A story of a company on the brink
John sat in his office staring at the latest financial reports. His company, a once-thriving manufacturing firm, was now struggling to pay suppliers and meet loan repayments. Cash flow had dried up, and John felt a knot in his stomach as he realised the company might be entering the zone of insolvency. He imagined the faces of his employees and creditors, and he knew he needed to make tough decisions. This hypothetical scenario might feel familiar if you’re a director in financial distress. It’s a critical moment when directors’ actions can determine not just the fate of the company, but their own personal liability. In this series of articles, we’ll explore John’s story as a guide, weaving in real-world lessons, legal duties, and practical dos and don’ts for operating in the zone of insolvency in England and Wales.
What is the “Zone of Insolvency”?
The zone of insolvency refers to the twilight period when a company is financially distressed and nearing insolvency, but not yet outright insolvent. In legal terms, a company is considered insolvent if it fails either of two key tests: the cash flow test (unable to pay debts as they fall due) or the balance sheet test (liabilities exceed assets). When a company is in this grey area – perhaps still paying some bills but only by juggling or delaying others – it’s effectively operating in the zone of insolvency. This was the situation John found himself in. For example, imagine having to choose which supplier or creditor to pay this month – a clear warning sign that insolvency is looming.
Directors should recognise these red flags early. Are you struggling to meet payroll or taxation deadlines? Are creditors sending warning letters? Is your balance sheet showing more liabilities than assets? These are clues that your company may be in the zone of insolvency. In John’s case, declining sales and increasing debt commitments signalled trouble. Recognising the zone of insolvency is crucial, because once a company is here, a director’s responsibilities and legal duties begin to shift.
Duties shift from shareholders to creditors
Under normal circumstances, a director’s primary duty is to promote the success of the company for the benefit of its shareholders (Companies Act 2006, s.172). However, when insolvency looms, the law in England and Wales requires directors to put creditors’ interests front and centre. In practical terms, this means that as a company approaches insolvency, you must start treating the creditors’ interests as equally important as those of the shareholders and even more as you go deeper into the zone.
This principle, decided in cases like West Mercia and recently confirmed by the UK Supreme Court in BTI 2014 LLC v Sequana (2022), is sometimes called the “creditor duty” or “creditor interest” duty. It’s not a brand-new, separate duty, but rather a modification of your existing fiduciary duty – a sliding shift of priorities as the company’s financial health deteriorates.
When exactly does this shift kick in? The Supreme Court in the Sequana case clarified that the duty to consider creditors’ interests is triggered once a company is insolvent, on the brink of insolvency, or when insolvent liquidation/administration is probable – not merely when insolvency is a remote risk. In other words, the zone of insolvency begins when insolvency is imminent or probable, not just a rough possibility. At that point, directors should start balancing the interests of creditors against those of shareholders, giving creditors increasing weight as the financial situation worsens. Once insolvency is inevitable and there’s “no light at the end of the tunnel,” creditors’ interests become paramount.
In John’s story, the moment he realised that without a major turnaround the company would be unable to pay its debts in a few months, he had likely entered this zone where creditor interests must be considered. He brought in his fellow directors for an urgent meeting. They agreed that continuing with “business as usual” was no longer acceptable – their decisions now had to focus on minimising harm to creditors.
The information provided in this article is for general information purposes only and does not constitute legal advice. Whilst we endeavour to ensure that the content is accurate and up to date, it may not reflect the most recent legal or regulatory developments related to insolvency. Accordingly, nothing in this article should be relied upon as a substitute for professional advice tailored to your specific circumstances and no liability will be accepted from you acting or refraining from acting in relation to any information provided in this article. Should you require specific insolvency advice please contact us.
