How business liabilities can balloon during insolvency
March 6, 2023
Following our first three articles on business devaluation during insolvency, we now turn our attention to the liabilities in the balance sheet.
What is often not realised is how a business’s liabilities can grow faster than Jack’s Beanstalk once the business has transitioned from a going concern to a financial downturn ending in insolvency proceedings. This can occur on a number of levels.
A good accounting system and internal controls will, hopefully, leave few surprises in this category. Yet strange things can happen in the Twilight Zone immediately before a formal insolvency. This is especially true if there has been sustained and severe cash flow pressures leading to mounting unpaid debts to suppliers and service providers.
Counter claims for damages
Contracts with both customers and suppliers, which are interrupted by an insolvency can generate potential claims for damages for the failure to comply with their terms. This is particularly prevalent in certain sectors, notably construction and the IT industry.
The requirement to make payments isn’t ended by an insolvency filing and the failure to maintain those payments will trigger all manner of penalties and other extra charges, as well as claims for any shortfall between the value of the underlying asset and the balance owed.
Rent and service charges continue to mount up and while the landlord has a duty to mitigate their potential loss, that does not mean that there can be a clean break with no additional liabilities, except in the most unusual of circumstances. Even if the landlord is willing to agree to an early termination, there may be a substantial extra debt for dilapidations (repair, reinstatement and redecoration costs) if the lease requires the tenant to return the premises to their original condition.
Here too, interest continues to run despite the insolvency and facility documentation may entitle the lender to levy a wide range of extra fees and charges in the event of default, which can rapidly increase the debt owed.
In group scenarios, it is not unknown for parent companies to seek to increase the amounts owed by an insolvent subsidiary by levying additional costs and charges to enable them to use set off to avoid paying any net amount due the other way.
You may also be interested in: How current assets melt away in an insolvency situation
Interest rate and currency hedging strategies may unravel in the event of an insolvency, or else major instability in the relevant markets at or around the time of an insolvency event can create or radically alter liabilities under hedging arrangements. The wild gyrations in the price of sterling and the UK interest rate market at the time of the Mini Budget saga in autumn 2022 is a prime example of what unexpected fluctuations can occur.
Where liabilities are denominated in foreign currencies and no hedging protection is in place, currency movements can swell the cost of settlement to the detriment of other creditors.
Where the insolvent company is a subsidiary or has associated businesses, it may have given cross guarantees to these connected entities’ lenders, landlords or other parties. This can generate substantial liabilities, which should have been disclosed in the notes to the accounts of the insolvent company but will not have appeared on its Balance Sheet.
Insolvency and the inability to either continue with contributions or to make good pension scheme deficits can increase an insolvent company’s obligations to the pension scheme. In a group scenario, deficits in the group scheme can fall unequally on subsidiary companies.
The impact of an insolvency on a company’s tax obligations can be considerable, sometimes increasing current and deferred liabilities.
Can a going concern sale of the business help to curb liability inflation?
This will be usually the case. Just as it can underpin asset realisation values, an early sale of the business and its continuation under new ownership will prevent some of the debt escalation we have described. For example, the buyer may take over a property lease with the landlord’s consent, so that its ongoing use can avoid early termination costs. Similar considerations apply to finance leases for plant, equipment and vehicles. Counter claims for damages can be limited if the trade with customers and suppliers is uninterrupted.
This underlines the crucial importance of taking the earliest and most decisive action possible when a formal insolvency becomes unavoidable. The later the process is left, the fewer and less beneficial the options are and the greater the eventual liabilities will be.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.