There is wide ranging confusion in the UK about what the term “insolvent” actually means. News outlets often use the term incorrectly, or otherwise blend it with other common phrases that apply to companies in financial struggle (for example, it is sometimes suggested that an insolvent company is a company that is being wound-up).
This is not the case, as the term “insolvent” has a very specific legal definition which could have far reaching consequences (including, but importantly not limited to, a company being wound-up). It is essential, therefore, that directors, shareholders and creditors understand exactly when a company will be classed as “insolvent” so they can take appropriate steps to mitigate any risk to themselves and protect the financially struggling company.
When does a company become legally ‘insolvent’?
There are a number of different ways in which a company can be classed as being legally insolvent. In brief summary, four separate tests can be applied, and if any of them are satisfied, then a company will be classed as insolvent.
Statutory demand test
If a company defaults on a payment to a creditor for an amount in excess of £750 (although this threshold was increased temporarily due to the COVID-19 pandemic), this creditor is entitled to serve a formal demand for payment on the company. This payment demand is called a “statutory demand”.
The company that has been served with the statutory demand then has 21 days to satisfy the terms of the statutory demand or validly dispute the debt, otherwise the company will automatically be classed as insolvent.
Although beyond the scope of this article, a statutory demand must be taken seriously and advice from a legal professional should be sought immediately upon receipt.
Cash flow test
If a court is satisfied that a company is unable to pay its debts, then it will be classed as having been insolvent from the date of its inability to pay its debts.
Balance sheet test
Under this test, a court needs to be satisfied that the amount of a company’s assets are less than its liabilities. If this is the case, then the company will have been insolvent from the date the assets were less than its liabilities.
This test will require an in-depth review of a company’s accounts and accountancy policies to determine what exactly are the company’s assets and liabilities.
Judgement enforcement test
If a company has been subject to a judgement debt order, but has failed to comply with this, then it will be classed as insolvent.
Impact of legal insolvency
Contrary to popular belief, a company being classed as insolvent does not automatically mean it will be wound-up.
While it will entitle a creditor to petition to the courts to liquidate the company, there are other routes available for an insolvent company (some of which could actually lead to the company’s rescue and continued trading!).
Insolvency should not, therefore, be seen as a taboo word that means a company is at its final stop. It should, however, be a call for the company’s directors and shareholders to seek appropriate advice before issues arise for themselves and the company.
How can we help?
Edward Beedham specialises in the legal and procedural aspects of corporate insolvency, including determining whether a company is legally insolvent. If you require advice on corporate insolvency, please contact Edward Beedham at edward.beedham@herrington-carmichael.com or on 01276 686 222, or visit our Insolvency page for more information.
This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to your own particular matter before action is taken.
