KEY POINTS:
Mike Whale and Mark Lowndes, of Lowndes Associates' insolvency and restructuring team, advise what directors should do when the cash runs out.
If a company can't pay its bills on time, are the directors personally liable?
Yes. Once a company is not meeting its bills on time, directors take a personal risk if the company keeps trading and buying goods and services on credit.
This is because directors must not agree to a company incurring an obligation unless they believe the company will be able to perform that obligation on the due date.
Directors cannot allow the company's business to be carried on in a manner likely to create a substantial risk of serious loss to creditors.
What about customer orders? What should directors do?
Directors are at risk if they take on obligations to customers the company may not be able to meet. A customer let down becomes a creditor.
The main mistakes are to not see a liquidity problem coming, or to continue trading on optimism. When directors can see there will be a point when bills cannot be paid on time, directors must focus, obtain accurate, up-to-date financial information, seek advice and embark on a clear plan to reinstate solvency, if possible.
The plan must be realistically likely to succeed in a reasonable time.
What are the options to reinstate solvency? What about formal insolvency tools?
There are too many restructuring possibilities to list but they include raising more capital from shareholders, debt finance, a sale of assets or all or part of the business, licensing some IP, reducing costs and obtaining financial support from creditors or customers.
Advice should be sought as to the use of new funds. Directors should often explore insolvency options, such as a scheme of arrangement or voluntary administration. But the common mistake is to leave these so late that really little can be done. The last resort is receivership and/or liquidation.
What is the risk while trying to sort out the problem? Is the easiest solution for the shareholders to provide some support?
Directors should take advice but basically the risk grows as creditors increase. One option is for shareholders to quarantine unpaid creditors and trade on a cash-in-advance basis.
In this way the company keeps trading but the position is not getting worse. Counter-intuitively it isn't appropriate to use cash flow to pay off old creditors and incur new ones unless the directors believe the new ones will be paid.
It is often the easiest solution for the shareholders to provide some support so long as they put their additional funding in as share capital or subordinated debt, i.e. debt that ranks after the ordinary creditors. If shareholders put in ordinary loans, the creditor's position is deteriorating as total creditors are increased by the shareholder loans.
Disclaimer: This column is, of necessity, only a summary of some relevant aspects of a complex area of law. Legal advice should be sought in relation to any particular situations.
