Adam McCaw, of Ellisons Solicitors in Bury St Edmunds, explains the issues around insolvency in small businesses

In the challenging economic climate, high inflation, high energy costs, rising interest rates and pressure on consumer income, businesses and particularly small and medium sized owner managed businesses are going to feel the pressure.

Some will be able to absorb it, adapt and move forward. Others won’t (or at least won’t without accessing processes designed to support them).

The Insolvency Service in England & Wales releases quarterly insolvency statistics.

Statistics for Q1 were released in May and the main messages from the Insolvency Service were:

- Between 1 January and 31 March 2023 (Q1 2023), there were 5,747 (seasonally adjusted) registered company insolvencies…

- After seasonal adjustment, the number of company insolvencies in Q1 2023 was 4% lower than in Q4 2022, but 18% higher than in Q1 2022…

- One in 197 active companies (at a rate of 50.8 per 10,000 active companies) entered insolvent liquidation between 1 April 2022 and 31 March 2023. This was an increase from the 38.9 per 10,000 active companies that entered liquidation in the 12 months ending 31 March 2022.

In fact, insolvencies are close to their highest levels since 2009 (when they peaked following the financial crisis).

Insolvency can be caused by gradual decline or sudden shock, such as regulatory change or failure of a major customer or supplier. In each case, there is framework designed to support the re-emergence of a re-shaped business if the underlying product or service is good and the management team are prepared to stick with it.

Insolvency legislation provides 3 types of insolvency process that are particularly relevant to small business owners:

- Company voluntary arrangement (CVA)

- Administration

- Liquidation

A company voluntary arrangement is a collective arrangement with a company’s existing creditors by which a plan for settlement of existing obligations over a period of years is reached. The entering into and carrying out the plan is supervised by a licensed insolvency practitioner. This process might be used where creditors are likely to support the plan (because, for example, it offers a better outcome than a terminal insolvency). Of the 5,747 insolvencies in Q1, there were only 38 CVAs.

Administration is a process by which a company is put under the control of a licensed insolvency practitioner and temporarily protected from action by its creditors (for example landlords are prevented from exercising rights of forfeiture) whilst steps are taken to either re-organise the business or (more commonly) dispose of the business as a going concern, at the best price that can be achieved. It is often followed by liquidation. Owner managers are often best placed to take the business forward on a going concern basis, free of the liabilities that caused it to be insolvent and will be able to engage in discussions about terms on which they would be prepared to purchase the business with the insolvency practitioner before the process commences. There were 318 Administrations in Q1.

Liquidation is a terminal process in which a liquidator is appointed to take control of the assets of the company and to sell them for the benefit of creditors. Creditors receive a distribution from the money recovered by the liquidator. The company isn’t given the same protection from creditor actions as in administration but a properly planned liquidation can still result in the early sale of the business and its re-emergence under the control of the previous owners and managers. Liquidation might be used in priority to Administration where, for example, there are significant staffing changes needed in order for the business to move forward profitably. In Q1, there were 5391 liquidations.

It is a sad fact of insolvency that there is rarely a good return for ordinary unsecured creditors out of these processes. Insolvency of one business can often ripple out to others who relied on the failed business as a key customer or supplier.

Even if things are going well and there are no problems on the horizon it is worth taking steps to protect your business against a sudden shock. Things to think about here are credit terms, passing of ownership of goods (retention of title), personal guarantees (can you get them from customers, do you need to give them to suppliers), enforcement of payment terms, credit insurance and carefully observing the terms of insurance. If you aren’t being paid promptly or are being asked to extend further credit it is worth thinking about what will put you in the strongest position should the worst happen.

In Administration and Liquidation, the appointed insolvency practitioner has a duty to review the reasons for failure of the business and the conduct of the directors. Where they consider there to have been wrongdoing, they may pursue claims and may submit a report to the insolvency service, prompting action to disqualify the directors from acting as directors for a period of years. The 6 – 12 month window prior to commencement of a liquidation will be the most closely scrutinised but liquidators will generally look back at least 2 years and it is important that directors trying to make their way through an incredibly challenging situation protect themselves. There are a few mistakes that are commonly made:

- Paying off certain debts in priority to others (preference payments) without proper commercial justification

- Taking director loans or dividends

- Committing personal funds to meet creditor demands

So many small business owners draw money from their company as “dividends” because it is tax efficient. In law dividends are not used to reward you for your work, they are a distribution of profit. If you don’t have profit, you can’t take dividends and if you do, you can expect repayment to be pursued if insolvency follows. You aren’t expected to work for free and if you are paid a fair salary for the work you are doing you won’t be asked to repay it even if the worst happens.

If you are exposed to personal guarantee liabilities, the temptation to pay off those liabilities must be huge. The issue is that if insolvency follows you may simply find yourself facing a claim from a liquidator and subject to an adverse conduct report. Just as there are insolvency procedures to support business, so too are there procedures to support individuals and it is worth taking advice.

Before you commit personal funds to your business, just consider whether it is the best long-term use of the money. If the reality is that your business needs to change and you are just meeting a demand, maybe keep your money to one side and invest in the re-shaped future. If you are going to invest in your own business at a difficult moment, will security over its assets protect you?

If you have concerns about the financial security of your business, take expert advice early. Professional advice can both support and protect you as you grapple with the challenges of running a business in difficult economic times.

For advice on this or any other insolvency issues, contact Adam McCaw by email at adam.mccaw@ellisonssolicitors.com or by telephone on 01284 763333.