There are two ways in which a company may be wound up: by the company voluntarily (voluntary winding up), or by the court (compulsory winding up). Conceptually there is no relationship at all between how a winding up commences and whether the company is solvent or insolvent. A solvent company may be wound up compulsorily, and an insolvent company may go into voluntary winding up. Most people equate winding up with insolvent winding up, but it is important to realise that a perfectly solvent company may nevertheless be wound up. It may happen because the shareholders can no longer get along, the company is in a declining business with no future prospects, the company has achieved the purpose for which it was set up, or for any other reason.
A compulsory winding up is initiated by an application to court by a person who is entitled to do so (ie they have locus standi or standing to do so). The application must be based upon one of the grounds set out in the Insolvency, Restructuring and Dissolution Act (IRDA) 2018.
The court will decide, at the hearing of the application, whether to grant or dismiss it. If the application is granted, an order to wind up the company will be made. The winding up is deemed to have commenced at the time of the application for winding-up.
Under s.124(1) IRDA, the creditor, amongst others, are entitled to present a winding-up petition.
By far the vast majority of winding up applications are made by creditors seeking to enforce the payment of undisputed debts. However a creditor whose debt is disputed by the company bona fide on substantial grounds should not apply to wind up the company as it would be dismissed. The ‘creditor’ in this case should establish the existence of the debt first.
Section 125 IRDA sets out a number of grounds on which the court may make a winding up order. The ground commonly relied on by the creditor is that ‘the company is unable to pay its debts.’
(b) Winding up on the ground of insolvency
There are different ways by which this ground may be established. It is useful to view them as falling broadly into two groups.
(i) The first group, contained in s.125(1)(e) and s.125(2)(c), consists of general criteria of inability to pay debts, which may be proven by reference to the cash flow (or commercial) insolvency test or the balance sheet test. In seeking to establish that either one of the two tests is satisfied, creditors may face difficulties due to lack of evidence or other problems. The legislature has thus provided for alternatives in the second group of tests of insolvency.
(ii) The second group, embodied in s.125(2)(a) and (b), consists of two very specific and readily ascertainable facts deemed to establish inability to pay debts – ie when a statutory demand for debts is not met or when an execution is returned unsatisfied.
Under the cash flow test, a company is insolvent when it is unable to pay its debts as they fall due. For this purpose, the fact that its assets exceed its liabilities is irrelevant; if it cannot pay its debts in the conduct of its business it is insolvent, for there is no reason why creditors should be expected to wait while the company realises assets, some of which may not be held in readily liquidated form. As for the balance sheet test, the underlying idea is that it is not sufficient for the company to be able to meet its current obligations if its total liabilities cannot ultimately be met by the realisation of its assets. Hence for this test contingent and prospective liabilities of the company will be taken into account in determining whether the company is balance sheet solvent.
A creditor who is owed more than $15,000 may serve a demand (known as a statutory demand) on the company at its registered office requiring payment of the sum due. If the company has not paid the claim within three weeks, it is deemed to be unable to pay its debts, and the creditor is entitled to apply to wind up the company based on that.
A creditor who has obtained judgment against another party is known as a judgment creditor. A judgment creditor who is not paid is entitled to levy execution against the assets of the company, for example, by seizing and selling its assets or obtaining a charging order against the company’s property, in order to be paid. If the execution is returned unsatisfied, the company will be deemed to be unable to pay its debts.
A compulsory winding up is a winding up ordered by the court. A voluntary winding up, on the other hand, is a winding up initiated by the company; hence the word ‘voluntary’ is used to describe this kind of winding up.
A voluntary winding up may be either a members’ voluntary winding up or a creditors’ voluntary winding up. Regardless of whether it is one or the other, a voluntary winding up is initiated by the company taking steps to pass a special resolution to that effect, and the winding up commences on the passing of the resolution.
The criterion that determines whether a winding up is a members’ or creditors’ voluntary winding up is whether the company is solvent or insolvent. If the directors make a declaration of solvency in accordance with s.163 IRDA, the winding up will be a members’ voluntary winding up. The declaration is a written statement, made not more than 5 weeks before the passing of the winding-up resolution, that the directors have inquired into the affairs of the company, and have formed the opinion, at a directors’ meeting, that the company will be able to pay its debts in full within 12 months after the commencement of the winding up. If the directors do not make such a declaration, the winding up will be a creditors’ voluntary winding up.
If the declaration of solvency turns out to be false, several consequences follow. The liquidator, once they form the opinion that the declaration is false, is under a duty to summon a meeting of creditors. At the meeting, the creditors are entitled to appoint another person to be the liquidator; and regardless of whether they do so, the winding up will thereafter proceed as a creditors’ voluntary winding up. Second, the directors who make the declaration will be guilty of an offence unless they can show that they had reasonable grounds for making it.
There are a few important procedural and substantive differences between the two forms of winding up. First, in the case of a creditors’ voluntary winding up, a creditors’ meeting must be summoned, to be held on the same day as the company’s meeting, or on the next day. This meeting is not necessary in a members’ voluntary winding up. Second, the members are in the driving seat in a member’s voluntary winding up, for example, they get to appoint the liquidator. The creditors, on the other hand, are in control in a creditors’ voluntary winding up. They appoint the liquidator and the members of the committee of inspection.
As the company is insolvent, the creditors will not be paid in full. Although the full picture is very much more complex, broadly speaking, creditors may be divided into two classes:
(i) secured creditors, and
The former class enjoys priority over the latter class, because it is able to point to specific assets of the company or in the company’s possession and realise them to discharge the debts owed by the company to it. The latter, on the other hand, has no such right – their claims are purely personal. Except for preferential creditors, who may enjoy priority over the claims of a floating charge holder, unsecured creditors are only entitled to participate in the distribution of the free assets of the company, ie property of the company not subject to security or proprietary claims of third parties.
First, the liquidator must determine what are the assets of the company and assets in its possession. Next, they have to discount those assets subject to the security interests of creditors and assets subject to the proprietary claims of creditors and other third parties. The remaining assets, called the ‘free’ assets, are then available for distribution to the unsecured creditors.
The above principle is subject to two qualifications. First, under the Companies Act Cap 50, assets subject to a floating charge are sometimes required to be employed to meet the claims of preferential creditors before meeting the claims of the holder of the floating charge. This occurs when the free assets are not sufficient to pay certain categories of preferential debts. Second, certain transactions entered into by the company before it enters into insolvent liquidation may be set aside in insolvent liquidation under the avoidance provisions. Assets dissipated by the company may thus be clawed back, and in certain situations they swell the pool of free assets available for distribution to the unsecured creditors.
(a) Pari passu principle (equal proportion)
The process of liquidation is not only collective but it is also mandatory in the sense that (i) all unsecured creditors are bound by it and (ii) it is the exclusive procedure for the satisfying of creditor claims. To get paid, creditors lodge what is called proofs of debts with the liquidator, and if the liquidator accepts them, the company, if it has sufficient assets, will pay a dividend on the debts.
Subject to important exceptions, the general principle is that upon the liquidation of an insolvent company its property must be applied pari passu – ie rateably or proportionately, to satisfy the claims of its creditors at the time when it goes into liquidation.
We have seen that secured creditors with claims against property in the company’s possession ‘rank’ ahead of the unsecured creditors. This is not an exception to the pari passu principle. The reason is that property that is subject to their security interests is no longer the company’s property. In truth, these creditors stand outside of the insolvent liquidation. On the other hand, preferential creditors, which were also mentioned earlier, constitute a true exception. They are unsecured creditors, but are given special status by the IRDA.
(b) Ranking of unsecured claims
Section 203(1) IRDA sets out the ranking of preferential debts, which are to be paid in priority to all other unsecured debts, in the following order: (a) the costs and expenses of the winding up incurred by the Official Receiver; (b) costs and expenses of winding up, including the remuneration of the liquidator; (c) costs of the applicant for the winding up order; (d) wages or salary up to a prescribed limit; (e) retrenchment benefits up to a prescribed limit; (f) workmen’s compensation under the Workmen’s Compensation Act Cap 354; (g) amounts due in respect of provident fund contributions ; (h) remuneration in respect of vacation leave; (i) taxes.
If there is insufficient to pay any class of preferential debts, the debts within the class share in equal proportions. Subsequent classes of preferential debts, if any, will not be paid and clearly, the unsecured creditors will get nothing as well. However, to protect the preferential creditors of the company, s.203(6) provides that in the event the ‘free’ assets of the company are insufficient to pay the preferential debts specified in (a), (b), (c), (d), (e), (g) and (h), these debts shall have priority over the claims of the holders of floating charge, and will be paid out of property subject to the floating charge.
The Companies Act Cap 50 enables a company to enter into a scheme of arrangement with its creditors. Essentially, the company in financial difficulty formulates a proposal to offer to its creditors and seek to reach an agreement with them with regards its outstanding debts. For example, the creditors may be asked to accept shares in the company in payment of their debt.
The company that seeks to negotiate with its creditors in order to formulate a proposal that is largely acceptable to them may seek a stay under the Companies Act or a moratorium under IRDA. If the court orders a stay under s.210(10) Companies Act, it will restrain further proceedings in any action or proceeding against the company except by leave of the court. Alternatively, the company may apply for a wide-ranging moratorium (of the same width as judicial management) by filing with the court certain documents under s.64 IRDA. The moratorium under IRDA covers all enforcement actions against the company, including those by secured creditors. More importantly, an automatic moratorium arises on the application under IRDA, which would last for 30 days or when the court hears and decides the application.
The objective of both the stay and moratorium is to suspend the creditors’ rights against the company so that the company can use the period of stay or moratorium to work out an acceptable proposal with its creditors.
After the company has formulated a proposal, it will apply to court to seek a court order to classify the company’s creditors into classes (Stage 1). To ensure fairness, creditors with different interests will be placed into different classes.
The next stage involves the company calling the class meetings as ordered by the court in Stage 1 above (Stage 2). In general the creditors for each class vote by a majority in number and three-fourths in value of the creditors of that class (subject to the court ordering a majority number otherwise) to approve the company’s proposal.
Once the creditors’ approval has been obtained in Stage 2, the company goes to court a second time to obtain the court’s approval of the proposal (Stage 3). The court considers matters such as whether there was adequate disclosure in the explanatory statements given to the creditors, correct classification of creditors, proper conduct of meetings and votes. Under s.70 IRDA, the court has power to cram down one or more dissenting class of creditors if certain conditions are satisfied.
Once the court sanctions the proposal under Stage 3, it will be implemented as a scheme of arrangement that is binding on all classes of creditors and the company.
An alternative corporate rescue mechanism is the judicial management. Under s.91 IRDA, the company or its directors or its creditor may apply to court for a judicial management order. The requirements are:
(i) Insolvency: the court must be satisfied that the company is or is likely to become unable to pay its debts.
(ii) Purpose: The court will make the order if it considers the making of the order will achieve one or more of these purposes set out in s.89 IRDA, namely:
On the making of an application for judicial management, an automatic moratorium kicks in under s.95 IRDA. The scope of the moratorium is extensive and covers all enforcement actions against the company, including those by secured creditors. The central feature of judicial management is the moratorium during which creditors’ rights of enforcement are suspended, which gives the company breathing space it needs to consider its exit route.
On the making of a judicial management order, the court will appoint a judicial manager who will manage the affairs, business and property of the company while the judicial management order is in force. Directors remain in office but all their powers and duties are to be exercised and performed by the judicial manager instead.
A scheme of arrangement is useful to the company because, even though an independent financial/special advisor will usually be appointed to monitor the financial affairs of the company, the directors will still remain in effective management and control of the company.
Judicial management allows the company a period of time to re-organise its affairs and to try to re-structure the company, its operations and debts. It seeks to give an opportunity to the company to undergo rehabilitation, to preserve at least part of the business as a going concern or to achieve a more advantageous realisation of the company's assets than would be effected on winding up. It is also useful if it is likely to result in the approval of a scheme of arrangement between the company and its creditors.
Unfortunately, there is generally a stigma of insolvency attached to judicial management and the view that it is a prelude to liquidation which will usually result in adverse publicity for the company. Moreover, time and costs are sometimes wasted because the judicial manager usually takes over from the previous management and would require time to acquaint themselves with the affairs of the company.
Written by a member of the Corporate and Business Law examining team