What Is A Contingent Liability In Liquidation?
When a company enters into liquidation, the formal process involves evaluating all of its financial obligations. Whether the company is solvent or insolvent, this aspect of the liquidation process is crucial as it determines how the company’s assets will be distributed or used to settle debts, and, if necessary, which creditors are entitled to repayment. The goal is to identify every debt, liability or claim against the company, including those that may arise in the future. These can be otherwise known as contingent liabilities and understanding exactly what these types of liabilities are and how they may arise is crucial if you are considering liquidating your business.
What Is A Contingent Liability?
A contingent liability is a possible obligation that may or may not become an actual debt, depending on the outcome of an event in the future.
This type of liability can be contingent on an event in either the near or long-term future, but the important thing to note is the fact that contingent liabilities are not definite. A contingent liability represents a specific risk that could lead to financial obligations, but these obligations will only materialise if certain things occur. For example, if your company is facing legal action, the liability for any subsequent damages remains contingent until the court has made its decision.
Common Contingent Liabilities
When answering the question of what is a contingent liability, it can help to understand how this type of liability may arise in your business. Contingent liabilities come in various forms depending on the nature of your business and the situation you are in (e.g. if the business is solvent or insolvent). Some of the most common examples of contingent liabilities include:
- Legal claims – When a business is involved in ongoing litigation, the outcome of the case could result in a financial penalty. This is viewed as a contingent liability until a judgement is passed.
- Loan guarantees – Many businesses provide guarantees for loans taken out by other companies or individuals. If the party taking out the loan defaults, the business may become responsible for repaying it as a guarantor.
- Product warranties – Companies that sell products with warranties face the risk of potential future claims for repairs or replacements.
- Pending tax investigations – If your company is under investigation by HMRC or disputing a tax payment, the amount of tax owed will remain a contingent liability until the dispute is resolved.
How Are Contingent Liabilities Treated During Liquidation?
Understanding what a contingent liability is in liquidation is crucial as this type of liability can affect the way the formal liquidation process is conducted. The way that contingent liabilities are treated depends on whether the company in question is solvent or insolvent.
Solvent Companies
If a solvent company is choosing to liquidate via a Members Voluntary Liquidation (MVL), directors must complete a Declaration of Solvency. This legal declaration takes into account all known liabilities (including contingent ones) and states that the company can pay all of its debts within 12 months. The liquidator will set aside enough funds to cover these contingencies before distributing the remaining assets. Should the contingent liability never materialise, reserved funds can then also be distributed.
In some cases, the materialisation of a contingent liability could mean that the company’s liabilities exceed its assets. If this happens, the company will no longer be solvent and will need to utilise the Creditors Voluntary Liquidation (CVL) process instead. This emphasises the importance of accurately completing the Declaration of Solvency and always taking contingent liabilities into account at the earliest possible opportunity.
Insolvent Companies
In an insolvent liquidation, the company is unable to pay its debts in full and will either liquidate voluntarily via a CVL or have its hand forced via a winding-up petition from HMRC. In both scenarios, a licensed insolvency practitioner will assess both actual and contingent liabilities when determining how to distribute the company’s assets to creditors.
Contingent liabilities are treated extremely carefully in the case of insolvent companies as they could affect the total amount available to pay creditors. When making calculations and distributing assets, the insolvency practitioner will assess the likelihood of a contingent liability becoming a real obligation. If it seems probable, they may reserve some of the company’s assets to cover it. However, if the contingent liability is unlikely to materialise, it may be given a lower priority than actual liabilities.
What Are The Implications Of Contingent Liabilities?
The identification of contingent liabilities can have implications for all involved in the company liquidation, including both creditors and the company undergoing liquidation.
For creditors, contingent liabilities can complicate the process of recovering debts as they can reduce the total assets available for distribution. Creditors may receive lower payouts as a result, especially in cases of insolvent liquidation where the company’s assets are already insufficient to cover debts.
For the company being liquidated, contingent liabilities must always be fully disclosed. Failure to account for contingent liabilities in liquidation could lead to complications should additional claims arise after the insolvency practitioner has distributed assets. In an MVL, not accounting for contingent liabilities and therefore making incorrect declarations about the company’s solvency could leave directors personally liable for debts.
With possible strict penalties for those who fail to assess their contingent liabilities in liquidation, it’s crucial that directors seek professional advice when embarking on the liquidation process. Contingent liabilities must be accounted for, as they represent potential financial obligations that could significantly impact the formal liquidation process.
At My Liquidation, our insolvency practitioners have a wealth of experience helping both solvent and insolvent companies through the complexities of liquidation and can work with you to ensure you fully understand your liabilities both now and in the future. Simply get in touch to find out more.