There can be many twists and turns over the life of a business, but one of the more serious (and usually final) turns is when it declares insolvency.
A recent spate of high profile collapses, most notably music retailer HMV, cake chain Patisserie Valerie, and department store House of Fraser, have all brought various insolvency methods to the fore.
While the word “insolvent” usually conjures up images of a business going bust and closing down, the reality is less clear.
Insolvency essentially means a company either cannot pay its bills when they are due, or its liabilities outnumber assets on its balance sheet.
A firm can still keep trading while in insolvency, although it often requires either agreement with, or legal protection from, creditors who will come knocking when their payments fall behind.
Insolvency options in the UK
Informal agreements
According to the UK’s Insolvency Service, one option for a company to stay in business is simply an informal arrangement between the firm and its creditors to pay debts on different terms than previously agreed.
This is usually used when a business is experiencing temporary financial difficulties and there is no threat of immediate legal action by creditors, although as it is informal, it can be withdrawn at any time.
Company voluntary arrangement (CVA)
A CVA is a binding agreement between the insolvent company and its creditors that involves the payment of all or part of its debts over an agreed period.
The firm will usually need to explain how it got itself into distress and offer a reduced payment plan, which can include actions such as rent reductions from landlords or a restructuring of payments to banks.
The proposal, which can only be issued by a company’s directors, will then be circulated to all its creditors who then vote on the plan.
Creditors normally approve CVAs as generally they will at least recoup some of their money as opposed to potentially losing everything if the company goes bust.
High-profile CVAs in the last year have included retailers Carpetright PLC (LON:CPR), Mothercare PLC (LON:MTC) and New Look as well as restaurant chains such as Byron Burger and Prezzo.
Administration
The option most recently splashed across the newspaper front pages, administration is when the company hands itself over to an insolvency practitioner known (unsurprisingly) as an administrator.
While an administrator is in control of a company, creditors cannot take legal action against the firm to recover their debts, or begin liquidating the company, without court approval.
An administrator will draw up a plan to help make the company profitable again or to work out an agreement with creditors. These can include CVAs, selling assets to pay secured or preferential creditors, or even selling the business for more money than it would have received from liquidation.
Creditors must choose whether to agree to the proposals, and it does not protect the company from liquidation if a court agrees to the administrator's plan.
However, administration can also mean a firm may not have to pay its debts in full.
Administrative receivership
Administrative receivership is initiated by the holder – usually a bank - of what is known as a “floating charge”, a liability that has its value attached to assets that may change in value or quantity.
The holder of the charge appoints an administrative receiver, usually a private insolvency practitioner, to recover the money owed to it.
Administrative receiverships are less common now as the Enterprise Act 2002 defines only a specific set of conditions in which a receiver can be appointed, and even then only if the floating charge was created after 15 September 2003.
Liquidation
If all else fails, the company will enter liquidation (also known as ‘winding up’), a process where it stops doing business and ceases to function.
Liquidation involves making sure all company contracts are completed or otherwise ended, settling any legal disputes, selling its assets, collecting any money owed to it, distributing funds to creditors, and repaying any share capital to investors (provided there is money left).
Creditors can also force an insolvent company to wind up through compulsory liquidation.
Insolvency options in the US
In the United States, businesses have two major methods of proceeding when they become insolvent, Chapter 11 bankruptcy and Chapter 7 bankruptcy.
Chapter 11 Bankruptcy
In the US jurisdiction, the most common tool to reorganise a business is in Chapter 11 of the Bankruptcy Code.
If a company files for Chapter 11 bankruptcy, the purpose is twofold: first to provide an automatic stay that prevents creditors taking action against the company and allow it to propose a reorganisation plan, and second, to maximise recovery for creditors.
Most companies prefer to file for Chapter 11 as it allows them to keep running the business and control the bankruptcy process, rather than just putting its assets in the hands of a trustee, providing time to potentially rework its finances and become profitable again.
However, the firm cannot simply do what it likes under Chapter 11 because a committee is assigned to represent the interests of creditors and shareholders who help the company develop its reorganisation plan.
While shareholders may vote on the plan itself, their priority is second to all other creditors and if the plan fails, they may not be able to stop assets being liquidated to pay the company’s debts.
Chapter 7 Bankruptcy
Chapter 7 is a little more straightforward; the company simply stops operations and goes out of business, with a trustee appointed to liquidate the company’s assets and use the proceeds to pay off its debts.
However, not all debt is equal in the eyes of the law, with low-risk lenders such as corporate bond-holders (who have lent the company money) paid first as they are deemed to have taken the lowest exposure risk to the company’s performance in favour of set interest payments.
By contrast, equity investors, as part owners of the company, stand at the back of the queue and may not get full payback for the value of their shares after the lenders and creditors are paid off.
What about investors?
While nobody invests money in a company expecting it to go bankrupt, there is always an element of risk involved.
Generally, if you’re a shareholder and the company appears to be going insolvent, the share price will go down, probably to an extremely low price.
When the company does finally go bankrupt, there is no guarantee that shareholders will get all or even part of their money back, as they rank fairly low on the creditor hierarchy.
The ‘official’ UK hierarchy, as laid down by the Insolvency Act 1986, ranks creditors as follows;
1. Secured creditors with a fixed charge - Generally a bank or other asset-based lender that holds a fixed charge over a specific business asset, such as a building. When insolvent, these creditors will be paid from the sale of the specific asset over which the security is held.
2. Preferential creditors – A creditor the receives a preferential right to payment, either for their whole amount or up to a specific value. This often includes employees who are owed wages.
3. Secured creditors with a floating charge – Similar to a fixed charge except for liabilities carrying a floating charge, which when defaulted on, becomes a fixed charge at the current level.
4. Unsecured creditors – A lender that does not have their money tied to any specific assets. These are higher risk as they have nothing to fall back on if the borrower defaults. Examples include contractors and suppliers.
5. Shareholders – The lowest rung. As shareholders have taken a business risk to provide money to the company, they are not entitled to anything until all the above groups have been paid.
Unsecured creditors like shareholders will also receive no more say on a company’s reorganisation plan than they would on other actions requiring shareholder votes.
In short, it is a similar situation to an unexpected dive in the price of shares; you either accept your investment is worthless or sell up – assuming you can sell up.