What Is Insolvent Trading?

By Nadya JosifovLast Updated August 30, 2020
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The terminology in the business world can be quite perplexing, particularly when it comes to money matters, but understanding the many stringent rules associated with finances is critical to a company’s survival and success. Ideally, a business thrives, and owners can focus on laws related to financial reporting, stock offerings and money management, but it’s equally important to follow the correct legal rules and procedures when a business is struggling financially.

If a company’s financial difficulties progress to the point of insolvency — a state that occurs when the company can no longer pay its debts — very specific rules must be followed to ensure that insolvent trading doesn’t occur. To help you better understand the rules and repercussions, we’ve put together this quick guide to explain insolvent trading claims and related topics like liquidation and bankruptcy.

A Brief Description of Insolvency

In layman's terms, you can think of insolvency as the trigger for bankruptcy. It's a sign of severe economic distress that comes in two forms: cash flow insolvency and balance sheet insolvency. Cash flow insolvency occurs when debtors don't have the money to make payments on financial obligations when they're due. In some cases, it could be a temporary situation that is corrected as soon as money comes into the company from sales, loans or other sources.

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Balance sheet insolvency is more severe and occurs when the company’s debts are greater than its assets. This type of insolvency is often the tipping point that pushes a company over the edge into bankruptcy, either in the form of debt restructuring or total liquidation of assets. Due to the differences in types, a business can be insolvent without being bankrupt if it can correct the cash flow problem. However, it can’t be bankrupt without first being insolvent.

Insolvent Trading Claims: A Brief Definition

For businesses around the world, putting shareholders first is par for the course during normal business operations. However, once a company becomes insolvent, the focus must legally shift to taking care of creditors above everyone else. Continuing daily business operations that could potentially incur additional debt when a business already can't pay its existing debts leaves company directors vulnerable to insolvent trading claims. If these claims are deemed valid, the directors are subject to civil penalties, including being held personally responsible for debts incurred during times of insolvency.

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In Europe, insolvency laws are similar to U.S. bankruptcy laws, except they have traditionally focused less on restructuring insolvent businesses to give them a chance to become profitable again. In other words, reorganization bankruptcy — Chapter 11 in the U.S. — is much less common in Europe, although the laws vary from country to country. Experts believe that reform is inevitable and will give businesses a better chance of recovering while limiting creditors’ losses.

Who Makes Insolvent Trading Claims?

When a company becomes insolvent, a liquidator is appointed to protect the interests of the company’s creditors and liquidate assets to pay debts. When liquidators are notified of insolvent trading, they are obligated to investigate. They often initiate insolvent trading claims themselves, but creditors can also take action regarding their debts. The claim period generally extends for a period of several years, starting from the onset of liquidation. Unless a company’s directors had reasonable grounds to believe the company was solvent when they conducted business, creditors could pursue legal action to collect debts from the directors personally.

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Liquidation Explained

In European markets and U.S. bankruptcies like Chapter 7, insolvency triggers the decision to end a business and liquidate the business’ assets, either by distributing its assets to various creditors or by selling the assets and distributing the proceeds to the various creditors. Once the process is complete, the business no longer exists.

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In the U.S., the Department of Justice oversees the distribution of assets. In most cases, the first distributions go to creditors with the most senior claims who secured collateral on the loans they provided to the business. Unsecured creditors like bondholders and employees are paid next. If any funds are left after paying those debts, shareholders receive the remaining assets.

U.S. Bankruptcy Laws

According to IRS rules in the U.S., a person or entity is insolvent when their total liabilities are greater than their total assets. At that point, bankruptcy is a valid legal tool governed by federal laws for creating a plan for paying creditors. Bankruptcy laws in the U.S. favor reorganization of debt more often than European insolvency systems. Chapter 11 bankruptcy allows a business' management team to continue with daily operations throughout the reorganization process.

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The bankruptcy courts have to approve all major business decisions, but this gives the business a chance to restructure its debt to reduce payments and potentially regain profitability. Chapter 7 bankruptcy, however, requires the business to halt all operations. The courts appoint a trustee to sell the company’s assets to pay the company’s debts in this form of bankruptcy.

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