Corporate Insolvency — SQE1 FLK1 Business Law and Practice

Your client's accounts show assets of £2 million against liabilities of £1.5 million. A comfortable surplus. Then a supplier owed £15,000 serves a written demand at the registered office. That was twenty-five days ago. Nothing paid, nothing secured. The finance director tells you a company with a surplus cannot be insolvent, and that a large customer payment lands in two months anyway. Is he right? No. That company is already treated as unable to pay its debts, and the supplier can act today.

This is Corporate Insolvency, the topic where a company's problems become its directors' problems. We are going to follow that company. Keep the surplus in mind, because it matters far less than anyone in that boardroom thinks.

Here is the route. The two tests for insolvency first, because everything hangs off them. Then the rescue procedures: administration, the company voluntary arrangement, and the tools the 2020 Act added. Then liquidation, in its three forms. Then personal exposure: wrongful trading, fraudulent trading, and the transactions a liquidator can unwind. Then who gets paid, and in what order. And finally, disqualification.

Start where the courts start. Two tests, independent of each other. The cash flow test, s.123(1)(e) of the Insolvency Act 1986: the company cannot pay its debts as they fall due. The balance sheet test, s.123(2): its assets are worth less than its liabilities, counting contingent and prospective liabilities.

A company can fail one and pass the other. That is the trap your finance director has walked into. And the balance sheet test is not arithmetic. The Supreme Court has held that the real question is whether the company has reached the point of no return.

Then there is the short cut. A creditor owed £750 or more serves a written demand in the prescribed form at the registered office. Three weeks pass, nothing paid, nothing secured. The company is deemed unable to pay its debts, under s.123(1)(a). Our supplier is already there.

Rescue procedures next, and administration leads. Three statutory objectives in a strict hierarchy, in paragraph 3 of Schedule B1. Rescue the company as a going concern. If that is not reasonably practicable, get a better result for creditors as a whole than a winding up. If neither works, realise property for the secured or preferential creditors.

Look hard at the first objective. Rescuing the company, not the business. Sell the trade and the business lives on, but the company is left an empty shell for the liquidator. That is objective two.

Three routes in. A court order, on the application of the company, its directors or a creditor. An out of court appointment by the holder of a qualifying floating charge, one covering substantially the whole of the company's property. Or an appointment by the company or its directors, after notice to that charge holder.

Then comes what makes administration work: an automatic moratorium, under paragraph 43 of Schedule B1. No winding up order. No enforcement of security. No proceedings begun or continued. No forfeiture by a landlord. No repossession of goods on hire purchase.

Read that last one again. Goods on hire purchase belong to the finance company, not to your client, and the moratorium still bites. Ownership is no escape route. Each of those steps needs the administrator's consent or the court's permission. Within eight weeks he must put proposals to the creditors.

The company voluntary arrangement is the next tool: a binding agreement with the creditors compromising the debts, typically paying less than 100p in the pound, or rescheduling. An insolvency practitioner acts as nominee and reports on whether it is viable. Members and creditors get at least 14 days' notice.

Two thresholds, and they differ. Members approve by 50% of those voting, at their own separate meeting. Creditors approve by 75% in value of those voting. Clear both and it binds every creditor who had notice, including those who voted against. The directors stay in control and the company trades on.

The Corporate Insolvency and Governance Act 2020 added two more. First, a free standing moratorium under Part A1 of the Insolvency Act 1986. Director led, and overseen by a monitor who must consider rescue likely. A payment holiday from most pre-moratorium debts, plus protection from enforcement. 20 business days initially, extendable.

Second, the restructuring plan, under Part 26A of the Companies Act 2006. A court sanctioned compromise, voted in classes, 75% by value in each. Its distinctive feature is the cross-class cram-down. The court can bind a dissenting class, provided it is no worse off than in the relevant alternative, and one class with a genuine economic interest has approved.

The same Act restricts ipso facto clauses. A supplier generally cannot stop supplying, or change its terms, merely because the company has entered an insolvency or restructuring procedure.

Liquidation now, where the company's existence ends. Assets realised, debts paid so far as they can be, any surplus to the shareholders. Three types. The members' voluntary, for a solvent company. The creditors' voluntary, for an insolvent one. And compulsory liquidation, by order of the court.

The members' voluntary turns on one document. The directors declare solvency: full inquiry made, and the company can pay its debts in full within 12 months. It must be made within the five weeks before the winding up resolution. Making it without reasonable grounds is a criminal offence.

If those debts are not paid inside the year, the liquidation converts to a creditors' voluntary, under s.95. Which brings us to type two. The same special resolution, 75%, and at least 14 days' notice. But the creditors have the final say on the liquidator, who acts for them, not the members.

Consequences are blunt. The business stops, employees are dismissed, and a statement of affairs goes in under s.99. The liquidator investigates, and may report wrongful trading or misconduct to the Insolvency Service.

Compulsory winding up belongs to the court, and the grounds sit in s.122. The company has resolved by special resolution to be wound up. The company is unable to pay its debts, much the most common ground. Or it is just and equitable to wind it up.

That last ground is wider than it looks. In Ebrahimi v Westbourne Galleries Ltd, a quasi-partnership with three members, one was removed as a director and shut out of management while keeping his shares. No specific wrongdoing was needed. The court looked past strict legal rights to the members' equitable expectations.

Back to our supplier. The demand has gone unsatisfied, so the company is deemed unable to pay, and a creditor with standing can petition. A petitioning creditor must typically be owed at least £750. In a compulsory winding up the Official Receiver acts as liquidator first.

Presentation of the petition is the moment that matters. The winding up is deemed to commence then, under s.129. Any disposition of the company's property afterwards is void unless the court orders otherwise, under s.127. Executions and distress are void too, under s.128.

Now the directors' own exposure, and wrongful trading is the big one. Look at s.214. The company has gone into insolvent liquidation. The director knew, or ought to have concluded, that there was no reasonable prospect of avoiding it. And only the liquidator can bring the claim.

The standard is where candidates lose marks. Under s.214(4) a director is judged by the higher of two things. The general knowledge, skill and experience reasonably expected of someone in that role. And the actual knowledge and experience this director has. Qualifications raise the bar, never lower it.

There is a defence, in s.214(3): the director took every step to minimise the potential loss to creditors that he ought to have taken. In practice, take advice, hold regular board meetings, stop taking credit you cannot repay, and document the reasoning.

Passivity is no defence, and hope is not a plan. In Re Produce Marketing Consortium Ltd, directors traded on for 18 months after the accounts showed the company was insolvent. They were liable. The court identified a moment of truth: the point at which insolvent liquidation became unavoidable.

Fraudulent trading is the older, harsher, rarer claim. Under s.213, business is carried on with intent to defraud creditors, or for any fraudulent purpose. It catches any person knowingly party to it, not just directors, and carries criminal liability under s.993 of the Companies Act 2006.

But it needs actual dishonesty. In Re Patrick and Lyon Ltd the court called it real moral blame. Mismanagement is not enough. Incompetence is not enough. Unreasonable optimism is certainly not enough. Which is why liquidators reach for wrongful trading.

Next, the transactions a liquidator or administrator can unwind. Three of them, each with its own clock. First, transactions at an undervalue, under s.238: a gift, or a transaction for significantly less than the value the company gave. The relevant time is two years before the onset of insolvency.

The company must also have been insolvent then, or become so as a result. For a connected person that is presumed, under s.240, and the connected category is wide: directors, shadow directors, their families and partners, and companies under common control, under s.249.

There is a good faith defence too, in s.238(5). The transaction was entered into to carry on the business, and there were reasonable grounds to believe it would benefit the company.

Second, preferences, under s.239. The company puts a creditor in a better position than they would have been in on insolvent liquidation, and was influenced by a desire to produce that effect. Desire is the whole battle. Knowing a payment helps a creditor is not enough. The company must have wanted it.

Try one. An insolvent company grants its bank a debenture after the bank threatens to withdraw the overdraft. Preference, or not? Not. That is Re MC Bacon Ltd. The company acted under commercial pressure to keep trading, not out of a desire to prefer. Pressure negates desire.

The clocks differ here. For an unconnected creditor, six months before the onset of insolvency, and the desire must be proved. For a connected person, two years, and the desire is presumed. So: a director's brother is repaid 18 months before liquidation. Out of time? No. Connected, so two years.

Third, floating charges, under s.245. A charge created at a relevant time is invalid, except to the extent of new value: money paid, or goods or services supplied, at or after its creation. For a connected person, two years, with no insolvency to show. For anyone else, twelve months, and insolvency must be shown.

Work this one. A bank already owed £200,000 unsecured takes a floating charge, and on the same day advances a further £50,000. How much is the charge good for? £50,000. New money is secured. The old debt is not, and dressing it up as security changes nothing.

Which brings us to the money, and the order it leaves in. Seven rungs. Fixed charge holders, out of the assets specifically charged. The costs and expenses of the liquidation. The preferential creditors. The prescribed part, ring-fenced for unsecured creditors. The floating charge holders. The unsecured creditors. And, rarely, the shareholders.

Who is preferential? Employees, for wages in the four months before the insolvency, capped at £800 each, plus accrued holiday pay. And since December 2020, HMRC, for the taxes it holds on trust: VAT, PAYE and national insurance contributions. HMRC ranks as a secondary preferential creditor.

The prescribed part, under s.176A, is the calculation to have cold. Take the floating charge realisations left after expenses and preferential debts. Set aside 50% of the first £10,000, then 20% of the remainder, capped at £800,000. The floating charge holder takes what is left.

Among the unsecured creditors, pari passu. They share pro rata. If there is not enough for everyone, each receives the same percentage of what they are owed. Not the loudest. Not the oldest.

Underneath all of this runs a shift. A solvent company's directors promote its success for the members. Approaching insolvency, they must have regard to creditors' interests too. Insolvent, and creditors' interests may be paramount. That is codified in s.172(3) of the Companies Act 2006.

In West Mercia Safetywear Ltd v Dodd, a director moved funds out of an insolvent subsidiary to reduce the overdraft of its parent, which was also in difficulty. The subsidiary's creditors lost out. He was liable to account. Once a company is insolvent, creditors come first, and group loyalty is no answer.

Last, disqualification. Under the Company Directors Disqualification Act 1986, a director of an insolvent company found unfit is disqualified. Under s.6 it is mandatory: minimum two years, maximum fifteen. Re Sevenoaks Stationers (Retail) Ltd set the brackets: two to five years for the less serious, six to ten years in the middle, eleven to fifteen for the worst.

Most disqualifications never reach a trial. The director gives an undertaking instead, agreeing to be banned for a period in the same range, avoiding the cost and delay of court. Breach it and that is a criminal offence, with personal liability for debts run up while disqualified.

A word on how SQE1 tests this. You will not be asked to recall a case name or a section number. You get a scenario, five answers, and one instruction: pick the best. Learn the rules. The names are memory pegs, nothing more.

If you keep only three pegs from this episode. Re MC Bacon Ltd, where a bank's own commercial pressure killed the preference claim, because desire is what s.239 demands. Re Produce Marketing Consortium Ltd, where 18 months of hopeful trading became wrongful trading. And West Mercia Safetywear Ltd v Dodd, where a director learned that on insolvency the creditors, not the group, come first.

Four traps. One: a surplus on the balance sheet does not make a company solvent. The tests are alternatives, not a pair. Cash flow problems sit perfectly happily alongside positive net assets, and the examiners build scenarios on exactly that gap.

Two: commercial pressure is not a preference. If a creditor threatens proceedings or threatens to pull a facility, and the company pays in order to keep trading, the company acted to survive, not to prefer. Look for the desire, not the effect.

Three: the exposure is never just one claim, it is a list. Wrongful trading, fraudulent trading, misfeasance under s.212, transactions at an undervalue, preferences, and disqualification. A liquidator picks whichever fits, and frequently more than one.

Four: a declaration of solvency is not paperwork. Make it without reasonable grounds and it is a criminal offence, and if the debts are not paid within 12 months the liquidation converts to a creditors' voluntary. That is a trap with a person's liberty attached.

Quick check, and you have met this company already. Assets of £2 million, liabilities of £1.5 million. A supplier is owed £15,000, a debt the company accepts is due. A written demand in the prescribed form was served at the registered office twenty-five days ago. Nothing paid, nothing secured. The directors expect a large customer payment in two months, and say a company whose assets exceed its liabilities cannot be insolvent.

Is the company to be treated as unable to pay its debts? Three candidate answers. One: no, because its assets exceed its liabilities. Two: yes, because the demand has gone unsatisfied for more than three weeks. Three: no, because the company expects funds sufficient to clear the debt. Pause here if you want a moment.

The answer is two. A company is deemed unable to pay its debts where a creditor owed more than £750 serves a written demand in the prescribed form at the registered office. Then, for three weeks afterwards, the company neglects to pay, secure or compound for it. That is s.123(1)(a). The debt is admitted, and twenty-five days have gone by.

Why the others fail. Option one answers a different test: a surplus goes to the balance sheet limb, not to the deeming provision. Option three misses the question, which is whether a debt due today has gone unpaid. Money expected in two months does not answer a demand outstanding now.

Five things to take away. One: two tests, and they are independent. Our finance director's surplus protected nobody, and an unpaid demand for more than £750 deems the company unable to pay after three weeks. Two: administration's objectives run in a strict order, and the moratorium reaches goods the company does not own.

Three: three liquidations. The members' voluntary needs a declaration of solvency. The creditors' voluntary gives creditors the final say on the liquidator. The compulsory one commences at presentation of the petition. Four: wrongful trading needs no dishonesty, and the standard is the higher of what a director ought to know and what he does.

Five: learn the waterfall and the three clocks. Undervalues, two years. Preferences, six months, or two years connected. Floating charges, twelve months, or two years connected. Next time, Personal Bankruptcy and Alternatives.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.