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Investigating Insolvent Trading Essay

1412 words - 6 pages

This paper considers “how, when and why” a firm ought reasonably suspect insolvent trading via exploration of areas of law, management, psychology and economics. Factors given consideration include the difference between risk and uncertainty, the imperfection of market information, the risk appetite of entrepreneurs, the impact of corporate culture on self-awareness and finally criteria for assessing proximity to insolvency from both a case law and a common-sense perspective.

An essential difference between risk and uncertainty is the ability to quantify and therefore manage risk, since risk is associated with measurable repeatable events and accessible to a probabilistic analysis. Uncertainty on the other hand stems from unique events, which may be foreseeable but are certainly unpredictable (Wennekers). A wide variety of management models exist for managing risk (Net Present Value, Capital Asset Pricing Model etc.) but all assume away the element of uncertainty. The “how” of managing uncertainty will be a subjective matter and depend greatly on the individual entrepreneur or manager. At this point it is easy to see a potential divergence between courts and businessmen, unless courts are able to reasonably but prudently incorporate the typical entrepreneurial outlook. Entrepreneurs are “more optimistic”, “less averse to risk” and likely to “dispose of relevant information reducing uncertainty” (Wennekers). Whilst some latitude might be given by the courts to this mindset, an element of dispassionate analysis should remain. Where conventional management theory allows, the level of uncertainty in the firm’s marketplace should be assessed and included in any decision on potential insolvency. Where “uncertainty levels are low, the firm is able to forecast with some degree of confidence, and make appropriate risk adjustments” (Hibbard). If this tool is available but unused the conduct of the directors can reasonably be considered lacking.

The “how” element is also strongly influenced by some of the inherent traits of a market economy. Economic theory concludes that abnormal profit levels only exist in imperfect markets, this imperfection extending to, amongst other things, the information available to suppliers as well as consumers. It is the existence of the higher profits that attracts business in the first instance. To combat this gap in knowledge businessmen are normally diligent in

respect to measuring and quantifying their own operations, costs and margins. The availability of internal data and the analytical tools available to interpret it are almost unlimited in the ‘information age”. Where financially viable, qualified staff will be employed to conduct detailed analysis beginning with the annual financial plans and drilling down to more concrete periodic reporting (see Shiao Yen-Wu). It cannot be expected that an untrained or under-resourced business could adopt such a detailed approach, indeed the theoretical complexity of the...

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