When a business goes into insolvency, it’s important to remember that they are unlikely to be the only party that is affected – suppliers and partners also have to come to terms with a big loss to their income.

In this guide we’ll cover the following:

 

What is insolvency?

Insolvency is a financial state in which an individual or business is unable to pay their debts when they fall due. It is often associated with bankruptcy proceedings, as they are a common legal mechanism for dealing with insolvency. While both individuals and businesses can become insolvent, the term is typically used in the context of businesses.

What qualifies as insolvency?

An accountant can carry out a balance sheet analysis to determine if a business is balance sheet insolvent. This analysis involves comparing the value of a company’s assets to the value of its liabilities. If the liabilities exceed the assets, the business is considered to be balance sheet insolvent, as it does not have enough assets to cover its debts.

In addition, a business can be deemed insolvent if it is subject to any legal action for an unpaid debt of £750 or more. This can serve as confirmation of insolvency.

What are the different types of insolvency in the UK?

In the UK, there are two main types of insolvency: cash flow insolvency and balance sheet insolvency.

Cash flow insolvency

Cash flow insolvency occurs when a company is unable to pay its debts as they fall due, even if it has assets that could be sold to generate cash. This type of insolvency can lead to a range of outcomes and legal processes, depending on the circumstances. For example, the company may enter into a voluntary arrangement with its creditors to repay its debts over a period of time. Alternatively, it may be forced into liquidation, where its assets are sold off to repay creditors.

Balance sheet insolvency

Balance sheet insolvency, on the other hand, occurs when a company’s liabilities exceed its assets. This means that the value of what the company owes (debts) is greater than the value of what the company owns (assets). In such cases, the company may be subject to a winding-up order from the court, which could result in its liquidation.

However, if the company can secure additional funding or restructure its debts, it may be able to continue trading. Overall, understanding the differences between these two types of insolvency is important, as it can help businesses and individuals determine their financial standing and the options available to them in the event of insolvency.

What are the effects of insolvency?

The effects of insolvency can be far-reaching and can have significant consequences for both individuals and businesses. Some of the key effects of insolvency include:

  1. Restrictions on trading: Insolvent companies may be subject to restrictions on trading, such as limitations on taking on new contracts or incurring new debts.
  2. Legal action: Insolvency can lead to legal action from creditors, such as petitions for winding-up orders or bankruptcy proceedings.
  3. Asset liquidation: In some cases, insolvent companies may be required to sell off assets to repay creditors, which can result in the loss of key business assets.
  4. Personal liability: Directors of insolvent companies can be held personally liable for any debts incurred after the point of insolvency.
  5. Credit rating: Insolvency can have a negative impact on a company’s credit rating, which can make it harder to secure funding or enter into new contracts in the future.

Overall, the effects of insolvency can be severe and can have a lasting impact on the financial health of a business or individual. Seeking professional advice early on in the insolvency process is crucial to help mitigate the potential impact and explore all available options.

Who can declare insolvency?

Both individuals and businesses have the ability to declare insolvency, although in certain cases, insolvency may be declared by a creditor or group of creditors.

For individuals, this typically involves filing for bankruptcy, while for businesses, there are various insolvency procedures available, such as administration, liquidation, and company voluntary arrangements (CVAs). It’s important to note that insolvency can have serious consequences for both individuals and businesses and seeking professional advice early on is recommended.

In some cases, a creditor may petition the court to wind up a company and declare it insolvent if it is unable to repay its debts. Similarly, in bankruptcy cases, creditors may file a petition to declare an individual insolvent if they are owed a significant amount of money that has not been repaid.

Overall, understanding the various options and implications of insolvency is crucial for individuals and businesses that may be facing financial difficulties. Seeking advice from a qualified professional can help to ensure that the most appropriate course of action is taken.

What happens if a company cannot pay its debts?

If a company cannot pay its debts, it may be declared insolvent and face various consequences as a result. Here are some possible outcomes:

  1. Legal action: Creditors may take legal action against the company, such as by filing a winding-up petition or seeking a court judgment to recover the debt.
  2. Asset seizure: If the company has assets that can be sold, they may be seized and sold to pay off creditors.
  3. Administration: The company may enter into administration, a process that is designed to protect the company from legal action by its creditors while a plan is made to repay debts and restructure the business.
  4. Liquidation: If the company cannot be rescued through administration, it may enter into liquidation, which involves selling off its assets to pay its debts and winding up the business.
  5. Personal liability: Directors of the company may be held personally liable for any debts incurred after the point of insolvency, depending on the circumstances.

Overall, the consequences of a company being unable to pay its debts can be severe, and seeking professional advice early on is recommended to explore all available options and mitigate the impact on the company and its directors.

 

How do you know if a company is in financial trouble?

There are a number of warning signs of financial distress to look out for – we’ve produced a checklist of the key signs, below.

Payment-related signs:

  • A sub-contractor not paying its own workers or suppliers.
  • Requests for release of retention when retention is not yet due.
  • Requests for advance payment.
  • Premature applications for payment.
  • Contra-charge claims being made without foundation, to inflate the sums applied for.
  • Inflated applications for payment generally.

Changes in conduct:

  • Underbidding at tender stage, for example, to secure work should raise questions over the underlying reason for low tenders. If it looks too good to be true, it probably is!
  • Radio silence i.e. failures to respond to calls or emails.
  • More aggressive communications, such as the threat of proceedings if payment is not made.

Site-based changes:

  • Suspension of works on site without justification.
  • Reduction in the level of resources on site, for example:
    • A reduced number of staff/workers and/or sub-sub-contractors not turning up without explanation; and/or
    • A reduction in the amount of materials being delivered to site or indeed sub-contractors removing materials or plant equipment from site prematurely before the works are complete.
  • Unexplained or unjustified delays in completing the works by the contractual completion date.
  • A decline in the quality of the works and any associated increase in the number of defects.

Other signs:

  • It is worth keeping an ear to the ground in relation to the ‘unofficial grape vine’. It can often be a case of ‘no smoke without fire’ and it is worth listening to workers / other trades on site as they sometimes have an inside track on what may be happening, which merits further due diligence.
  • Becoming aware of any programme of redundancies or restructuring.
  • Last but not least, late filing of accounts or unsatisfied court judgments can both be clear signs of financial issues.

It is important to ensure that all your key staff (including site staff and those in the commercial and accountancy teams) are aware of what the warning signs are and, subsequently, the need to flag any concerns they have identified as soon as possible.

 

The options for managing and mitigating risks

Generally, there is no right or wrong approach. However, keeping the channels of communication open often leads to the best outcomes. Being upfront about whatever a workable solution could be is certainly a good first port of call, such as:

  • Increasing the frequency of payments to improve the sub-contactor’s cash flow to assist them in completing the works; or
  • Omitting elements of the works. However, you need to be careful here as any agreement should be documented so as to ensure that there is no ‘sting in the tail’ (i.e. the sub-contractor seeking to claim for loss of profit on the omitted works).

 

Can a sub-contract be terminated in the event of insolvency?

Ultimately, in the event of formal insolvency or failure to carry out the works, exercising the right to terminate the sub-contract might be the best option.

However, there are a number of considerations before terminating. Most housebuilders engage their sub-contract supply chain on standard sub-contracts (whether on an individual or framework basis). Therefore the first thing to check is whether the sub-contractor is actually “insolvent” as defined in the sub-contract.

If you terminate when the sub-contractor is not insolvent, as defined in the sub-contract, you can end up in a sticky situation, as this can of itself constitute a repudiatory (serious) breach of contract. If there is no formal insolvency within the meaning of the sub-contract, it will be necessary to look carefully at the terms of the sub-contract to check if there are any other grounds on which to terminate.

Grounds for termination of sub-contracts

Contractual grounds for termination often include matters such as delay, poor workmanship or even a deterioration in the sub-contractor’s financial standing.

In our experience, sub-contracts will often include a ‘termination at will’ provision. This means that the housebuilder can terminate the sub-contractor’s employment, even if there is no basis on which to do so.

This can be a useful tool, particularly, where the sub-contractor has not yet entered into any formal insolvency arrangement/process.

However, that said, it is worth being aware that termination at will provisions can (and often do) give rise to arguments about whether there is compensation payable to the sub-contractor as a result of depriving them of the benefit of the sub-contract, namely the carrying out of the sub-contract works for payment.

As a result, it can be preferable either to look to reach an agreement to close out the sub-contractor’s involvement, or wait for the formal insolvency to occur to avoid any potential dispute on this front.

Getting termination right

In the event that you do decide to terminate the sub-contract, it is crucial that you follow any requirements in that sub-contract. For example, such provisions might include requirements as to the form and content of the notice and/or the means by which the notice is to be served. Strict compliance is necessary, as getting it wrong can mean placing you in a repudiatory (serious) breach.

We know from experience that, on occasion, sub-contractors are engaged without any formal sub-contract being put in place. Looking to terminate in this situation is a little trickier, as it might be necessary to have regard to the common law (general) right to terminate the subcontract.

In conclusion, it will be necessary to be able to establish a repudiatory (serious breach) of the sub-contract. This is a breach so fundamental in nature that it entitles the innocent party to bring the sub-contract to an end. Often the position can be quite nuanced and, as such, it is worth seeking legal advice around whether a sub-contractor’s apparent breach of the terms of the sub-contract is sufficiently serious to give rise to a common law (general) right to terminate.

Keep a record of evidence

Along the way, it is important that detailed records are maintained, not only recording and evidencing the breaches on the part of the sub-contractor but also any losses arising out of those breaches.

 

Communication is key

Developing and maintaining trusted relationships with your sub-contract supply chain will go a long way to keeping an even keel. However, it isn’t always possible to avoid the risk of insolvency in the supply chain altogether. The key is to keep a close eye on any tell-tale signs and manage the risks which arise as early as possible.

 

What to do if a major client goes bust?

Seven steps to handling client insolvency

There is nothing more stressful than learning that one of your major clients has gone into insolvency but there are steps you can take to limit the damage as much as possible.

Step one – act quickly

If you find out a client has gone into insolvency, business owners must be quick. The action taken in the first 24 hours is crucial to limiting damage and recouping some of the cost.

Step two – find out what you’re dealing with

You need to quickly understand what type of insolvency process your client is going through. This may help you decide what you need to do next. The most common insolvencies are:

  • an administration
  • a liquidation
  • a Company Voluntary Arrangement (CVA)
  • a bankruptcy (which may be relevant if your client is a sole trader)

Depending on which of the above you’re dealing with, will help you understand your rights, whether the insolvency is terminal for your client and if there is a chance that your contract might continue.

Step three – speak to the administrators

In order to find out the facts, speak to the appointed administrators or other appointed office holder. Don’t rely on the rumour mill or media reports to find out what you’re dealing with. Speaking directly with the administrators as soon as you’re informed about the insolvency may also help you to receive payment for your goods or services more quickly, or if the future of the business isn’t over, you can negotiate a deal with the new purchaser and keep your contract running.

Step four – understand the pecking order

When a business goes into insolvency, there are often a lot of people – just like you – that are trying to get their physical goods or money owed back. For example, if you are an unsecured creditor in liquidation, you can presume that there is going to be no attempt to rescue your client’s business and that you are likely to be one of the last to get paid. In these circumstances, it can take up to a year and sometimes even longer to receive what you’re rightfully owed.

Step five – know your inventory

You may be a goods or service provider, but for many, such as those in the manufacturing or construction sectors, there may be physical materials or even machinery at play. If you have goods, materials or machinery in your client’s possession, you must try and retrieve your assets within the first 24 hours. You must check the contents of your supplier agreements first, however. You’ll need to ensure a valid retention of title clause is present. This can allow you to physically go and retrieve your items from your client, but you should speak to the administrators first.

Step six – know your contracts

Regardless of where you sit in the creditor pecking order, it is always wise to understand the detail in the contracts that you have with your clients. Depending on the circumstances, it can help you to recover some of your assets in the short term. If part of your contractual obligation involves you having physical goods or assets on a client’s premises, you must ensure that ‘retention of title’ clauses are written into your contracts to provide you with a bit more protection.

Step seven – don’t panic

Insolvency has the ability to quake the boots of even the most hardened business owner, but it doesn’t always mean business failure. It can sometimes provide the perfect opportunity for you to renegotiate your contracts and forge better deals for the future. For situations where you’re unsure where you stand, or just want some peace of mind that you have your house in order just in case one of your large clients goes bust – please click here to discuss.

Written By

Published: 6th March 2023
Area: Corporate Restructuring & Insolvency

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Andrew is a highly regarded and experienced restructuring lawyer.

He is head of our restructuring, recoveries and insolvency team and advises on all aspects of insolvency.

Andrew works with companies, insolvency practitioners and lenders on restructuring and turnaround options. He also advises on formal insolvency issues including the sales of assets and undertakings, validity of security/appointment, asset realisations, director’s conduct and antecedent transactions.

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