed ‘Insolvency Practitioner’ (IP).

Next steps

Ok, so you’ve been forced into CL or taken matters into your own hands through a CVL. What happens next?

To answer that question, we need to understand the duties of a ‘Liquidator.’

Duties of a liquidator

The liquidator has a number of duties in both a CVL and CL, but the main ones are:

1. Realising any assets and distributing funds to stakeholders.

2. Investigating the reasons for the company's failure as well as preparing a report to the Insolvency Service on the director's (or directors’) conduct for them to consider disqualification.

No doubt that second point can bring back those nightmares! This is especially the case as the liquidator is obligated to consider actions against the company’s management / directors!

Let’s now break this down, to find out what activity can place a director in hot water

First, let’s look at the liquidator’s duty to investigate the failure, before we come to what the Insolvency Service will consider for disqualification.

The liquidator’s investigation into the reasons for failure

The regulatory bodies that license insolvency practitioners make clear the steps that should be taken by a liquidator to investigate the company’s failure.

These steps can be found in the Statement of Insolvency Practice 2, here.

The five fundamental tasks a liquidator carries out…

The main areas of interest for a liquidator (and probably for contractors) are:

1. Overdrawn director's loan account – does the director(s) owe the company money?

2. Transaction at a undervalue – were any assets sold for less than they were worth?

3. Preferences – were any payments made to certain creditors placing them in a better position than others?

4. Illegal dividend – were any dividends taken at a time when the company could not afford to make them?

5. Wrongful Trading – did management continue trading an insolvent company when they knew it had no prospect of surviving?

If these main claims (and others less known claims) are not relevant to you, then the chances are that the liquidator’s investigations will be closed off just as quickly as they started!

If so, does that also get you off the hook for any potential director disqualification proceedings with the Insolvency Service?

‘No’ is the short answer. But let’s now take a closer look at why directors get disqualified.

Reasons for director disqualification

Some of the main reasons a director gets disqualified are:

• Not paying HMRC but instead paying other creditors.
• Not keeping adequate financial records.
• Using company money unreasonably or excessively for personal or family/associates' benefit.
• Fraudulently applying for Bounce Back Loans or other government funding (yes, these loans are still being pursued).

Please note, in the event of a disqualification, the Insolvency Service could go after the director personally, to contribute towards the company’s losses.

How to avoid these hotspots

The actions of a director ONLY come under scrutiny if the company is insolvent and subsequently gets struck off the register or enters into a formal insolvency process such as liquidation.

It is in this period that the director is at the greatest risk of doing something wrong.

Avoiding it is simple: seek advice at an early stage from a licensed insolvency practitioner as soon as the company satisfies the criteria for ‘insolvent’ (outlined at this article’s introduction).

The initial consultation will (in all likelihood) be free, and you can then go about putting a strategy in place to protect stakeholders including management to mitigate your risks of later encountering a liquidator's action against you or disqualification proceedings. Good luck!