The Zone of Insolvency: Directors' Duties Explained
What the zone of insolvency means in practice, how directors' duties change as a company's finances deteriorate, and what to do about it.
Enquire NowJonathan Lea Network advises directors on how their duties change as a company’s financial position deteriorates, a period often described as the zone of insolvency. We advise on the cash flow and balance sheet tests, the point at which creditors’ interests enter the balance, what directors should and should not do while the company is under pressure, how decisions should be recorded, and the personal exposure that can follow if the company later fails.
The decisions you take now will determine whether you end up in a formal process
Your company is under pressure. It is still trading and still paying most people, and you are hoping the next few months look better than the last few.
That period has a name in professional shorthand: the zone of insolvency. It is not a formal status and there is no moment at which you cross into it. What it describes is the stretch of time when your company’s finances have deteriorated enough that the ordinary rules about running a business start to change, and when decisions you take can be examined by somebody else later.
Working out where you are is what keeps your options open. Directors who do it early tend to have more room to move, better records and fewer problems afterwards. Directors who do not tend to find out from a liquidator.
When should you take advice?
Sooner than most people do. The usual signs that it is worth a conversation:
- cash tightening month on month, or a forecast you no longer believe
- creditors chasing harder, or one of them threatening a statutory demand or a winding-up petition
- arrears building with HMRC, a time-to-pay arrangement that has broken down, or a missed PAYE or VAT payment
- losing a major customer, or renewing a key contract on much worse terms
- a breach of a banking covenant, a facility withdrawn, or a refinancing that will not complete
- putting your own money into the business, or deferring your own pay
- not being confident that the company can meet its liabilities over the coming months
One of these on its own may mean nothing. Two or three together usually mean the conversation is better had now than in three months.
What does the zone of insolvency actually mean?
It describes a period, not a single moment, and the phrase appears nowhere in the legislation.
Behind the shorthand is a straightforward idea. Once a company’s finances have deteriorated, the way its board behaves carries consequences it did not carry before. The interests of the people the company owes money to start to matter to your decisions, and steps that would have been unremarkable a year earlier can be reopened by an administrator or liquidator.
Nobody will tell you when you have entered it. That is why the practical answer is to check the company against the two tests that do have legal force, and to start writing down your reasoning.
Is the company insolvent? The two tests
Can you pay your bills as they fall due? If not, the company is cash flow insolvent. This looks at what is actually happening rather than at the accounts. A business holding substantial assets can still fail this test if it cannot turn them into money in time.
Do you owe more than you own? If the company’s liabilities, including those that have not crystallised yet, exceed its assets, it is balance sheet insolvent. This turns on what things are genuinely worth. A debt owed to the company by somebody who cannot pay is not worth its face value, whatever the ledger says.
A company can fail one test and pass the other. Failing one does not mean you have to stop trading, and it does not mean the business cannot be saved. It means you now need to be more careful about the decisions you take, and much better at recording why you took them.
How your duties change as the difficulties increase
While the company is healthy, your job is to promote its success for the benefit of its shareholders.
As insolvency becomes more likely, the people the company owes money to enter the picture, and the weight their interests carry grows as the position worsens. If insolvent liquidation or administration becomes unavoidable, their interests come first and the shareholders’ come last.
In practice that means three things.
Every significant decision needs a reason that serves the company and its creditors, rather than the shareholders or the directors.
That reason has to exist at the time. A justification assembled afterwards, once everyone knows how it turned out, carries very little weight.
It has to be written down. The board minute, the figures you relied on, the advice you took, the alternatives you considered and why you rejected them. This is the most useful thing a board under pressure can do, and it costs nothing.
Can the company keep trading?
Often, yes. A shortage of cash does not oblige you to close the business.
Continuing to trade is defensible where the board has a reasonable basis for believing the company can avoid insolvent liquidation, and keeps testing that belief as things change. What causes problems is drift: carrying on without looking at the numbers, taking on credit you have no realistic way of repaying, or relying on a rescue that keeps moving further away.
Before you decide, look at a short-term cash flow forecast built on assumptions you actually believe, the position of your largest creditors, what any funder has committed to in writing rather than in conversation, and what happens to everyone else if you turn out to be wrong. Then minute the decision and fix a date to look at it again.
What you should and should not do
None of the steps below is automatically wrong. Each of them can be reversed later, and several can lead to a claim against you personally.
| Under consideration | Why it gets looked at afterwards |
|---|---|
| Paying one creditor and not the others | Where that creditor is connected to you, or you have personally guaranteed the debt, the payment can be reversed and you can be asked to repay it. |
| Repaying your own loan account, or money owed to another company you own | The first thing an administrator or liquidator checks, and the easiest money for them to pursue. |
| Taking a dividend, a bonus or other value out of the business | If the reserves or the cash do not support it, the payment can be recovered from you personally. |
| Selling an asset, particularly to a friend or a relative | If the price cannot be shown to have been a proper one, the sale can be set aside. |
| Giving security to a creditor who did not have any | Improving an unsecured creditor’s position shortly before insolvency can be undone. |
| Taking on new commitments or new credit | Where you have no realistic means of meeting them, this is the territory in which wrongful trading claims arise. |
| Using company money to meet a shareholder’s personal obligations | The company gets nothing of value in return, and the recipient is usually easy to identify and pursue. |
The point is not that you must do none of these things. It is that each of them is worth a conversation before it happens rather than an explanation afterwards.
What are the options before a formal process?
More than most directors assume, and the list gets shorter the longer you leave it.
Restructuring what the company owes. Negotiating with the creditors who matter most. A time-to-pay arrangement with HMRC. Refinancing, invoice discounting or asset-based lending, with a clear view of what it costs and what security it takes. New money from existing shareholders or from outside. Cutting costs, including the employment steps that go with that. Selling assets or a division you can manage without. An agreed workout with the main creditors. In the right case, a company voluntary arrangement or a formal restructuring plan.
Which of these is realistic depends on your numbers and on how much time is left. That is the practical reason early advice is worth more than late advice.
When should an insolvency practitioner get involved?
There is a difference between the two professions worth understanding.
We give you legal advice. An insolvency practitioner takes formal appointments as administrator, liquidator or supervisor, and advises on how those processes work and what they would produce. Once appointed, their duties run to the creditors rather than to you, which is why your own legal advice sits separately from them.
Where a formal process needs to be looked at, we will introduce you to a practitioner suited to your business and work alongside them. Having that conversation does not commit you to an appointment, and it frequently establishes that one is not needed.
What could you be liable for personally?
If the company does fail, these are the claims that can follow. They are brought against directors personally.
| The claim | What it means in practice |
|---|---|
| Wrongful trading | You kept going past the point at which insolvent liquidation could not reasonably have been avoided. |
| Misfeasance and breach of duty | You made decisions in breach of your duties, including by ignoring creditors’ interests once insolvency was likely. |
| Transaction at an undervalue | The company gave something away, or sold it for significantly less than it was worth. |
| Preference | One creditor, often a connected one or one you had guaranteed, was put in a better position than the rest. |
| Transaction defrauding creditors | Assets were moved to put them out of reach. There is no time limit on this one. |
| Personal guarantee | A lender, landlord or supplier calls in a guarantee you signed. |
| Disqualification | The Insolvency Service investigates your conduct and seeks to stop you acting as a director. |
Claims of this kind are also sold on to specialist funders, so one can arrive several years after the company was wound up, long after you assumed the matter was finished.
Taking advice early reduces this exposure. It does not remove it, and anybody who tells you otherwise is selling something.
How we can help
Taking advice at this stage is not preparation for insolvency. Most of the time it is the opposite.
We will tell you where the company actually stands, what you can and cannot safely do with its money, which options are still open and what you should be recording from now on. Where the business can be stabilised, that is the objective. Where it cannot, the objective becomes a controlled process and a protected position for you personally.
FAQs: The Zone of Insolvency
No. It is a description of a period, not a statutory concept. The tests that do have legal force are cash flow insolvency and balance sheet insolvency, and the duty to have regard to creditors’ interests arises by reference to how probable insolvency has become. Creditors’ interests enter the balance as insolvency becomes probable and carry more weight as the position worsens. Where insolvent liquidation or administration is inevitable, they take priority. In practice the safer approach is to treat them as relevant well before you think that point has arrived. No. Advice is confidential, and nothing about taking it needs to be disclosed. What tends to damage those relationships is a board that has clearly not thought the position through. Tell us about it early. Some payments can be explained and justified on the evidence, and some can be addressed before an office holder ever looks at them. Either way, the position is better understood now than in response to a letter two years from now.
Get a clear view of where the company stands
You do not need to have decided anything before you speak to us. Send us a short summary of the position and any key financial information, and we will tell you where the company sits, what you can safely do and what your realistic options are.
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To make an enquiry, please email us at wewillhelp@jonathanlea.net, complete our contact form, or call us on 01444 708640.
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