Insolvency: becoming insolvent or bankrupt

What is insolvency?

Insolvency occurs where a company or individual is unable to pay their debtors at a specified time. In the case of an individual this is popularly known as bankruptcy, while the term insolvency is more usually used to describe the financial mishap of a company. Different rules apply to companies and individuals.

Insolvency in companies can be brought about by poor sales and marketing strategies, accumulation of unused supplies, acquisition of risky investments and tough economies. An individual’s bankruptcy might result from mismanagement of assets, wrong financial investments, abuse of credit limits, unemployment, death, health expenses, etc.

A person or company that fears they are going insolvent should weigh their assets up against their debts. Where debts outweigh assets and creditors, they may be able to enter into an arrangement with their creditors which allows them time to reorganise their affairs and pay off their debts. Where debts far outstrip assets and monies owed, however, a company may need to be wound up or an individual declared bankrupt.

Corporate insolvency

To determine whether your company is insolvent, two tests apply:

  • cash-flow test: is your company unable to pay its debts as they become due? (a company is taken to be unable to pay its debts if it can’t pay a court order against it or if a creditor who you owe more than £750 to, has formally demanded its money and the debt has not been paid within three weeks);
  • balance sheet test: are your company’s assets worth less than the amount of its present and future debts?

Insolvency laws in the UK provide three main measures for handling insolvency in companies. These are:

  • administration;
  • company voluntary arrangement;
  • liquidation.

Administration

Administration is designed to keep the business running despite its financial troubles. The court will usually appoint an insolvency practitioner who will run the company while a restructuring process is undertaken and a debt management plan put in place. An administration order prevents creditors from immediately demanding repayment of their debts which gives the company time to get its affairs in order.

Company voluntary arrangement

A company voluntary arrangement (CVA) allows the company to continue trading and involves it and its creditors agreeing a payment plan. The creditors will usually agree to accept reduced or rescheduled repayments while the company is restructured. The process is overseen by an insolvency practitioner, to whom the company directors will submit a report on the company’s finances, together with the debt repayment plan.

Liquidation

Liquidation means the court has decided to close down the company and stop its operations before it accrues further debts or fails to provide any further services. Once this happens, there is no chance for the company to revive itself. The company’s assets will be broken up and sold off and the proceeds distributed among its creditors.

Bankruptcy

If you are never going to be able to pay your debts, you can file for bankruptcy yourself or a creditor can apply to the court to have you declared bankrupt if they are owed more than £5000.

A bankruptcy order lasts for one year. You will be given enough money to live on and you’ll be allowed to keep essential household items and tools you need for your work, but all your non-essential property and assets will be sold off to pay your debts and you may need to pay out a proportion of your wages each month. Most debts unpaid after the bankruptcy order is lifted will be written off. Your affairs will be overseen by an Official Receiver.

If you are facing bankruptcy, you can use the following alternatives:

Debt relief order

A debt relief order is only granted to individuals whose income and assets are low, whose debts are less than £20,000 and to those who do not own their own home. The order typically lasts for 12 months. Once you prove your financial situation has not improved, you will be given an exemption from your debts.

Informal arrangement

An informal arrangement is an arrangement with the creditor that stipulates the terms by which you have to pay back debts. This may be an oral agreement. They are not legally binding and the risk of such an arrangement that the creditor can still at any time force you to pay your debts by arguing their case in court.

Individual voluntary arrangement

An individual voluntary arrangement (IVA) is a formal legal agreement, where you make monthly payments for a set number of years (usually 5-6) if you have a house. A majority of your creditors have to agree to accept an IVA – it is then binding on all your creditors.