The Legal and Financial Aspects of Insolvency

The creditors winding up petitions and the administration process for medium sized firms.

According to the Office for National Statistics the UK has finally emerged from the longest recession on record.

However, commentators have suggested that this should by no means be seen to signal of the beginning of the end of business failures. It has in fact been suggested that the 2009 Q4 growth will result in an increase the number of insolvency related events over the next two years, with the peak expected in 2011.

So what does this mean for mid-sized businesses who are still suffering the effects of the recent recession? This article focuses on creditors winding up petitions and the administration process as they are relevant to failing mid-sized companies.

Winding-up Petitions

A winding up petition can be brought by a creditor in a number of circumstances but the reason must be because the creditor suspects that the company is insolvent. "Insolvency" is determined on the cash flow test and the balance sheet test and ultimately the court must find that the company is unable to pay its debts as they fall due.

Although it is not strictly permitted by the relevant legislation, creditors will often present a winding up petition because of a failure to settle the debt. The insolvency tests must be met for the petition to be effective, and creditors should be aware that bringing a winding up petition for an improper purpose is an abuse of process, but winding up will usually stem from failing to pay debts. It is expected that we will start to see a large number of petitions coming from HM Revenue and Customs, signifying an end to the recent leniency which has been noticed with respect to unpaid tax bills.

Companies should be wary of any demands for payment from creditors threatening winding up petitions. If at all possible payment arrangements should be negotiated with such creditors as, once issued and advertised in the London Gazette, the Company's bank account is frozen, credit ratings are damaged and petition is difficult to remove. Furthermore, if a petition is presented to the court and a winding up order is subsequently made by the court, unless ordered otherwise by the court, that order will have the effect of voiding any transfers of property or shares or any alteration of the company's members that have occurred since the time that the petition was presented.

Administration

Winding up is not the only outcome for businesses struggling to pay debts. Administration is a procedure used with the objective of rescuing the failing company as a going concern or realising its assets for the benefit of the creditors. Once appointed, the administrators are responsible for the day to day management of the business and will decide the best way to conduct the administration for the benefit of the creditors.

The economic downturn has seen an increase in the popularity of pre-packaged administrations ("pre-packs"), where certain parties (often the current management of the failing business) enter into negotiations before the company is placed into formal administration for the purchase of those parts of the business that can continue to trade profitably. The asset purchase agreement and related documentation are negotiated and prepared beforehand and the administrators are involved at an early stage. The sale is completed shortly after the administrators are formally appointed over the company.

Pre-packs have been criticised by many as potentially preventing the realisation of the true value of the assets of the business for the benefit of the creditors due to the secretive nature of the negotiations prior to the administrators' appointment and the lack of competitive bidding. However, when considered in comparison to the alternative of winding-up, pre-packs are a useful way of rescuing those parts of the business that are and can continue to make a profit. It is also a means of protecting a certain amount of jobs and ensuring continuity of supply to customers who may well struggle without the business of the failing company.

Neither insolvency process is desirable for any business, but it is important that mid-sized businesses which may still be struggling with debts and suspect increased pressure from the tax authorities in the near future understand the possible options for dealing with creditors' demands and, if necessary, restructuring as a means of ensuring future profitability. Such awareness not only benefits the creditors but is also in the interests of shareholders, employees and customers alike.

Republished with permission of Director of Finance online.