What is insolvency?
A business reaches a state of insolvency when it cannot pay money owed to its creditors, such as Inland Revenue, banks, suppliers, landlords, contractors and staff.
In most cases, a business is considered insolvent when the value of its debts is greater than the value of its assets.
When a business fails and is unable to service its debts, what happens next will normally be determined by its structure:
If the business is a company, it will go into liquidation.
If the business is a sole trader or partnership, the owners themselves can become bankrupt.
What is cash flow insolvency?
Cash flow insolvency is when a business has enough assets to offset the value of its debts but does not have enough available funds to make an outstanding debt repayment.
For example, a business may own a large property and lots of valuable equipment, but not have enough liquid assets to pay a debt by its due date.
Cash flow insolvency can usually be resolved through a process of negotiation. In some cases, a creditor may be prepared to wait until a business has sold assets before collecting a loan repayment.
What is balance sheet insolvency?
Balance sheet insolvency occurs when a business does not have enough assets to pay all of its debts. A business that is balance sheet insolvent might go into liquidation or bankruptcy, but not necessarily. Once a loss has been accepted by all parties, negotiation is often able to resolve the situation without the need for formal insolvency processes.
A company that is balance sheet insolvent may still have enough cash to pay its next bill on time. However, the business is unlikely to pay that bill unless it will directly help all their creditors. For example, an insolvent farm may choose to hire additional staff to help harvest a crop, because not harvesting and selling the crop would be even worse for the business’s creditors.
What are secured and unsecured creditors?
Creditors are people or businesses who are owed money by a company. Depending on the loan agreement in place, creditors might be secured or unsecured:
A secured creditor has a ‘security interest’ over some or all of the company’s assets. This means that in case of insolvency, the assets may be sold to repay any debts owed to the secured creditor.
An unsecured creditor does not have a security interest over the company’s assets and is not guaranteed any debt repayment through the sale of assets in the event of insolvency.
Liquidation
When a limited liability business becomes insolvent and goes into liquidation, a ‘liquidator’ will be appointed. The liquidator’s job is to sell off the company’s assets to pay the individuals or businesses who are owed money. Some creditors, including employees, are paid preferentially.
If the business is closed by the liquidator, employment ends for the business’s employees. In some cases, the liquidator can choose to sell assets to repay debts but leave the business open.
Bankruptcy
When a registered business becomes insolvent and goes into liquidation, this could mean that the company directors may also apply for individual bankruptcy. This normally happens if the company directors have personally guaranteed some of the business’s debt, or they owe money to the company that they are unable to repay.
The Insolvency Act determines that an Official Assignee will be appointed to administer all insolvency options in the case of a sole trader or partnership. The Official Assignee will decide how the insolvent business will be dealt with and if there are assets that can be sold to recoup money to pay any outstanding debts.
Insolvency practitioners
An insolvency practitioner, also known as an IP, is a trained professional who is licensed to help businesses experiencing financial difficulties.
In a worst-case scenario, insolvency practitioners may be appointed to administer formal insolvency processes, such as liquidation and bankruptcy. However, an insolvency practitioner can also be an invaluable source of support before a business reaches full insolvency.
How can businesses avoid insolvency?
When you realise that your business’s debts are mounting, it’s best practice to follow these simple steps:
1: Sell your assets:
This can result in having enough money to pay your creditors and reduce your debt. When dealing with insolvency, your aim is to pay less in interest and penalties as quickly as possible. When your creditors see you’re serious about paying them back, they might be more willing to negotiate.
2: Negotiate with your creditors:
You may be able to reach some kind of arrangement with your creditors. If you can show you have a plan to repay your debt, your creditors may be willing to:
Give you more time to make repayments.
Offer you a lower interest rate.
Charge fewer penalties.
3: Contact Inland Revenue
If your business has any unpaid taxes with Inland Revenue, you may be able to reach an agreement with them too. This could save you extra penalties and might mean you can pay off what you owe over a longer period of time.
4: Avoid taking on any new debts
If you’re offered a way to consolidate your debts, always seek advice from a financial expert. Unless consolidation loans are structured in your favour, they can have the unwanted effect of compounding your business’s problems.
5: Appoint an insolvency practitioner
An insolvency practitioner can help you explore what can be done to turn around a failing business. They might suggest restructuring your debts, selling assets or building a new repayment plan, all of which can buy you valuable time to get the business back on its feet.
Are you letting staff go?
Making employees redundant is one of the hardest parts of running a business. If you’re forced to let go of staff, make sure you do it the right way and follow the proper process. Get across all the facts with our FREE Redundancy E-Guide.
When employees are owed money
When an insolvent business enters liquidation or bankruptcy, employment of all staff is terminated. Employees can file a claim against the liquidated or bankrupt business for any unpaid wages and salary, holiday pay or redundancy compensation.
Before filing a claim, employees should gather evidence demonstrating the amount owed. Employees can also contact the appointed liquidator or Official Assignee for help collecting the bankrupt business’s records as evidence.
An employee’s claim may be considered preferential, which means money owed to them is paid out before any unsecured creditors (if there are funds available).
What are employee debt preferences?
Depending on the structure of the business, an employee may be able to claim any money owed by an insolvent employer. Some of the amounts owed are paid in preference to other creditors.
These preferences are detailed in the Companies Act 1993 and the Insolvency Act 2006 as follows:
Any wages or salary (including commission and piece rates) earned by the employee in the four months prior to the business going into liquidation or bankruptcy.
Any donations that have been deducted from an employee’s pay but not transferred by the employer.
Any holiday pay that has not yet been paid to an employee.
Any compensation for the employee being made redundant due to the company failing.
Any child support or student loan payments that have been deducted from an employee’s pay.
Any reimbursements or awards from determinations by the Employment Relations Authority (ERA) or Employment Court that found in favour of the employee. This is only if they relate to money the employee may have earned in the four months prior to liquidation or bankruptcy.
Any superannuation or KiwiSaver payments that apply to any of the above.
Which employee debts are not given preference?
Not all payments owed to employees are given preference. Staff are not entitled to preference in the payment of:
Any wages or salary earned prior to four months before the business fell into liquidation or bankruptcy.
Any wages or salary earned for work after the business was placed into liquidation or bankruptcy.
Any bonuses, commissions or other financial incentives.
Any awards of compensation from determinations by the ERA or Employment Court found in favour of the employee that are not specifically mentioned in the previous section.
How much preferential debt can an employee claim?
The maximum amount an employee can claim on a preferential basis is $23,960. This limit is outlined in the Companies Act 1993 and the Insolvency Act 2006.
Any amount above $23,960 will not be paid on a preferential basis. This means that only when a business has paid off all its creditors will an employee receive more than this amount. Any payment made beyond the preferential limit is normally paid as a percentage of any remaining debt.
How can Employsure help?
If your business is facing insolvency and you’re concerned about any obligations to your staff, call Employsure’s 24/7 Advice Line on 0800 568 012 to get all your questions answered.
