When a business fails: Understanding the terms

It’s often a surprise when a business fails, especially one that’s well-known and seemingly successful.

Unless you’ve been hiding under a rock you would have heard that yesterday, Carillion, has gone into liquidation. While the reasons for a business failing may never be fully understood, the terms used to describe the process give some explanation of what is happening.

Insolvency: Can’t Pay the Bills

Insolvency describes a situation where an individual or company cannot pay the money they owe when the bills are due. If the directors of an insolvent company want to continue trading, they must take one of the following actions:

  • Try to make informal arrangements with creditors to make payments.
  • Negotiate with creditors to come to an agreement. This is called a Company Voluntary Arrangement. The goal is to restructure (and sometimes reduce) the company’s debt, but since 75% of creditors must agree, it is most commonly used for smaller companies.
  • Put the company into administration.

Liquidation: Legally Closing the Company

When a business is in liquidation it is no longer doing business. It doesn’t always happen under circumstances of insolvency—for example, a business owner may liquidate their business when they are ready to retire or can’t find a replacement to run the firm – this process is known as members’ voluntary liquidation.

During this process, a liquidator will first ensure contracts with employees and other businesses are completed or transferred. The business is then shut down, the assets are sold, debts are paid (if enough funds are not available then the debt is written off) and any remaining funds are paid out to shareholders. Once the liquidation is complete, the business is struck off the official Companies House register and no longer legally exists.

Bankruptcy: The Individual Option

In the UK, only individuals can apply for bankruptcy. Again, it comes into play in cases of insolvency when they can no longer pay the money they owe when the bills are due. There are three ways an individual can enter bankruptcy:

  • An individual can apply through the gov.uk site for bankruptcy when they are unable to meet their financial obligations.
  • A creditor can apply for an individual to enter bankruptcy when they are owed more than £5,000.
  • An insolvency practitioner can determine bankruptcy when an individual fails to keep the terms of a voluntary agreement for paying off their debts.

A trustee may use an individual’s business assets to pay off debts and distribute the funds first to employees and then to creditors.

Receivership: The Takeover

In receivership, a creditor (or creditors) who have been able to collect sufficient payment for debts may request that a receiver be appointed to meet the requirements of the debt. In these cases, the receiver’s first priority is to the creditor. The receiver may collect income, and sell assets in order to pay all creditors. Even if only one creditor has requested the receivership, all creditors will be included in the disbursement of payments.

A business may continue to operate if there are sufficient assets to cover the debt. However, most companies in receivership face total liquidation and the closure of the business.

Administration: The Final Effort

A company under administration has had their legal ownership handed to an administrator. The administrator’s job is to handle the company’s debts and assets in order to meet as many obligations as possible. Their primary commitment is to the creditors. Administration also prevents legal action against the company by creditors unless special permission is given. Not every company in administration will be closed, but the majority find administration to be the end of their business.

One of the first duties of the administrator is to decide whether to allow the company to continue trading whilst under administration. If it does, it will be under the daily control and management of the administrator.

An administrator has a certain amount of freedom over how assets are distributed to creditors. They may invite the creditors to vote on a proposal, or make a decision without consultation. Either way, they are required to explain their decisions. Often, administrators negotiate with creditors to pay less than what is owed. They may also liquidate assets with the permission of the courts.

What Happens to a D&O Policy?

A common misconception is that cover ceases should one of the above scenarios occur. It is normal that a Directors & Officers (D&O) policy will continue in full force and effect until the natural expiry date of the policy, but will only respond to claims for wrongful acts that were committed before such event took place.

There are, of course, other outcomes that could be arrived at and given the sensitive nature and complexities that often surround this issue it would be usual for insurers to review on a case by case basis.