Insolvency Litigation

By James Dugdale

What is insolvency?

Insolvency is the inability of an individual or company to pay off their liabilities (debts, expenses, taxes, etc.) by the time they are due. In the UK, the term insolvency is often used to refer to companies who cannot pay off their liabilities, whereas the term bankruptcy is used for individuals in the same situation. This is sometimes clarified by the use of the term corporate insolvency, which may be used to refer to the insolvency of companies.

The definition of insolvency outlined above refers specifically to cash flow insolvency, however, there is another form of insolvency called balance sheet insolvency. A company is balance sheet insolvent when the value of its assets is less than that of its liabilities. This includes both the company’s current liabilities, as well as any prospective liabilities.

Cash flow insolvency is generally easier to calculate. Where cash flow insolvency occurs when a company is unable to pay its debts, balance sheet insolvency requires the valuation of assets and a prediction of prospective liabilities. Because a company that is balance sheet insolvent may still be able to pay its creditors, balance sheet insolvency is sometimes referred to as technical insolvency. On the other hand, cash flow insolvency is sometimes called actual insolvency.

Conversely, a company is considered solvent when it can meet its long-term liabilities. This is the opposite of cash flow insolvency, however, solvency can also be used to describe the opposite of balance sheet insolvency. This latter definition would therefore define a solvent company as one which holds assets that are worth more than their liabilities.

What does litigation have to do with insolvency?

A claim may be brought against the insolvent company, and conversely, insolvent companies may themselves bring a claim against another company or an individual. If a company goes into administration or liquidation, the office-holder (administrator or liquidator) will usually have the power to bring and defend proceedings for the insolvent company.

Claims made against an insolvent company

Reasons that an individual or company may begin legal proceedings against an insolvent company could include, for example, the failure of the insolvent company to fulfil contractual obligations. Claims that can be made against a solvent company can usually also be made against an insolvent one. However, making a claim and taking an insolvent company to court may not be preferable for the claimant. The proceedings may not be particularly cost-effective, and litigation fees could end up costing more than the claimant could realistically take away.

Even if the claimant does win the case, the insolvent company may not have the necessary capital or assets to pay what is owed to them. What is more, there will in all likelihood be creditors who will be prioritised before the new claimant (see our guide on Acquisition Finance for more information on lender prioritisation). All this considered, for some, making a claim may not be worth the lengthy legal proceedings and litigation costs.

Claims made by an insolvent company

However, insolvent companies too can begin legal proceedings against an individual or company. An insolvent company may, for example, feel that a supplier has unfairly terminated a contract. The supplier may have chosen to do this because they did not want to become a creditor to a struggling business.

However, there are laws in the UK and Wales which prevent certain suppliers from terminating contracts upon a company’s insolvency. Insolvency and its related concerns are regulated by the Insolvency Act 1986, which has recently been updated by the Corporate Insolvency and Governance Act 2020. According to these regulations, suppliers of essential goods and services (such as utilities and communications) cannot terminate contracts, unless an exemption applies, such as being permitted by the office-holder or the court (Insolvency Act 1986, 233-233A).

Continued access to these essential supplies ensure that the financial situation of insolvent companies is not exacerbated. If, for example, a company had its electricity contracts terminated upon becoming insolvent, it would not be able to operate, therefore diminishing any hopes of becoming solvent again. As such, an insolvent company which believes that a contractor has unfairly terminated a contract may choose to claim against the contractor.

Winding-up petitions

What is a winding-up petition?

A winding-up petition is an application made to the court by a creditor, or multiple creditors. If successful, the company would have to ‘wind up’, which is also known as compulsory liquidation. A creditor can submit a winding-up petition if they are owed £750 or more, and can prove that the indebted company cannot pay the debt. If the application is successful, the company’s assets are sold, legal disputes are settled, and creditors are paid where possible.

If the petition is successful and a winding-up order is issued, the creditors may then choose to apply for a stay. A stay is a court ruling that suspends current legal proceedings, and in this case, would halt ongoing litigation that the company concerned was engaged in. Creditors may choose to pursue a stay to prevent a debtor from incurring further court and litigation fees. Such fees could hinder the debtor’s ability to pay their debts, and would therefore rather be avoided by the creditors.

How has COVID-19 affected winding-up petitions?

The Corporate Insolvency and Governance Act 2020 (CIGA 2020), which came into force in June of this year, has temporarily altered the criteria for a winding-up order. The Act was introduced as a response to the COVID-19 pandemic. It contains several temporary provisions which seek to alleviate the financial pressures felt by companies that, due to the pandemic, may be facing insolvency.

One such provision stipulates that creditors can only present winding-up petitions if they have reasonable grounds to believe that “coronavirus has not had a financial effect on the company” (CIGA 2020, Schedule 10, 2(2)(a)). This ensures that companies that have become insolvent as a result of the pandemic will be protected from creditors forcing them into compulsory liquidation. Companies in such a situation will hopefully become solvent again once the pandemic and lockdown have passed, although some companies have unfortunately already collapsed under the current economic pressures.

Case studies

Bresco Electrical Services Ltd (in liquidation) v Michael J Lonsdale Ltd – In June 2020, the Supreme Court unanimously ruled that adjudication, as a form of dispute resolution, has the jurisdiction to resolve claims made by companies in liquidation. Adjudication is generally faster and more cost-effective than starting court proceedings, and therefore allows insolvent companies to resolve disputes which the high costs of litigation may otherwise have made difficult.

Shorts Gardens LLB v London Borough of Camden Council [2020] – In April 2020, Saint Benedict’s Land Trust and Shorts Gardens brought their respective councils to court, both applying to restrain the presentation of a winding-up petition. The claimants argued that the winding-up petitions should not proceed until the UK was out of lockdown. However, since the case was heard prior to the Corporate Insolvency and Governance Act 2020 coming into force, Justice Snowden’s decision was based on what he believed was the Government’s intention behind the Act. Ultimately, Justice Snowden dismissed the claims.

Wright & Anor v The Prudential Assurance Company Ltd [2018] – In this case, the liquidators of SHB Realisations Ltd argued that the obligation to pay outstanding rent upon the termination of a company voluntary arrangement (CVA) was an unenforceable penalty. The High Court turned down the claim, since the rent had already been reduced to enable the company’s finances to be restructured, and the rent payable at the termination of the CVA was a legitimate contractual term within the arrangement.