Company Insolvency and Its Prevalence in the Economic World

Introduction

Insolvency refers to a situation where a business is not able to settle its debts as they fall due. The current economic down surge has rendered many business entities insolvent, the inability to pay creditors on time, pay employees remunerations, and finally reward shareholders as required can only be achieved if the company can record reasonable profits. The increasing competition, future uncertainties, and the business desire to achieve a competitive edge have exerted pressure on businesses to make sound and informed strategic financial decisions. ¹

This has been hell for most entities forcing them to quit. A few which have managed to survive have been compelled to make ruthless financial decisions including mass sackings, pay reduction and discontinue some of their operations in other segments or departments. However insolvency can arise in two main ways; a firm can be forced to go under liquidation by forces that are beyond its management, These forces may include changes in government policies, external and internal competition or by major disastrous natural calamities i.e. earthquakes, floods etc. The second insolvency may arise as a result of poor management.

This can be brought about by a firm’s inability to hire competent and qualified management staff. In this situation, several inefficiencies are expected that may include failure to institute adequate internal control systems. Where operating systems are weak certain individuals may be able to take advantage of the situation to pursue their selfish and subjective interests leading to big financial losses being incurred by the organization. It is the responsibility of any business to institute strong and properly functioning internal systems to subvert the possibility of any fraud occurring. ¹

This will ensure that the firm is not plunged into any unnecessary financial losses. In this company we see managers who are very determined despite the fact that they had actually realized that the company was leading into liquidation earlier, they continued to work hard in the hope that they would move mountains but they did. In this the management may be liable for prosecution for failure to use their knowledge to inform the company and its shareholders of the possible insolvency. They failed to adhere to their professional due diligence and public practice and ethics act. The business law requires that it’s the responsibility of managers to provide shareholders with relevant market information regarding the company’s performance. ²

Everybody knows that most economies in the world have gone under recession and it’s not a crime to be insolvent however these managers failed to avail this information to the shareholders. This is why they are highly liable for prosecution by not only the shareholders but also by the stakeholders at large. Under these circumstances Paresh and Joe should be under obligation to trade with care and caution but their attempt to brazen through this long period of uncertainty will eventually carry severe consequences. These will apply to both of them as they are the sole directors of this company. They are therefore deemed to be executive directors.³

Where a liquidator can reasonably establish that the directors were actually aware at some time or ought during the inception of winding up and there were limited actions to avoid the insolvency, the liquidator will be guided by the requirement of provisions of wrongful trading as contained in section 214 of the insolvency Act 1986 that states that a company may go into insolvent liquidation when its assets are deemed in the light of directors as being insufficient to pay its debts and liabilities as they fall due. ⁴

In this scenario, Paresh and Joe could have continued with trading only after getting an okay from the courts that they actually took necessary steps to mitigate the possible insolvency however this was not done. They failed to do anything that could have leveraged the situation instead they continued to trade despite the earlier signs of the prevailing circumstances. They are therefore liable for the potential loss caused to the company creditors and should be ordered to contribute to the assets of the company to compensate the creditors.⁵

In most cases, the court will reach these conclusions after performing both subjective and objective tests. It is beyond any reasonable doubt that Paresh and Joe were actually aware and the alternative steps they should have taken owing to their diverse skills, knowledge and experience that they should professionally display. They are therefore under obligation to match the standards of performance that are reasonably expected of people holding similar positions in those capacities as the articles outline. ⁶

Directors are normally hired on qualifications and experience as per their credentials by the shareholders. Remember that under the agency principal shareholders are the bonafide owners of the company, but due to lack of relevant managerial know-how and technical competencies, they entrust managers with the role of managing the company on their behalf. Directors are therefore expected to manage the company affairs in a manner perceived to be efficient so that shareholders can be reasonably assured of their returns. Directors can therefore be executive, non executive, or full-time. However, when giving their judgment the court will make these considerations in order to determine the functions attributed to each. The provision requires that non-executive directors have a responsibility to keep them informed about the business activities of the company and have in principle the same obligations and liabilities as executive directors as well. In this company both Paresh and Joe are executive full-time time directors and therefore have no reason to complain. The more a given director is involved in a company the more courts are likely to apportion stands on him. ⁶

Paresh and Joe were under obligation to establish the truth about the information they received that the company was headed for a possible insolvent liquidation and ascertain the true position of the entity, and take any appropriate actions. If they had actually perceived the company to be facing such a financial crisis they ought to have sought a professional advice on the matter. If they did this the courts could have given a leeway by according them the statutory protection that may have been relevant as far as the insolvency laws are concerned. But these men had the information but decided to trade in the hope that things could get better unfortunately the company was put under liquidation. These are some of the dots that managers are expected to observe in order to be able to prove their competency especially now when the economic environment has become so dynamic and volatile, most organizations have been caught off guard implying it might prove technically impossible to trade again. ⁷

Directors should be able to take any necessary steps to ensure that no loss arises that is likely to cause any potential damage to creditors. If for instance a director has tried many times to avail the information to the management but failed, he is under no obligation to continue but to resign. Parish and Joe showed no signs of resignation. Courts could interpret the resignation to mean an attempt to leverage creditors and may therefore give the director in question some protection. If this could have been taken by either of the directors then courts could have given the director a protection.⁸

At this stage the matter is so grave that it is impossible to avoid court judgment. The decision is now obvious and as the section provides judges will give their verdict based on the content of the Act 214 of Insolvency. The Act requires that the directors are under no obligation to continue trading and the company to be consequently put into liquidation. However the court ruling might be interpreted by financial experts as being too harsh, this is because when a company goes under insolvency the immediate step is not to put the firm into liquidation. ⁹

There could be certain several strategic options for the firm managers including selling an undertaking or contemporary trading for a specific period while other possible courses are evaluated. Generally wrongful trading Acts are very ruthless on all managers and are non-discriminative. This law is one of the most applied in business across the world. ¹⁰

Relevance of Wrongful Trading Acts

Due to the agency relationship that exists between shareholders and the directors of an organization, care should be taken to avoid a possible conflict of interest that may arise. Shareholders expect the directors to make reasonable profits in order to compensate them for their risks, at the same time directors are working hard day by day in executing their implied as well as fiduciary duties with the hope that they get their remunerations. The wrongful trading Act prevents directors from pursuing selfish interests other than overseeing the general performance of the company.

It further puts directors on toes to ensure that all the stakeholders are protected including clients, creditors, shareholders, the government, the community and themselves by instituting adequately functioning internal controls that would be able to detect and report any unusual event that is likely to plunge the company into series of endless financial losses. Where a company has been put under temporary liquidation and the liquidator has reasonable assurance to believe that the directors are incompetent then he/she can write to the court to stop or remove the directors from getting access to the liquidated assets. ¹¹

Limitations of the Act

This act is normally associated with several court procedures which are not only lengthy but also time-consuming. Several court cases are still pending and the possibility of them being dealt with is not known. This coupled with certain factors like corruption that have highly characterized most of our public judiciaries makes it very difficult to be applied and used by everybody. In Paradise Properties Limited it could be the best method of solving insolvency as the directors i.e. Joe and Parish have left and have started a company in the same name. ¹²

There are so many cases of wrongful trading but only a few are dealt with under this section. This makes it to be unpopular among other countries. It does not give an exclusive approach to handling similar scenarios. This implies that there are some circumstances when creditors can suffer adversely at the hands of their legislators.

If for example paradise is already insolvent where will it get money to pay its creditors and at the same time remain sufficiently enough to pay the court? Court proceedings are costly and at times people may avoid them. These are some of the criticisms that this Act has always met from the public. ¹³

The decision that is now available to the creditors of Paradise Properties Limited is to sue the directors for wrongful trading. This is to ensure that they are paid for the losses they have incurred as a result of the director’s adamant stand on market conditions. They had a prior knowledge of a possible insolvency but failed professionally to seek relevant advice on that matter and went ahead to trade thereby implicating creditors into this adverse financial condition. The directors are also liable for any damages caused to employees. This implies that employees can sue the company for unprocedural termination when the liquidator decides to sell the company to another party. ¹³

Employees will end up losing their jobs and when this happens the company is expected to incur a redundancy cost. All these expenses are likely to be catered for by the directors or the liquidator. However Paresh and Joe may decline under this section of the Act, which states that if the directors, came to notice the possibility of a company going into insolvent liquidation and thereafter undertake a course of action likely to mitigate any adverse effect on creditors then the court may protect such directors given there is sufficient and corroborating evidence to believe that directors took extra steps to leverage creditors. From this scenario, Paresh and Joe can argue that they undertook aggressive marketing and advertising policies to remedy the situation but unfortunately the matters proved strong against their strategy. ¹⁴

Transactions at an undervalue

This is a transaction entered into by a company that is subsequently going into insolvency and which the court issues orders requiring it to be set aside upon receipt of the liquidator’s application for the benefit of creditors. The courts are ordinarily under no obligation to look into the adequacy of the consideration but if a company seems to be under serious financial risks, then courts will provide such mechanisms rendering transactions that appear to be adversely commercially affected useless in order to protect creditors. A transaction is said to be undervalued when the consideration received by the company in the transaction is significantly less than the value provided at a time when the company was unable to pay its debts. In this case Paresh and Joe have already sold the assets of the company to themselves at a price lower than the market value. This constitutes to undervalue transaction. This amounts to breach of their fiduciary duty under section 212 IA 1986. ¹⁵

This makes Paresh and Joe liable for prosecution however, under section 238 the courts are barred from making any order in respect of transaction at an undervalue if it is satisfied that the company in question entered into the transaction in good faith and to carry on its business and that at the time there were reasonable grounds for believing that the transaction would benefit the company. Sands v Clitheroes [2006] BPIR 1000. ¹⁴

Conclusion

Insolvency in business can be brought about by either the management or external factors that the firm has no control over. But the truth of the matter is that it is always brought about by bad management. Where creditors strongly believe that they are hanging in a dangerous position as a result of the actions taken by the management, they are obliged to go to court to sue the directors for wrongful trading. The court has a legal responsibility to ensure that directors compensate creditors and that no further conflict of interest arises. However before such decisions are made creditors should consider certain factors that include time, cost, and whether the courts have the capacity to handle all of their cases. Directors should therefore be able to play their cards safely.

They have a professional duty of diligence and competence to ensure that there are no eyebrows lifted about their responsibilities. Directors should therefore keep themselves informed about the company matters and where possible use their judgment where they believe things could be going wrong. This is the only way of ensuring that the company achieves its objectives including that of shareholders’ wealth maximization. ¹⁶

List of References

1. Andrew K. (2005) “Wrongful Trading and the liability of company directors: a theoretical Perspective” 25 Legal Studies.
2. Andrew K. (2006) Directors’ Responsibilities to Creditors Insolvency.
3. Henderson M. (2007) Wrongful Trading.
4. Andrew K. and Peter W. (2008). Insolvency Law Corporate and Personal Chapters 29, 32, 33, 37-42.
5. Fiona T. (2003) Corporate and Personal Insolvency Law (2nd edition Cavendish) Chapters 23 and 31.
6. Goode, R.M. (2005) Principles of Corporate Insolvency Law. 3rd edition Sweet & Maxwell chapter 11.
7. Insolvency Act (1986) s 214.
8. Law and Practice (2005) Personal Liability for Trading Under a Prohibited Name: Recent Developments. Page 12.
9. Mike G. (2006) “The Phoenix Syndrome” 156 NLJ 7218 at 530 – 531.
10. Rebecca P. and Hamish A. (2002).Transaction Avoidance in Insolvencies. Oxford University Press.
11. Re Brian D Pierson (Contractors) Ltd (2001) 1 BCLC 275.
12. Re Oasis Merchandise Services Limited (1998) 1 Ch 170.
13. Singer V. B. (2001) Re Continental Assurance Co of London plc. BPIR 733, Ch D, 2 BCLC 287.
14. Smith A. (2007) “Fraudulent Trading Whilst Company Dissolved: When Section 653 Met Section 213” 20(2) Insolv Int 28 Cork Report, chapter 28.
15. Swanson J., Marshall P, Lokey H, Norley L., Kirkland & Ellis International LLP (2008). A Practitioner’s Guide to Corporate Restructuring. City & Financial Publishing, 1st edition.

Footnotes

1. Re Brian D Pierson (Contractors) Ltd (2001) 1 BCLC 275.
2. Singer V. B. (2001) Re Continental Assurance Co of London plc BPIR 733, Ch D, 2 BCLC 287.
3. Re Oasis Merchandise Services Limited (1998) 1 Ch 170.
4. Swanson J., Marshall P, Lokey H, Norley L., Kirkland & Ellis International LLP (2008). A Practitioner’s Guide to Corporate Restructuring. City & Financial Publishing, 1st edition.
5.  Fiona T. (2003) Corporate and Personal Insolvency Law (2nd edition Cavendish) Chapters 23 and 31.
6. Andrew K. (2006) Directors’ Responsibilities to Creditors Insolvency.
7.  Law and Practice (2005) Personal Liability for Trading Under a Prohibited Name: Recent Developments. Page 12.
8. Mike G. (2006) “The Phoenix Syndrome” 156 NLJ 7218 at 530 – 531.
9. Andrew K. (2005) “Wrongful Trading and the liability of company directors: a theoretical Perspective” 25 Legal Studies.
10. Smith A. (2007) “Fraudulent Trading Whilst Company Dissolved: When Section 653 Met Section 213” 20(2) Insolv Int 28 Cork Report, chapter 28.
11. Goode, R.M. (2005) Principles of Corporate Insolvency Law. 3rd edition Sweet & Maxwell chapter 11.
12. Andrew K. and Peter W. (2008). Insolvency Law Corporate and Personal Chapters 29, 32, 33, 37-42.
13. Rebecca P. and Hamish A. (2002).Transaction Avoidance in Insolvencies. Oxford University Press.
14. Insolvency Act (1986) s 214.
15.  Goode, R.M. (2005) Principles of Corporate Insolvency Law. 3rd edition Sweet & Maxwell chapter 11.
16. Henderson M. (2007) Wrongful Trading.