Corporate Insolvency

by The FindLaw Team

What are the common causes of corporate insolvency?

Many companies will find themselves in financial trouble at some stage. The reasons can be varied. At one end of the spectrum, they may include global economic conditions, business disruption following natural disaster, exchange-rate exposure, or the failure of a major customer or supplier. At the other end of the spectrum, they may include excessive gearing, inadequate cash-flow, insufficient cost-control, over-rapid expansion, inadequate management procedures, or the ill-health or death of key personnel. There are many others.

When is a company technically insolvent?

The Companies Act 1993 defines corporate solvency, rather than corporate insolvency. The solvency test is set out in s 4(1) of the Companies Act 1993.

  • The solvency test has two limbs   -   the liquidity limb and the balance sheet limb. Both limbs must be met in order for a company satisfy the solvency test:

  • The liquidity limb of the solvency test requires the company to be able to pay its debts as they become due in the normal course of business; and

The balance sheet limb of the solvency test requires the value of the company’s assets to exceed the value of its liabilities, including contingent liabilities.

What are the consequences of corporate insolvency?

Companies may or may not survive insolvency. The consequences of a company’s insolvency may extend far beyond the company itself. Directors may lose their power to control the affairs of the company, and may find themselves facing litigation. Shareholders may lose all or part of their investment in the company. Unpaid creditors may have their own solvency put at risk. Employees may find themselves unemployed. The insolvency of a significant industry participant may affect the wider industry. The insolvency of a significant regional employer may have an impact on the wider economic welfare of the region.

What are the formal corporate insolvency procedures?

There are five formal corporate insolvency procedures: receivership; compromises with creditors; voluntary administration; liquidation; and statutory management. An insolvent company may become subject to one or more of those procedures, at times concurrently.

Receivership

Receivership is an insolvency procedure available to secured creditors, pursuant to powers given to creditors under a debenture or other security deed or agreement. Receivership allows a secured creditor to appoint a receiver or manager to take control of secured assets, in order to obtain repayment of secured debt. A receiver’s primary duty is to obtain repayment of the secured debt owed to the creditor who appointed the receiver. A receiver’s duty to the company’s other creditors is secondary. In exceptional cases, a receiver may be appointed by the High Court, rather than a secured creditor.

The laws relating to receivers are partially codified in the Receiverships Act 1993. The Act regulates the appointment of receivers. It disqualifies certain persons from being appointed, or acting, as receivers. A receiver is generally the agent of the company, rather than the appointing creditor. The Act sets out the powers and duties of a receiver.

Directors are not displaced from office by the appointment of a receiver, and cannot be removed from office by a receiver. They retain limited residual powers, but their powers in respect of the secured assets are suspended, to the extent necessary to enable the receiver to discharge the functions of the receivership.

Compromises with creditors

Parts 14 and 15 of the Companies Act 1993 provide procedures for companies to enter into compromises with creditors. Compromise procedures are intended to facilitate the rehabilitation of companies that are insolvent, or at risk of insolvency. Part 14 regulates compromises approved by the company’s creditors. Part 15 regulates compromises approved by the High Court. 

In practice, creditor-approved compromises under Part 14 are relatively infrequent. That is partly attributable to the fact that the procedure does not place an automatic moratorium on claims by creditors, in the interval between proposal of the compromise, and creditors voting on the compromise. A Part 14 compromise may cancel all or part of the company’s debt, vary the rights of creditors, vary debt terms, or relate to an alteration of the company’s constitution affecting the liklihood of it being able to repay debt. Once approved by creditors, a Part 14 compromise binds the company, and binds all creditors in each notified class of creditor.

Court-approved compromises under Part 15 also occur relatively infrequently, in practice. That is partly due to the fact that the procedure is relatively costly and cumbersome. Part 15 compromises may be made on terms and conditions the court thinks fit. Those terms and conditions need not conform with the Act or the company’s constitution. The test applied by courts in approving Part 15 compromises has become, in practice, an amalgam of an intelligent and honest business person test, and a fair and equitable test.

Voluntary administration

Voluntary administration under Part 15A of the Companies Act 1993 is a relatively new insolvency procedure. It became available from 1 November 2007. It provides a more flexible rehabilitation option for companies that are insolvent, or at risk of insolvency, than compromise procedures under Part 14 or Part 15.

The primary objective of voluntary administration under Part 15A is to provide for the short-term administration of the business, property and affairs of an insolvent, or near-insolvent, company in order to maximise the liklihood of the company remaining in business. Failing that outcome, the secondary objective of the voluntary administration procedure is to achieve a better outcome for creditors and shareholders than would flow from an immediate liquidation.

As the name suggests, administration under Part 15A is usually a voluntary process, set in motion by the company’s directors. However, it may in some circumstances effectively become an involuntary process, in that it can be initiated by a liquidator, a secured creditor, or the court, rather than the company itself. 

While a company is in voluntary administration under Part 15A, there is generally (in contrast to a compromise under Part 14 or Part 15) a moratorium on creditors’ claims. The administrator assumes control of the company’s business, property and affairs. It then reports to the company’s creditors. At a watershed meeting, creditors decide upon one of three options: a deed of arrangement, liquidation, or termination of administration.

Liquidation

The liquidation of companies is regulated by Part 16 of the Companies Act 1993. Liquidation is available to both solvent and insolvent companies. The process for both is essentially the same. A liquidator may be appointed in one of four ways. Shareholders may appoint a liquidator, by special resolution. The company’s directors may appoint a liquidator, on the occurrence of an event specified in the company’s constitution. Creditors of a company in voluntary administration may appoint a liquidator, at a watershed meeting. The court may also appoint a liquidator, in specified circumstances.

Once a liquidator has been appointed, a number of consequences flow. A liquidator generally has immediate custody and control of the company’s assets. However, a secured creditor may generally still take control of secured assets. Creditors’ rights are effectively otherwise frozen, with some exceptions. Directors remain in office, but retain only the limited powers, functions and duties specified in Part 16. Shareholders are prohibited from transferring shares in the company, although share transfers are void only as against the company. They remain valid as between the parties. Shareholders are also subject to restrictions upon the exercise of their powers. The company’s constitution cannot be altered once liquidation has commenced, and special rules apply to the company’s contracts.

Liquidators’ statutory duties are set out in Part 16. The principal duty of a liquidator is to take possession of the company’s assets, in order to protect, realise and distribute those assets (or their proceeds) in a reasonable and efficient manner. In contrast to receivers, liquidators have no duty to individual creditors. Liquidators are required to act in good faith. They are also required to avoid conflicts between their duties as liquidators, and their personal interests. Liquidators are required to report to the Registrar of Companies, creditors and shareholders, and to hold creditors’ meetings. They are also required to keep mandatory accounts and records. Liquidators are under an ultimate duty to distribute the company’s assets, or the proceeds of their realisation, to those entitled to them, in accordance with the priorities and principles set out in the Act.

Liquidators’ statutory powers are also set out in Part 16. Liquidators have powers to avoid certain preferential transactions and charges, and certain transactions at undervalue, or for excessive value, entered into by the company prior to liquidation. They may apply for pooling or contribution orders, to swell the assets available to creditors and shareholders. They may also apply for orders for the recovery of company money or property misapplied by the company’s promoters, directors, managers, receivers, administrators or former liquidators.

Liquidation is completed when the liquidator has distributed the company’s assets, or the proceeds of their realisation, in accordance with the Act, and has delivered the final reports and statements required by the Act. Upon completion of liquidation, the company is removed from the register of companies. 

Statutory management

Statutory management is a rarely used process that is available to deal with the most seriously reckless or fraudulent management of companies. Once appointed, a statutory manager has wide-ranging powers to manage the company, with a view to protecting the rights of creditors and shareholders, resolving the company’s difficulties, and preserving its business and undertaking. Companies in statutory management are usually, although not inevitably, ultimately placed in liquidation.



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