When a company closes down, whether due to financial problems or because the owner no longer needs the business, the process used is called liquidation. The liquidator sells off business assets such as vehicles, stock, and equipment, and the company name is removed from the register at Companies House.
Liquidation means the end of the business, which can’t be reinstated at a later date. Hence, directors need to understand why they’re entering the process and the potential consequences.
The reason for entering liquidation is the starting point, but the company’s financial status ultimately dictates which of the two processes is used:
- If the company is solvent and able to pay its creditors in full within a period of 12 months, Members’ Voluntary Liquidation can be used.
- If it’s insolvent and there’s no possibility of rescue or recovery, the company can enter Creditors’ Voluntary Liquidation.
What do Solvent and Insolvent mean?
Solvency means a business can pay its bills as they fall due, or within a reasonable timescale – concerning Members’ Voluntary Liquidation, the company must repay creditors within 12 months. Additionally, the company’s total assets’ value must exceed its liabilities for it to be solvent.
Company directors are legally obliged to be aware of their business’ financial status at all times, so it’s imperative to act quickly if they feel that insolvency is a threat. The interests of creditors must be prioritized over the interests of the company to minimize creditor losses.
3 Tests for Insolvency
1. The Cash Flow Test
The cash flow test assesses whether the company can pay its bills as they fall due, or in the near future. If the business struggles to pay weekly or monthly wages, for example, or there’s insufficient cash to pay creditors, it may be insolvent. Cash flow is a huge issue for businesses struggling to survive, and the lack of cash can be the first warning sign of impending insolvency.
2. The Balance Sheet Test
If the company’s liabilities’ total value is greater than its assets, this is a strong indication that the business is insolvent. When using the balance sheet test, it’s crucial to include contingent liabilities in the calculation, so the result is an accurate reflection of the company’s status.
Contingent liabilities are payments that could become due in the future, such as a claim made against the company by an employee. They aren’t payments that definitely need to be made, but there’s a strong chance that a future event could result in the company having to payout.
3. The Legal Action Test
The legal action test identifies whether any creditor action has been taken against the company, such as a County Court Judgment, statutory demand, or winding up petition. A statutory demand is commonly used before a winding-up petition, representing a serious threat to a business. If a company is unable to pay the demand, it provides proof of insolvency to the courts.
These tests provide an overall picture of a business’s financial health, but it’s important to take a wide view and look at each test’s result test’s results together rather than in isolation.
A company could pass the cash flow test and continue trading, for example, but fail the balance sheet test. So directors could assume that their business is financially solvent, when in fact it’s insolvent, and they’re at risk of allegations of wrongful trading.
What Does Liquidation Entail?
Both liquidation processes involve the appointment of a licensed insolvency practitioner (IP) whose role s to sell its assets and distribute the proceeds. How the funds are distributed differs according to whether a Creditors’ Voluntary Liquidation or Members’ Voluntary Liquidation procedure is being followed.
An insolvent liquidation (CVL) results in the proceeds that have been generated from the sale of assets repaying creditors, but only as far as the liquidator is able. Unfortunately, it’s rare for all creditors to receive a return, and unsecured creditors are typically the group that loses out in this respect.
Funds generated during an MVL, on the other hand, are distributed among company members once all the creditors have been repaid. This solvent liquidation provides a tax-efficient way for directors to extract value from a company that’s no longer required.
What are the Differences Between a CVL and an MVL?
1. The Financial Position of the Company – is it Solvent or Insolvent?
The main difference between a Creditors’ Voluntary Liquidation and Members’ Voluntary Liquidation lies in the financial position of the company involved. CVL can be entered into by insolvent companies, but MVL is only appropriate for those financially healthy companies and can repay their creditors in full.
Once creditors have received their money from an MVL, the remaining funds are distributed to the company’s shareholder company’s shareholders by the liquidator.
2. Reasons for Entering Liquidation – Purpose of the Procedure
The reasons for entering a CVL and an MVL differ considerably – a CVL is for companies experiencing serious financial problems that cannot be overcome. The company ceases trade to limit creditors’ losses, and directors can fulfill their statutory obligations about running an insolvent company.
The reasons for entering a Members’ Voluntary Liquidation vary, but it’s a commonly used process when directors wish to retire. MVL can be a tax-efficient procedure, but it’s not only retiring directors that can use it.
Sometimes a business that’s part of a large group is no longer required, and if it’s served its purpose, Members’ Voluntary Liquidation can be used to close it down according to the statutory process.
3. Repayment of Company Debts
Being a solvent liquidation process, MVL involves full repayment of debts to company creditors. The business has 12 months to repay all its liabilities in full, plus interest, including any contingent liabilities.
By its very nature as an insolvent liquidation process, Creditors’ Voluntary Liquidation means that creditors aren’t repaid in full, and in some cases, unsecured creditors receive no payment at all. Once the funds generated from the sale of assets have been used, any remaining debts are written off.
4. Who Receives the Money From the Sale of Assets?
Both of these liquidation processes involve selling all the business’ assets, but they differ in how the funds are used. Once creditors have been repaid in a Members’ Voluntary Liquidation, the remaining monies are distributed to shareholders.
Once the assets of an insolvent company are sold during a CVL, however, the funds are used to pay creditors in the prescribed order – a statutory hierarchy exists in this respect, with secured and preferential creditors at the top.
5. Potential for Reputational Damage for Directors
As CVL is an insolvent liquidation process, directors may suffer some reputational damage, given that creditors won’t receive all of their money back. Unsecured creditors generally receive very little following the liquidation of an insolvent company. As the process is publicly advertised, it’s difficult to hide that creditors have suffered financial loss.
With an MVL, however, there’s no risk of reputational damage for directors as their company repays its creditors in full, albeit over a period of time. Only if an MVL must convert to a Creditors’ Voluntary Liquidation would a director face bad publicity and potential damage to their business or personal reputation.
6. Eligibility for Director Redundancy Pay
Some directors can claim redundancy pay and other entitlements following a Creditors’ Voluntary Liquidation. Various eligibility conditions exist in this regard, including working under a contract of employment for the same company for a minimum of two years.
With a Members’ Voluntary Liquidation, director redundancy pay isn’t an issue. The process aims to close down a business that’s no longer needed, with directors possibly retiring or moving onto new business ventures.
7. Treatment of Employees in Liquidation
The Transfer of Undertakings (Protection of Employment) Regulations (TUPE) protects employees’ rights when the ownership of a business change. TUPE doesn’t apply to ‘terminal’ insolvency procedures; however, staff employed by a company entering Creditors’ Voluntary Liquidation will automatically be redundant.
In the case of Members’ Voluntary Liquidation, parts of TUPE can apply in some cases. Employers must notify the staff of their intention to enter an MVL. If this doesn’t happen correctly, it can lead to unfair dismissal claims against the company.
Considerations for Directors When Entering a CVL and an MVL
1. Signing the Declaration of Solvency
The declaration of solvency is an important consideration for directors entering into an MVL, and they need to establish beyond doubt that the company is solvent. Making a false declaration, whether intentional or not, can result in serious repercussions for directors, potentially including disqualification and personal liability for company debts.
2. Liquidator’s Investigations
The liquidator is legally obliged to investigate the directors’ actions following an insolvent liquidation process, looking for wrongdoing or misconduct instances. Once the investigations are complete, the IP sends a report to the Secretary of State. With an MVL, there’s no need for directors to be investigated by the liquidator as the company has repaid its debts in full.
3. Obtaining Professional Help
Professional insolvency help is crucial when considering placing a company into either form of liquidation. Both CVL and MVL require a licensed insolvency practitioner to be appointed, but in the case of MVL directors need to ensure that all liabilities are included in the assessment of solvency.
When determining its financial position, professional guidance helps directors avoid costly mistakes and potential penalties.
4. Possibility of an MVL Becoming a CVL
Both Members’ Voluntary Liquidation and Creditors’ Voluntary Liquidation are publicly advertised in the Gazette. Problems can arise if a company enters an MVL and omits to inform a creditor of their intention to close the company.
That creditor can claim repayment of their debt, depending on the claim’s amount, and the company could be tipped into insolvency when previously it was thought to be solvent.
This would lead to the Members’ Voluntary Liquidation process; it had entered becoming a Creditors’ Voluntary Liquidation, with the ensuing investigation by the liquidator and possibility of serious repercussions for directors.
5. Potential for Personal Liability
Directors face the threat of personal liability if they deliberately or accidentally forget to inform creditors during a Members’ Voluntary Liquidation. Furthermore, if the liquidator uncovers any wrongdoing or misconduct during their investigations, such as deliberately falsifying the solvency declaration, a director can face disqualification for 2-15 years. In the most serious cases, a prison sentence could be handed down.
There’s also the possibility that directors could be held personally liable for company debts during a CVL, but this can arise from different circumstances.
Fundamental Differences Between a CVL and an MVL
Corporate liquidation is based on a company’s solvency, with Members’ Voluntary Liquidation is commonly used when directors want to retire. There’s nobody else to take over, or where the business serves no further purpose.
This form of liquidation allows directors to extract value in a tax-efficient way, as distributions are taxed as capital gains rather than income. There’s also the potential for members to use Business Asset Disposal Relief (previously known as Entrepreneurs’ Relief) to lower their tax liability to a 10% effective rate.
The insolvent liquidation process, CVL, also offers benefits to directors, albeit in more challenging circumstances, given their financial situation. But by prioritizing creditor interests, directors can minimize the risk of misconduct allegations and potentially claim redundancy pay.
In practice, significant similarities exist between these two liquidation processes. However, the background reasons for entering into liquidation and how funds are distributed are fundamentally different.