When a company is in financial difficulties, it is essential that the directors seek and obtain competent and professional advice. Once the prospect looms that the company may fail and that the directors may be called upon to fulfil obligations under personal guarantees, it becomes more difficult for directors to make rational judgments with regard to the business they are running.

There is no precise legal definition of insolvency and it is therefore arguable as to the exact moment when a company becomes insolvent. A company is normally regarded as insolvent on two counts - when its liabilities exceed its assets, or when it is unable to meet its liabilities as they fall due.

In view of the problem in determining precisely when a company is insolvent, directors should seek advice and be extremely careful about the liabilities their company incurs once they are aware that financial problems exist. Directors, particularly those controlling and possibly owning smaller family businesses, often fail to appreciate the alternative courses of action open to them, and the consequences of these both for the company and for themselves.

These are: a) To take corrective action within the existing company, with the aim of alleviating the company’s cash shortage.

b) It may be possible to arrange a sale or merger with a third party with greater financial resources to assist the company over its difficulties.

c) If the cash position is so critical that continued trading is no longer possible, then the directors will have to either come to an informal or voluntary arrangement with creditors in an attempt to resolve the company’s difficulties, or take steps to arrange for the appointment of an administrative receiver, an administrator or a liquidator, and follow the appropriate formal insolvency procedure.

A very common feature of companies that experience financial difficulties is that the accounting records are poorly maintained. Accurate and up-to-date accounting records are never more vital and necessary than when a company is running out of money. Without them, neither the directors, nor their advisers, can hope to make the right decisions. Short-term profit forecasts and cash flow projections must be reviewed so that the benefit of future trading can be evaluated.

If there is a real risk that creditors may not be paid and trade is allowed to continue, any bills incurred during this period not subsequently paid may be held to be the personal responsibility of the directors. The directors’ duty is to preserve the status quo for the benefit of creditors and shareholders until the company’s future is determined. The directors should take advice as to whether trading should continue, and whether plans for the future are realistic. If it is possible to formulate a rescue plan which is regarded as achievable, then it will probably be important to inform creditors, as far as possible, of the company’s financial position and of the intentions for the settlement of outstanding accounts.

Creditors are more likely to give a sympathetic hearing if the proposals are presented and supported by an insolvency practitioner. Throughout this period, the directors must have regard to the potential penalties of being found guilty of either wrongful trading or of trading fraudulently while insolvent. Although efforts will be concentrated on the resolution of the short-term cash flow difficulties, the directors must not forget to consider the viability of their company in the longer term.

If the decision is made that the company should continue to trade, there must be clear evidence of a real prospect that all creditors will ultimately be paid. If there is no such prospect then, apart from the possible conversion of work in progress into finished stock, trading may well have to cease immediately.

Ben Hopps is a solicitor in the commercial litigation team at Sykes Anderson LLP