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What are the legal risks when a company becomes insolvent?


Can litigation be taken against a company director if the business fails?

A business becomes insolvent when it can no longer pay its debts when they become due. If your company is insolvent or you’re struggling financially and think things could go that way, it’s understandably a stressful and worrying time. 

But don’t bury your head in the sand. There are several legal risks that you need to be aware of. And with the right approach and professional help, you can lift your business out of insolvency or close it down properly without the risk of any action being taken against you.

What are the warning signs to look out for?

The earlier you identify the threat of insolvency, the more chance you have to prevent it and the better you can protect yourself from any potential recriminations. There are several insolvency warning signs to look out for, including but not limited to:

  • An increase in creditor pressure and threats of legal action
  • Struggling to pay your staff
  • Suppliers refusing you credit, a maxed-out overdraft and no other credit facilities
  • Moving from one cashflow crisis to the next
  • You’re constantly dealing with problems in your business

If you recognise these signs in your business, get professional help as soon as you can. If you continue to trade despite knowing the business cannot pay its debts, you could face a hefty fine, be made personally responsible for company debts and even be disqualified from acting as a company director in the future.

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Do insolvent companies have to cease trading?

If you believe that your company is insolvent, your legal duties as a company director change. You are now required to act in the best interests of your creditors, and in most cases, that means ceasing trading immediately to minimise their losses. 

A licensed insolvency practitioner may decide that you can continue to trade if the company can return to profitability in the short term, or if continuing to trade is likely to increase the return to creditors.

Is your company insolvent?

If your company is insolvent you have a number of legal responsibilities that you must adhere to. Taking steps to protect creditors from further losses by contacting a licensed insolvency practitioner can help ensure you adhere to these duties.
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What are the legal risks during insolvency?

Personal guarantees

When starting a company, it’s relatively common for a company director to sign a personal guarantee to obtain finance. If the business can afford to make the payments then it’s not a problem. However, if the company defaults, you can be made personally liable for the full amount. 

Wrongful trading

If you know or ought to know that the business cannot pay its debts but you carry on trading and cause additional loss to the company, you face accusations of wrongful trading. If you’re involved in wrongful trading, you can be made to contribute to the assets of the company from your personal funds to compensate the creditors.

Preference payments

Another risk is if you make preferential payments to one or more creditors while the business is insolvent. A preferential payment is a payment to a connected company or a business run by a friend or family member that puts that business in a better position than the creditors as a whole. In this case, the preferential payment can be set aside and you could become personally liable for those debts. 

Transaction at Undervalue

A transaction at undervalue occurs when you sell a business asset for less than its true value as a way of diverting assets away from your creditors. A transaction at undervalue during or in the period leading up to insolvency can lead to a fine, personal liability for company debts and disqualification as a director.

Asset disposal

As part of their role, insolvency practitioners look at whether you have sold off company assets while the insolvency was in progress. If they find any suspicious transactions, they can reverse the asset disposal and restore it to your company before selling it for the benefit of your creditors. If the insolvency practitioner cannot recover the asset, they can seek to recover compensation for the creditors from you. 

Misfeasance and breach of duty

Misfeasance occurs when the finances of your company suffer due to your actions. It includes things like misusing company property, making unauthorised loans to directors or taking high salaries that the company cannot afford. It can lead to a financial penalty equivalent to the losses incurred and disqualifications from office.   

Fraudulent trading

This risk arises when the directors of a company that becomes insolvent manage the business with the intention of defrauding their creditors. One example of fraudulent trading is taking credit agreements despite knowing the business will not be able to pay the money back. Unlike the other legal risks we’ve looked at, fraudulent trading is a criminal offence and can lead to prison sentences of up to 10 years as well as fines, personal liability for company debts and director disqualifications.  

Beware of the risks

If your company enters into liquidation after becoming insolvent, a liquidator will investigate the conduct of the directors before and during the insolvency. If a director is found to have committed any of these trading offences, the liquidator will include it in their report. They will then pass the report to the Insolvency Service and action could be taken against you.

Need help?

At Real Business Rescue, our insolvency professionals can help you work through financial issues and help you comply with UK insolvency laws to avoid these key risks. Please contact our team to arrange a free, same-day consultation at one of our network of offices around the UK.

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