What is the legal meaning of insolvency?

Estimated reading time: 8 minutes
Insolvency. What is the legal meaning of insolvency?
  • Insolvency is the term that is used to describe the position of a company when it is unable to pay its debts as they become due and payable
  • It is interpreted by the Courts using what is known as the “cash-flow test”
  • If directors of a company suspect that their company is or may become insolvent, yet continue to trade the business and incur debt, they may be breaching their duty to prevent trading whilst insolvent (section 588G of the Corporations Act 2001 (Cth)).

Section 95A of the Corporations Act

At law, insolvency is only defined by its opposite in the Corporations Act 2001 (Cth). Section 95A of the Act defines insolvency by providing a definition of what it is not (i.e. solvency). Section relevantly provides that:

  1. A person (including a company) is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
  2. A person who is not solvent is insolvent.

The word ‘person’ here is taken to include a company. Under Australian law (section 1.5.1 of the Corporations Act 2001 (Cth)), once a company is registered with the Australian Securities and Investment Commission (ASIC) it becomes what is known as a separate legal entity, giving the company a degree of legal personhood. This gives the company the ability to own property, exercise rights, and perform obligations, distinct from the people who own and/or operate the business.

Cash flow test vs. balance sheet test

At common law, there are two tests that measure whether a company is insolvent. These tests are known as the “cash-flow test” and the “balance sheet test”.

The cash-flow test refers to the assessment of the ability of a company to pay its debts (or sell its assets fast enough to satisfy its debts) as they become due and payable.

On the other hand, the balance-sheet test assesses the solvency of a company in reference to the total external liabilities against the total value of company assets. Therefore, if a company’s liabilities are greater than the total sum of its assets, the company is insolvent.

The cash-flow test is the principal test that is used by the Courts when determining whether a company is solvent or insolvent. The cash-flow test requires an analysis of:

  • The company’s existing debts;
  • Whether the company’s debts are payable in the near future;
  • The date each debt will be due for payment;
  • The company’s present and expected cash resources; and
  • The dates any company income will be received.

The Court will consider whether the company is suffering from a temporary lack of liquidity (and therefore is not insolvent) or a chronic shortage of working capital (and therefore is insolvent). Justice Owen in The Bell Group Limited (In Liquidation) v Westpac Banking Corporation [No.9] (2008) WASC 239 describes the threshold as “insurmountable endemic illiquidity”. A Court will need to be convinced that the company has gone past “the point of no return” and is no longer viable to trade.

What amounts to a “debt” under section 95A?

In common usage, debt is a legal obligation for a debtor to pay money or money’s worth to a creditor under an express or implied agreement. In corporate law, debts are usually incurred by choice, where an intent to be bound can be established, and a deliberate act or omission by the debtor renders them liable to the creditor for a determined sum.

A debt may be due and payable, payable prospectively, or a present obligation contingent on a future event. For the purposes of insolvency, section 95A only concerns debts that are due and payable.

The meaning of a “debt” that is due and payable under section 95A of the Act is not expressly defined so we must look to common law to determine its meaning. The Courts have interpreted debts to be limited to all claims that are provable in the winding up (Bank of Australasia v Hall (1907) 4 CLR 1514) and claims for immediately ascertainable liquidated amounts (Box Valley Pty Ltd v Kidd & Anor (2006) NSWCA 26). Whilst these cases provide some clarification, there is still debate around how to define a debt.

The ability to characterise a liability as a debt will affect a director’s ability to give a declaration of solvency under the winding up provisions, and to decide to enter voluntary administration. For a liquidator, where a presumption of insolvency is not available (see below) they must prove that a company was unable to pay their debts when they fell due and payable when bringing a claim in respect of insolvent trading.

What are the indicators of insolvency?

In ASIC v Plymin & Ors (2003) 46 ASCR 126, Justice Mandie of the Supreme Court of Victoria referred to a checklist of 14 indicators of insolvency:

  1. Continuing losses;
  2. Liquidity ratio below 1 (a ratio of current assets to liabilities)
  3. Overdue Commonwealth and State taxes;
  4. Poor relationship with the present bank including inability to borrow additional funds;
  5. No access to alternative finance;
  6. Inability to raise further equity capital;
  7. Supplier placing the debtor on COD (Cash on Delivery) terms, otherwise demanding special payments before resuming supply;
  8. Creditors unpaid outside trading terms;
  9. Issuing of post-dated cheques;
  10. Dishonoured cheques;
  11. Special arrangements with selected creditors;
  12. Solicitors’ letter, summon(es), judgments or warrants issued against the company;
  13. Payments to creditors of rounded figures, which are irreconcilable to specific invoices;
  14. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

This is not an exhaustive list and it is not necessary for all of the above factors to be present for a company to be considered insolvent. It is possible for a company to remain solvent even when many of the above factors are present. This is particularly true where sufficient outside funds are available, such as funds from a director or other related party. It is possible for a company to prove solvency where they can show that an outside party would come to the company’s aid. In this regard, it is important to note that the test for insolvency requires that a company is unable to pay its debts. This inability to pay is not proven by the fact that debts were not paid. If the company could choose to ask for outside help but did not, they may still be considered solvent at law.

The non-proscriptive nature of these indicators means that Courts still make findings of insolvency ‘on the facts’ of each case. Liquidators, therefore, do not have a ready-made template to prove insolvency, and they need to explain the circumstances of the company to support an allegation of insolvent trading.

For more information on these indicators and the case they arose from, please read our article on the ASIC v Plymin (Water Wheel) case.

Presumptions of insolvency

Pursuant to section 459C (2) of the Corporations Act 2001 (Cth) there are various circumstances in which a company is presumed to be insolvent. Creditors can, therefore, commence proceedings under section 459P to have a company wound up on the basis of insolvency. The cases in which companies will be presumed to be insolvent are:

a. Failure of the company to comply with a statutory demand;
b. Execution of process returned wholly or partially unsatisfied;
c. Appointment of a receiver, either under the power of an instrument or by court order;
d. The possession or control by a person of secured property of a company, or a person appointed for this purpose.

These presumptions are able to be rebutted with adequate evidence. In the case of Ace Contractors & Staff Pty Ltd v Westgarth Development Pty Ltd [1999] FCA 728, several rulings were made in regards to proving solvency:

  • A company should ordinarily present the Court with the “fullest and best” evidence of its financial position – unaudited accounts, unverified claims of ownership or valuation, and general assertions (even from accountants) will likely not be significant to prove solvency
  • A distinction can and will be drawn between solvency and a mere surplus of assets
  • The adoption of the cash flow test does not mean that the extent of the company’s assets are irrelevant to the inquiry (credit resources should also be taken into account)
  • Solvency is to be determined as at the date of the hearing, but future events should not be completely ignored where probative

Key takeaway

If directors of a company suspect that the company is or may become insolvent it is vital that the proper steps are taken (avoiding illegal, last-resort behaviours such as phoenix activity – for more information on this, listen to our podcast) to ensure that action is not commenced either against the company or them in their personal capacity (e.g. a claim against a director for insolvent trading). A director may either:

  1. Utilise the ‘safe harbour’ provisions of the Act by engaging a restructuring adviser and develop a turnaround plan (for more information, listen to our podcast on the safe harbour from insolvent trading);
  2. Appoint a voluntary administrator (make sure you pick the right one – for information on this, please read our guide The Complete Guide to Voluntary Administration;
  3. Appoint a liquidator (consult our article on how to choose the right liquidator); or
  4. Cease to trade and inform their creditors whilst working on the above three options.

If you are facing a commercial litigation or insolvency challenge, you may wish to engage a lawyer to help defend your interests. At Sewell & Kettle, we specialise in insolvency, with over 17 years’ experience in the area. We represent clients in all Australian courts, as well as in mediation and arbitration, and are experts in protecting and recovering assets. We provide personalised solutions for complex legal and commercial challenges, and where necessary, we can deliver pre-pack insolvency arrangements and provide restructuring advice. If you are interested in our services, please contact us.

If you want to learn more about insolvency, read our blog posts:


Starting a Business Misconceptions

Business Survival Series: Misconceptions About Starting a Business

Estimated reading time: 4 minutes

Starting a business can be a mystifying process. It involves overcoming complex and seemingly never-ending challenges that can be frustrating to navigate and sometimes will not lead to a quick return. As such, when considering whether to begin such a difficult undertaking, it is immensely important to clarify some of the ideas surrounding starting a business.