Your Company Is in Financial Distress: What Should Directors Do Before Insolvency?

Financial distress does not necessarily mean that a company is insolvent. Nor does insolvency necessarily mean that liquidation is inevitable. A viable business may experience serious cash-flow pressure because of delayed receivables, excessive debt, loss of a major customer, lender enforcement or inadequate working capital. If the underlying business remains viable, there may still be scope for restructuring, refinancing or new investment.

The critical question for the board is:

Is the financial problem capable of being cured, or will continued trading simply increase the eventual loss to creditors?

The earlier that question is addressed, the more options the company is likely to retain.

Financial distress, insolvency and unavoidable liquidation are different

These concepts should not be treated as interchangeable.

Financial distress describes commercial pressure. Insolvency is a legal and financial condition assessed against the statutory tests, including inability to pay debts. A further and more serious stage arises where there is no reasonable prospect of avoiding insolvent liquidation.

Ordinarily, directors are required to promote the success of the company for the benefit of its members. Section 143(3) of the Companies Act, however, expressly preserves the operation of laws requiring directors, in certain circumstances, to consider or act in the interests of creditors. As financial distress deepens, the board should therefore assess its decisions against the risk of further creditor loss.

Directors should not wait for a statutory demand, enforcement action or liquidation petition before examining the company’s position.

Reliable current information on cash flow, creditor balances, secured debt, tax obligations, expected receipts and asset values should be considered together.

The board must distinguish a credible recovery plan from optimism about future sales, expected funding or anticipated payments.

Can the company continue trading?

Yes, where there remains a reasonable commercial basis for doing so.

A distressed company may still be capable of rescue through improved cash flow, creditor restructuring, refinancing, disposal of non-core assets, new investment or a combination of these measures.

The legal risk increases where the directors know, or ought to know, that there is no reasonable prospect of avoiding insolvent liquidation.

Section 506 permits a liquidator to seek an order requiring an officer to contribute to the company’s assets where that threshold is met. The Court will, however, consider whether the officer took the steps that could reasonably have been expected to minimize potential loss to creditors.

Wrongful trading therefore does not mean that directors become personally liable merely because a genuine rescue attempt eventually fails.

The greater risk arises where the company continues incurring liabilities after its position has become commercially hopeless without taking reasonable steps to avoid further creditor losses.

Fraudulent trading under section 505 is distinct and more serious. It concerns business conducted with an intention to defraud creditors or for another fraudulent purpose.

As insolvency becomes increasingly probable, the board should therefore be able to demonstrate that its decisions were directed towards preserving value and avoiding unnecessary deterioration in the position of creditors.

Creditor engagement may preserve the business

Formal insolvency is not always the first restructuring option.

Early engagement with secured lenders and major creditors may create room for a consensual solution. Depending on the circumstances, this may involve revised repayment terms, covenant waivers, temporary standstill arrangements, restructuring of existing facilities or negotiated settlements with material creditors.

Timing is important. A creditor may be more willing to accommodate a restructuring while the company remains operational and capable of presenting a credible recovery plan than after defaults have multiplied and enforcement has commenced.

The company should therefore approach creditor negotiations from a position of reliable financial information and a realistic proposal rather than merely requesting additional time.

Can refinancing or new investment preserve the business?

Potentially.

A company may have viable operations but an unsustainable capital structure. In such circumstances, new capital may provide an alternative to formal insolvency. The solution may involve additional debt, equity investment, conversion or restructuring of existing obligations, disposal of non-core assets or a combination of these measures.

Rescue financing often requires more than introducing new money. Existing lender consents, the priority of new security, shareholder dilution, restructuring or subordination of existing debt, and the company’s ability to service additional borrowing may determine whether the transaction is viable.

The board should therefore assess whether the proposed funding genuinely restores financial stability.

New borrowing that simply allows an unviable company to continue accumulating liabilities may postpone insolvency rather than prevent it. Conversely, properly structured capital introduced into a viable business may restore working capital, refinance unsustainable debt or provide sufficient time to implement a wider restructuring.

Funding should be part of the rescue plan, not a substitute for one.

Directors should also consider transactions entered into during distress

Financial distress can also place particular transactions under later scrutiny.

If the company later enters administration or liquidation, transactions at an undervalue and preferences given during the statutory relevant periods may be scrutinized and, where the requirements of the Insolvency Act are satisfied, challenged. Directors should therefore exercise particular care when disposing of assets, granting security or making selective payments during serious financial distress.

This does not mean that a distressed company must stop dealing with its assets or creditors.

It means that material transactions should have a proper commercial basis, be entered into on defensible terms and be documented accordingly.

When should administration or liquidation be considered?

If consensual restructuring or new funding cannot resolve the problem, formal insolvency should be considered while the company still has value to preserve.

Administration is principally concerned with preserving or realizing going-concern value. Under section 522, its primary objective is to maintain the company as a going concern. Where that is not reasonably practicable, administration may seek a better outcome for creditors than immediate liquidation.

It may therefore be appropriate where creditor pressure threatens an otherwise viable business and time is required for restructuring, refinancing, investment or a goingconcern sale.

Liquidation reflects a different commercial conclusion.

Where there is no credible rescue, no sustainable funding solution and continued trading is likely to increase creditor losses, the focus shifts from preserving the business to the orderly realisation and distribution of its assets.

The distinction is therefore relatively simple:

Administration seeks to preserve or realize going-concern value. Liquidation accepts that rescue is no longer realistic and focuses on an orderly realisation of what remains.

Board discipline matters

The board should make material decisions from current financial information and record the basis upon which those decisions were made.

Board meetings, cash-flow information, proposed funding, creditor negotiations and the reasons for continuing or restricting trading should be properly documented.

This governance discipline is commercially useful in its own right. It also becomes important if the company later enters liquidation and questions arise about what directors knew, when they knew it and what they did thereafter.

The board should be able to demonstrate that continued trading was based on a credible plan rather than hope.

How we assist directors and distressed companies

We advise boards, shareholders and companies experiencing financial distress.

We help boards determine whether the business remains capable of rescue, whether continued trading remains commercially and legally defensible, what creditor and security constraints exist, and whether the appropriate route is consensual restructuring, refinancing, new investment, administration or liquidation.

Where recapitalization remains viable, we advise on the legal structuring of debt and equity funding and, where appropriate, work alongside financial advisers, funding facilitators and investors in evaluating and implementing potential transactions.

We also advise directors on creditor negotiations, transactions undertaken during financial distress and potential exposure under the wrongful and fraudulent trading provisions of the Insolvency Act.

The board’s task is to determine, while options remain available, whether the business can be rescued or whether formal insolvency should be considered.

This article provides general information on Kenyan insolvency and commercial law and does not constitute legal advice.