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 - either voluntarily or by application of creditors.
- 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, have valuable pieces of machinery, equipment or office technology, but not have enough liquid assets to pay a debt by its due date. Liquid assets are types of assets that can be quickly converted into cash with minimal to no loss of value. These resources can include cash on hand, a bank savings account, stock market shares, or accounts receivable.
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. Although this is not always the case. 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 individuals or businesses who are owed money. Some creditors, including employees, are paid preferentially.
All employment agreements terminate when the business is put into liquidation. A liquidator may carry on the business, in whole or in part during the winding up process and may ask some or all of the employees to continue work during this time and a new employment agreement is usually concluded with those employees.
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 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, which they are unable to repay.
The Insolvency Act 2006 determines that an Official Assignee will be appointed to administer all insolvency options in the case of a sole trader or partnership.
The role of the Official Assignee includes:
- Managing the estate.
- Selling the assets.
- Distributing funds to creditors.
Bankruptcy usually lasts for three years. it can be extended if an application is made to the High Court by the Official Assignee.
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 your business’s debts are mounting, it’s best practice to follow some simple steps:
1: Sell your assets
This can result in raising enough money to pay creditors and reduce your debt. When dealing with insolvency, your aim is to pay less in interest and penalties as quickly as possible. When 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 an 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.
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 your business, an employee may be able to claim money owed by you as 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:
- 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 by has not been paid over by the employer
- 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 $31,820. This limit is outlined in the Companies Act 1993 and the Insolvency Act 2006. This figure doesn't guarantee the amount employees will receive if an employer becomes insolvent.
Any amount above $31,820 will not be paid on a preferential basis. This means 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 Peninsula help?
Peninsula works with Kiwi business owners and employers, offering tailored HR and HSW support to streamline processes and implement efficiencies.
Call our advice line on 0800 2150 36 to talk to our team.
This article is for general information purposes only and does not constitute as business or legal advice and should not be relied upon as such. It does not take into consideration your specific business, industry or circumstances. You should seek legal or other professional advice regarding matters as they relate to you or your business. To the maximum extent permitted by law, Peninsula Group disclaim all liability for any errors or omissions contained in this information or any failure to update or correct this information. It is your responsibility to assess and verify the accuracy, completeness, and reliability of the information in this article.
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