Introduction to Corporate Insolvency
Insolvency law dates to the first bankruptcy statue in 1542, aiming to stop debtors escaping the realm and that debtor’s assets were divided equally and rateably among creditors. Before companies existed, the law was concerned with the insolvency of individuals only – i.e. bankruptcy.
Historical background
Cases such as Fowler v Padget (1798) 101 ER 1103 show that courts treated bankrupts as fraudsters. In 1705, bankrupts could be discharged from their debts for the first time: a ‘fresh start’. In 1825, debtors could initiate their own bankruptcy proceedings, as before only creditors could do so via a bankruptcy petition.
The first companies’ legislation in 1844 included the Winding-up Act. Today, corporate insolvency and personal bankruptcy are both governed by the Insolvency Act 1986 and the Insolvency Rules 2016.
Meaning of insolvency
Creditors can petition the court to wind-up a company on the ground of insolvency. There are two types of insolvency set out in section 123 of the Insolvency Act: (a) cash flow insolvency and (b) balance sheet insolvency. The first type is where companies are unable to pay debts as they become due, meaning there are insufficient funds available to pay creditors. Evidence of this is where a company might be asset-rich but does not have the liquidity to pay short-term debts. The second type is when total liabilities are greater than the value of assets, meaning the debtor has insufficient assets to discharge its liabilities. In other words, the company may have sufficient liquidity to pay immediate sums as they fall due, but cannot cover larger, long-term debts. Therefore, it is possible to insolvent in cash-flow terms but be asset rich, and vice versa.
Effects of insolvency
Unsecured creditors can only rely on a contractual right against the debtor, whereas secured creditors have this along with a proprietary interest in some or all of a debtor’s property. If sale of the property produces enough to pay the creditor, they will not petition for liquidation. Companies can operate while insolvent, but doing so can be risky and give rise to legal proceedings against directors under the wrongful trading provisions in the Insolvency Act, section 214.
Purposes of insolvency
The Cork Report 1982 laid the foundation for the Insolvency Act 1986. It articulated several purposes of insolvency law, including:
(a) providing a fair and orderly procedure to ensure creditors receive equal and equitable distribution of assets,
(b) to ensure debts are satisfied with little delay and expense,
(c) to ensure insolvencies are conducted honestly, independently and competently,
(d) to try and rescue insolvents before their position is hopeless,
(e) to protect the public interest from the deleterious effects of insolvency,
(f) to provide a flexible and respected system for insolvency, and
(g) to maintain corporate morality by examining the conduct of insolvents/bankrupts, their associates and controllers.
Principles of insolvency law
The most important principle in insolvency law is pari passu, i.e. there should be an equal and rateable distribution of the insolvent company’s assets among unsecured creditors. This ensures that loss is spread among those who have a claim and do not hold a pre-existing security interest.
There is a distinction, therefore, between secured and unsecured creditors. Secured creditors are those who have lent money to the company, and received a property interest as security for the loan in return. Unsecured creditors who have lent money but did not receive a security interest only have a personal, contractual right against the insolvent, which is suspended in favour of the pari passu principle upon insolvency. This distinction means that secured creditors “skip the queue” and are paid first. Unsecured creditors will receive whatever is left (if anything) equally and rateably under the insolvency regime.
When a company goes technically insolvent, the company may be placed into a formal insolvency procedure. First, it may be placed into administration. This aims to rescue the company and achieve better outcomes for creditors by restructuring its debts or selling the business. Second, it may be put into liquidation. This involves closing a company and selling assets to repay creditors, usually when there is no prospect of the company being rescued. Other mechanisms may be used, such as a company voluntary arrangement, voluntary or compulsory liquidation, receivers, and a moratorium.
Insolvency procedures are collective proceedings. Once initiated, individual unsecured creditors lose their pre-regime right to claim for repayment of what they are owed by a separate action. In return, they are given the same right to participate in the assets with all unsecured creditors. Secured creditors retain their right to priority where it was obtained before the advent of the formal liquidation regime.
