Are You Trading Whilst Insolvent?

What Every Director Needs to Know

Cash flow issues, slow-paying customers and unexpected liabilities can place even successful companies under significant financial pressure. However, if your company is struggling to pay its debts, it is important to understand when financial difficulties become insolvency, and what that means for you as a director.

When Does Financial Pressure Become Insolvency?

Under section 123 of the Insolvency Act 1986 (“the Act”), a company may be insolvent if it is unable to pay its debts as they fall due (exceeding £750.00), or if its liabilities exceed its assets. However, Insolvency does not automatically mean that a company must cease trading immediately. What it means is that directors must be increasingly mindful of the interests of creditors, rather than focusing solely on shareholders/dividends and the growth of the business.

Can Directors Be Personally Liable?  

Many directors mistakenly believe that the protection of limited liability means they cannot be held personally responsible for decisions taken whilst a company is insolvent.

Whilst that protection is fundamental, it is not absolute. Once insolvency becomes a realistic prospect, a director’s actions may later be scrutinised by a liquidator, administrator or the court.

Preferences, Transactions at an Undervalue and Phoenix Companies

A director whose company is facing insolvency may repay a loan from a spouse, family member or another company whilst leaving other creditors unpaid. Whilst this may seem understandable, such payments can later be challenged as preferences under section 239 of the Act. Similarly, transferring a company vehicle, stock or equipment to a connected company for less than market value may be challenged as a transaction at an undervalue pursuant to section 238 of the Act.

Particular care should be taken when dealing with company assets. Transactions entered into before insolvency may later be challenged as transactions at an undervalue under section 238 of the Insolvency Act 1986, where assets are transferred for significantly less than their true value. Likewise, repayments made to connected parties, directors, family members or favoured creditors may constitute preferences under section 239 if they put one creditor in a better position than others in the event of insolvency.

Wrongful Trading and Misfeasance

Perhaps the best-known risk is a claim for wrongful trading under section 214 of the Insolvency Act 1986. If a company subsequently enters liquidation, a liquidator may seek a court order requiring a director to contribute personally to the company’s assets if they knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation and failed to take every step to minimise losses to creditors.

Directors should also be aware of misfeasance claims under section 212 of the Act. This provision allows a liquidator to seek repayment or compensation where a director has misapplied company money or property, retained company assets, or breached their duties (pursuant to sections 171 to 177 of the Companies Act 2006). Common examples include payment of personal expenses through the company or transferring company funds or assets for non-commercial purposes.

The Risk With “Phoenix Companies”

The temptation to transfer assets into a new company can be especially dangerous. Whilst not all so-called “phoenix companies” are unlawful, any arrangement that seeks to move valuable assets or business opportunities away from creditors is likely to attract scrutiny from an insolvency officeholder. What may appear to be a sensible commercial decision at the time can later become the subject of litigation.

In more serious cases involving dishonesty, directors may face allegations of fraudulent trading under section 213 of the Insolvency Act 1986. Unlike wrongful trading, fraudulent trading requires an intention to defraud creditors and can have serious personal and financial consequences.

What Should Directors Do Next?

The good news is that insolvency does not necessarily mean the end of the business. Many companies successfully recover through restructuring, refinancing, investment, informal arrangements with creditors, Company Voluntary Arrangements (CVAs), administration or other formal insolvency processes. However, the earlier advice is sought, the more options are likely to be available.

Directors should seek professional advice if they notice persistent creditor pressure, unpaid tax liabilities, increasing arrears, county court judgments, threats of winding-up proceedings, or a reliance on borrowing merely to meet existing debts. These are often warning signs that a company’s financial difficulties require urgent attention.

The key message is simple: trading whilst insolvent is not automatically unlawful, but ignoring insolvency can be. Directors who recognise the warning signs, keep accurate financial records, take professional advice and make decisions with creditors’ interests in mind are far better placed to protect both the company and themselves.

If you are concerned that your company may be insolvent, obtaining advice at an early stage can often make the difference between a successful turnaround and personal exposure to claims from a future liquidator.

If your company is experiencing financial difficulties, early advice can often make all the difference. At Wellers, we advise directors and businesses on insolvency risks and creditor claims. To discuss your situation, please contact James Day at james.day@wellerslawgroup.com or on 01732 457575, or another member of the Dispute Resolution team for a no-obligation initial discussion.