What is insolvency?

Put very simply, a company is insolvent if it is unable to pay its debts as they fall due or when its liabilities exceed its assets.  When this happens, it is likely to enter into an insolvency process with an insolvency practitioner to manage its affairs.

The most common procedures are:

1. Liquidation

A liquidator displaces the directors and management and has a duty to identify all assets of the company with a view to realising those assets to distribute to the creditors in the order provided in the Insolvency Act 1986.  A company is likely to cease trading immediately upon the liquidator's appointment.

There are two categories of liquidation: compulsory (by order of the court) and voluntary (by members or creditors)

2. Administration

An Administrator is appointed to rescue the company or realise its assets.  The Administrator will explore ways of preserving the  company but, in practice, it will usually lead to a sale of assets. 

Do contracts of employment automatically terminate when an employer becomes insolvent?

The answer to this depends on the insolvency procedure involved:

Compulsory liquidation

Yes. Contracts of employment are automatically terminated with immediate effect from the date of publication of the winding up order.  As the dismissal is by operation of law, the employee will have no right to claim unfair dismissal (although it may be possible to claim for wrongful dismissal).

If the liquidator wants to retain employees, new contracts will normally be entered into with employees.

Voluntary liquidation

No.  Contracts of employment may not be immediately affected because the business does not automatically cease.  This is because Liquidators have limited powers to carry on the business so far as necessary for winding up.  It is likely that the business will cease shortly after and the liquidator will terminate employment contracts.

Administration

No.  Because the administrator is the agent of the company, their appointment does not amount to a change of employer, so contracts do not terminate on the appointment of an administrator.

In administration, a 14-day window operates from the date of appointment to give the administrator time to get to know the business and decide which, if any, of the employees to retain.  Of the ones they choose to retain, these contracts are "adopted".  This is important because it gives special protection to employees in relation to the ranking of claims (covered below).

What can be done to recover debts owed to employees?

Ranking

Remuneration owed to employees is ranked as a "preferential debt" in insolvency, which means it ranks third in priority and is usually paid in full. 

"Remuneration" includes wages, sick pay, maternity pay, commission / bonus, overtime,  and a protective award.  It covers these payments for a 4-month period before insolvency and is not subject to the statutory cap on a weeks' pay, however, the amount payable under this category is capped at £800 and so an employee may still be left out of pocket.

Other debts owed to employees (such as notice pay, redundancy pay and expenses) are unsecured and rank second to last on a realisation of assets.

Unfortunately what this means is that an employee is unlikely to receive payment of these debts in insolvency.

Qualifying liabilities and their "super priority"

An exception to the above occurs where an administrator has been appointed and does not dismiss an employee within the first 14 days, as covered above.

From the date of adoption by an administrator, moneys owed to employees are given special status.   Any wages or salary due to employees after that date rank as an expense ("super priority") and will usually be recovered.

National Insurance Fund (NIF)

The NIF is a state-guaranteed fund to protect employees when their employers become insolvent.  Employees can apply for payment of outstanding sums due from the NIF, although there is a limited category of debts which can be claimed and certain conditions must be met (section 184, Employment Rights Act 1996):

* Includes protective awards.

** Only where liability has been assessed by the Employment Tribunal and Judgement granted.  Note that, in some cases, a moratorium (sist) will be applied by the Tribunal and the case will not be allowed to proceed without the consent of the court or insolvency practitioner.

The conditions which must be met are:

• the employer is insolvent;
• the employee's employment has terminated; and
• on the "appropriate date" (which depends on the type of debt), the employee must have been entitled to be paid the whole or part of the debt.

To apply for payment, employees need to complete a Form PR1, found on the Insolvency Service's website.  If an application is rejected, employees have three months from the date of rejection to raise a claim to the Employment Tribunal appealing the decision.

Any other options available to employees?

Unpaid statutory payments, such as maternity pay, can be claimed from HMRC. The Pension Protection Fund (PPF) can pay compensation to members of a DB scheme if affected by employer’s insolvency.

In most cases, the most prudent first step to take on the insolvency of an employer is to get an RP1 form completed and sent to the Insolvency Service as soon as possible.  The viability of the other options covered above can then be explored and assessed.