Overview of Corporate Insolvency and Personal Bankruptcy in Australia

Estimated reading time: 110 minutes Company liquidation, Other

Insolvency occurs when a business or an individual is unable to meet their debts as they become due and payable. There is a distinction in Australian law between bankruptcy (applies to individuals) and insolvency (applies to corporate bodies), and each has its own particular process. Read our article to learn more about corporate insolvency and personal bankruptcy.

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Insolvency occurs when a business or an individual is unable to meet their debts as they become due and payable.

It should be noted that there is a distinction in Australian law between bankruptcy, which applies to individuals, and insolvency, which applies to corporate bodies. Corporations are treated differently than persons since a company has neither a soul to lose nor a body to kick. 

Corporate insolvency:

  • Corporate insolvency 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’.
  • When the insolvent debtor is a company, they will be dealt with under the Corporations Act 2001 (Cth) and any litigation will occur in the Federal Court or a state Supreme Court, with assistance, recourse and regulation provided by the Australian Securities and Investments Commission (ASIC). 

Insolvent individuals (bankruptcy):

  • Personal insolvency (more commonly referred to as bankruptcy) is used to describe the position of an individual when they are unable to pay their past debts as they become due and payable.
  • When the insolvent debtor is an individual, they will be dealt with under the Bankruptcy Act 1966 (Cth) and any litigation will occur in the Federal Court or the Federal Circuit Court, with regulatory oversight provided by the Australian Financial Security Authority (ASFA). 

Although many provisions in the Corporations Act are similar to those contained in the Bankruptcy Act, each has its own particular process of dealing with insolvency. One difference of particular note is the access within each regime to third party debt. It is much harder for companies to get access to third party debt when insolvent compared to individuals that are insolvent. This is a consequence of the unique and separate development of each body of law. 

What is insolvency for individuals?

There is no precise definition or piece of law about when a natural person is insolvent, only acts of bankruptcy. Therefore, there is no legal obligation for a natural person to put themselves into bankruptcy, a point of significant difference from corporate insolvency. There are criminal laws that relate to fraud that apply to individuals where there is dishonesty.

Section 95A of the Corporations Act: when are companies insolvent?

At law, corporate insolvency is defined by its opposite. Section 95A of the Corporations Act defines insolvency by providing a definition of solvency. The 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), once a company is registered with the Australian Securities and Investment Commission it becomes 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: corporate insolvency

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 on this test.

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). This was considered in The Bell Group Limited (In Liquidation) v Westpac Banking Corporation [No.9] (2008) WASC 239. The case concerned a claim against 21 banks made by the liquidators of Bell Group. The claim challenged the means by which securities were given and taken in by the Bell Group following its takeover by the Bond Corporation and sought to recover proceeds. Justice Owen concluded that the threshold was an ‘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 due and payable ‘debt’?

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. 

The meaning of a ‘debt’ that is due and payable is not expressly defined in statute 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). 

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 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.

Presumptions of insolvency at law 

For individuals

In order for a creditor to commence bankruptcy proceedings against a debtor, an act of bankruptcy must occur. An act of bankruptcy is any one of a number of events listed in section 40 of the Bankruptcy Act. These events reasonably indicate that a debtor is unable to pay their debts.

Section 40 – Acts of bankruptcy

1)  A debtor commits an act of bankruptcy in each of the following cases:
                     (a)  if in Australia or elsewhere he or she makes a conveyance or assignment of his or her property for the benefit of his or her creditors generally;
                     (b)  if in Australia or elsewhere:
                              (i)  he or she makes a conveyance, transfer, settlement or other disposition of his or her property or of any part of his or her property;
                             (ii)  he or she creates a charge on his or her property or on any part of his or her property;
                            (iii)  he or she makes a payment; or
                            (iv)  he or she incurs an obligation;
                            that would, if he or she became a bankrupt, be void as against the trustee;
                     (c)  if, with intent to defeat or delay his or her creditors:
                              (i)  he or she departs or remains out of Australia;
                             (ii)  he or she departs from his or her dwelling-house or usual place of business;
                            (iii)  he or she otherwise absents himself or herself; or
                            (iv)  he or she begins to keep house;
                     (d)  if:
                              (i)  execution has been issued against him or her under process of a court and any of his or her property has, in consequence, either been sold by the sheriff or held by the sheriff for 21 days; or
                             (ii)  execution has been issued against him or her under process of a court and has been returned unsatisfied;
                  (daa)  if the debtor presents a debtor’s petition under this Act;
                   (da)  if the debtor presents to the Official Receiver a declaration under section 54A;
                     (e)  if, at a meeting of any of his or her creditors:
                              (i)  he or she consents to present a debtor’s petition under this Act and does not, within 7 days from the date on which he or she so consented, present the petition; or
                             (ii)  he or she consents to sign an authority under section 188 and does not, within 7 days from the date on which he or she so consented, sign such an authority and inform the chair of the meeting, in writing, of the name of the person in whose favour the authority has been signed;
                      (f)  if, at a meeting of any of his or her creditors, he or she admits that he or she is in insolvent circumstances and, having been requested by a resolution of the creditors to bring his or her affairs under the provisions of this Act, he or she does not, within 7 days from the date of the meeting, either:
                              (i)  present a debtor’s petition; or
                             (ii)  sign an authority under section 188 and inform the chair of the meeting, in writing, of the name of the person in whose favour the authority has been signed;
                     (g)  if a creditor who has obtained against the debtor a final judgment or final order, being a judgment or order the execution of which has not been stayed, has served on the debtor in Australia or, by leave of the Court, elsewhere, a bankruptcy notice under this Act and the debtor does not:
                              (i)  where the notice was served in Australia—within the time specified in the notice; or
                             (ii)  where the notice was served elsewhere—within the time fixed for the purpose by the order giving leave to effect the service;
                            comply with the requirements of the notice or satisfy the Court that he or she has a counter-claim, set-off or cross demand equal to or exceeding the amount of the judgment debt or sum payable under the final order, as the case may be, being a counter-claim, set-off or cross demand that he or she could not have set up in the action or proceeding in which the judgment or order was obtained;
                     (h)  if he or she gives notice to any of his or her creditors that he or she has suspended, or that he or she is about to suspend, payment of his or her debts;
                   (ha)  if the debtor gives the Official Receiver a debt agreement proposal;
                   (hb)  if a debt agreement proposal given by the debtor to the Official Receiver is accepted by the debtor’s creditors;
                   (hc)  if the debtor breaches a debt agreement;
                   (hd)  if a debt agreement to which the debtor was a party (as a debtor) is terminated under section 185P, 185Q or 185QA;
                      (i)  if he or she signs an authority under section 188;
                      (j)  if a meeting of his or her creditors is called in pursuance of such an authority;
                     (k)  if, without sufficient cause, he or she fails to attend a meeting of his or her creditors called in pursuance of such an authority;
                      (l)  if, having been required by a special resolution of a meeting of his or her creditors so called to execute a personal insolvency agreement or to present a debtor’s petition, he or she fails, without sufficient cause:
                              (i)  to comply with the requirements of this Act as to the execution of the agreement by him or her; or
                             (ii)  to present a debtor’s petition within the time specified in the resolution;
                            as the case may be;
                    (m)  if a personal insolvency agreement executed by him or her under Part X is:
                              (i)  set aside by the Court; or
                             (ii)  terminated;
                     (n)  if a composition or scheme of arrangement accepted by the debtor’s creditors under Division 6 of Part IV is:
                              (i)  set aside by the Court; or
                             (ii)  terminated;
                     (o)  if the debtor becomes insolvent as a result of one or more transfers of property in accordance with:
                              (i)  a financial agreement (within the meaning of the Family Law Act 1975); or
                             (ii)  a Part VIIIAB financial agreement (within the meaning of the Family Law Act 1975);
                            to which the debtor is a party.

Pursuant to section 44(1)(c) of the Bankruptcy Act the commission of an act of bankruptcy is a precondition to the presentation of a creditor’s petition in the Federal Court of Australia and the act of bankruptcy must have taken place within the six months prior to the petition being presented. A creditor’s petition is an application to the Court for a sequestration order against the estate of a debtor. Pursuant to section 43(2) of the Bankruptcy Act upon making a sequestration order, a debtor will become bankrupt.

The bankruptcy of the debtor will be deemed to have commenced for the purposes of claw-back actions at the date of the earliest act of bankruptcy within the six months before a sequestration order is made: see section 115(1) of the Bankruptcy Act. At this point all property that belonged to or was vested in the bankrupt prior to them becoming bankrupt, or has been acquired by the bankrupt after the commencement of the bankruptcy, is property that is divisible among the creditors of the bankrupt and therefore vests in an appointed trustee.

The most common act of bankruptcy is the failure to comply with a bankruptcy notice under section 40(1)(g) of the Bankruptcy Act. A bankruptcy notice is a formal demand for payment of a debt, in respect of a judgment or order that has been made within the previous six years against a debtor. The amount of the judgment (or judgments) must be at least $10,000 (or accumulatively at least $10,000). The act of bankruptcy will be deemed to have been committed if a debtor doesn’t comply with the demand within 21 days of it being served.

It should be noted that even if a person has committed an act of bankruptcy, they do not necessarily become bankrupt. For bankruptcy to be successfully established, the creditor must establish a number of factors:

  • Must prove that the act of bankruptcy (the failure to repay the debt) was committed by the debtor.
  • Must present the petition to the court within 6 months of the act of bankruptcy.
  • The debt (or debts) owed must be for the sum of at least $10,000.

For corporations

Pursuant to section 459C(2) of the Corporations Act 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:

  1. Failure of the company to comply with a statutory demand.
  2. Execution of process returned wholly or partially unsatisfied.
  3. Appointment of a receiver, either under the power of an instrument or by court order.
  4. 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 is 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 takeaways for directors

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) to ensure that action is not commenced either against the company or them in their personal capacity (eg. 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;
  2. Appoint a voluntary administrator;
  3. Appoint a liquidator; or
  4. Cease to trade and inform their creditors whilst working on assessing the above three options.

Bankruptcy has a history of stigmatising failure

Bankruptcy in Australia has long been an issue sought to be penalised. Governments have historically opted to come down harshly upon those unable to repay their debts and introduced various penal consequences for this behaviour. Law reforms throughout the years have attempted to impose rules and obligations upon this socially disruptive situation but in a somewhat piecemeal and disjointed manner. The area was initially regulated by the Commonwealth since the Australian Constitution provides in section 51(xvii) that the federal government has the power to legislate with respect to bankruptcy and insolvency. The federal government exercised this power by bringing in the Bankruptcy Act 1924 (Cth). However, the legislation underwent numerous amendments until it was reviewed in 1960 by the Clyne Committee. The review led to the introduction of the Bankruptcy Act 1966 (Cth), and although this has since been amended many times, this piece of legislation remains the operative law across Australia.

Because Australia’s insolvency regime has evolved over time in this piecemeal fashion to meet the ever-changing needs and demands of the community, commercial sector and consumers, it is widely accepted that the regime does not always serve its full purpose. This view was reflected by Professor Jason Harris and Michael Murray who note that “if one were to devise an insolvency regime afresh, it would be quite different from the set of laws which we have today”. This is in contrast to the Singapore system. Recent reforms to Singapore’s bankruptcy and insolvency regimes have unified the two bodies, thereby creating a more wholistic and consistent body of law to govern the area across all sectors. It is now accepted that persons going bankrupt from credit card debt or small business failing does not represent any dire threat to our economy and society.

The main problem arises from the disconnect between the theory and the reality of insolvency practice in Australia. For the most part, the aims and purposes of insolvency law are sound, but the reality is less optimistic. For example, although Australia has a comparatively low number of personal insolvencies, there remains a stigma surrounding bankruptcy. Bankruptcy attracts quasi-penal consequences and many laws link bankruptcy with unlawfulness. These penalties damage the public’s perception of the process and stigmatise bankrupt individuals as failures. In this way bankruptcy continues to carry its history of stigmatising failure, which is wholly unproductive in achieving good outcomes in bankruptcy. This is not the case in the US, where bankruptcy is often perceived to be an inevitable consequence of entrepreneurship. This attitude is far more productive in the attainment of sound economic outcomes. However, this is subject to requiring honest dealings and sensible risk taking.

A thorough understanding of the Australian insolvency regime requires an understanding of the fundamental principles that underpin the legislation. Roy Goode’s 13 guiding principles for insolvency are set out in ‘Goode on Principles of Corporate Insolvency Law’.

  1. Corporate insolvency law recognises rights accrued under the general law prior to liquidation.
  2. Only the assets of the debtor company are available for its creditors.
  3. Security interests and other real rights created prior to the insolvency proceeding are unaffected by the winding up.
  4. The liquidator takes the assets subject to all the limitations and defences.
  5. A contractual provision for the removal of an asset from the estate of an insolvent company upon winding up may be void as contrary to public policy.
  6. Unsecured creditors rank pari passu.
  7. The pursuit of personal rights against the company is converted into a right to prove for a dividend in liquidation.
  8. On liquidation the company ceases to be the beneficial owner of its assets.
  9. No creditor has any interest in specie in the company’s assets or relations.
  10. Liquidation accelerates creditors’ right to payment.
  11. Members of a company are not as such liable for its debts.
  12. On insolvency, directors’ duties are altered so as to require enhanced regard for creditors’ interests.
  13. In cross-border insolvencies, a principle of modified universalism applies. 

What is Pari Passu and why is it important?

Pari passu is Latin for ‘with an equal step’. The English interpretation of the pari passu rule gives it the meaning, ‘on equal footing, proportionately’. Black’s Law Dictionary defines the concept as ‘proportionally; at an equal pace; without preference’.

The pari passu principle is a fundamental feature of insolvency law theory where the assets of a person in bankruptcy or a company in insolvency are equally distributed between creditors during a voluntary administration, liquidation, or other restructuring. The principle applies to both personal and corporate insolvency.

The pari passu rule applies to creditors who do not have a secured interest in the company’s property beyond any other creditor. This means that after secured creditors have their debts repaid, the remaining creditors have the collected asset value distributed among them equally and proportionally.

This principle is stated in section 108 of the Bankruptcy Act, ‘Except as otherwise provided by this Act, all debts proved in a bankruptcy rank equally and, if the proceeds of the property of the bankrupt are insufficient to meet them in full, they shall be paid proportionately’. 

The principle arose out of equity, a body of law developed in the English Court of Chancery. Equity has always been concerned with the conscience of the individuals brought before it, and it is out of this context that the principle of pari passu arose. However, since the principle arose out of this defined context, it is not primarily concerned with the economics of the issues to which it now applies. Pari passu does not function with allocative efficiency or innovation as primary objectives. This is because rateable distribution will not be of much assistance when there are no assets or money to distribute, a fundamental contradiction within Australian insolvency law. As such, although the principle remains important in the functioning of insolvency, its application is not as innovative, efficient or fair as desired and a case could be argued for the implementation of a more pro-business, economically minded principle than that provided by pari passu

How to make an application to wind up an insolvent company

Who can make a winding up application?

The most common party to file an application to wind up an insolvent company under section 459P of the Corporations Act are its unsecured creditors. A creditor in these circumstances is, as discussed by Young J in National Australia Bank Ltd v Market Holdings Pty Ltd [2000] NSWSC 1009 (and referring to Crossman J in Re North Bucks Furniture Depositories Ltd [1939] 2 All ER 549) includes every person who has a right to prove in a winding up. However, when a creditor makes an application under section 459P(1)(b), they must have a valid debt that is capable of being enforced (eg. a judgment debt).

Section 459P(1) of the Corporation Act also outlines various other parties that can make an application to the Court, including:

  • The company;
  • A contributory;
  • A director;
  • A liquidator or provisional liquidator of the company;
  • ASIC; and
  • An agency prescribed by the Corporation Regulations (ie. Australian Prudential Regulation Authority (APRA)).

When can a winding up application be made?

Pursuant to section 459C(2) of the Corporations Act, an application to wind up a company in insolvency must be done within 3 months of the date that a company commits an act of insolvency.

The most common presumed insolvency event under section 459C is that a company has failed to comply with a statutory demand. In this instance, the creditor company must make an application under section 459P within 3 months after the expiry of the 21 day period to comply with the statutory demand (subject to an application being brought to set aside or extend time for compliance with a statutory demand).

How is a winding up application made?

An application to wind up an insolvent company is made by filing in the Federal Court an originating process supported by affidavits. Pursuant to section 465A(b) of the Corporations Act, once the application has been filed and accepted by the registry, the applicant has 14 days to serve the application on the respondent company.

Pursuant to section 459Q of the Corporations Act, there are special rules that govern applications that are based on a company’s failure to comply with a statutory demand. This type of application must:

  1. Set out the particulars of service of the demand on the company and the failure to comply with the demand;
  2. Must have attached to it:
    • A copy of the demand; and
    • If the demand has been varied by an order under subsection 459H(4) – a copy of the order; and
  3. Unless the debt, or each of the debts, to which the demand related is a judgment debt – must be accompanied by an affidavit that:
    • Verifies that the debt, or the total of the amounts of the debts, is due and payable by the company; and
    • Complies with the rules.

How do you oppose a winding up application?

If your company has been served with an application for the company to be wound up and have received notice of a hearing date, a director or the company’s legal representative can appear at the hearing, either to support or oppose the application.

If a company wants to oppose the application, pursuant to section 465C of the Corporations Act, they must file and serve on the applicant:

  • A notice of grounds upon which the person opposes the application; and
  • An affidavit verifying the matters stated in the notice.

If a company does not file and serve these documents, it will require leave from the Court to oppose the application. Leave is normally granted where there is no prejudice to the applicant.

One of the most common grounds to oppose an application to wind up a company is to prove that the company is in fact solvent. On the other hand, if the company cannot prove that it is solvent, it is unable to rely upon the ground of a genuine dispute to the validity of the creditor’s debt.

Regarding applications that are based on a company’s failure to comply with a statutory demand, a respondent company cannot oppose the application on the following grounds without the leave of the Court:

  • On a ground that was relied on for the purposes of an application by a company to set aside a statutory demand; or
  • That the company could have relied on the ground for the purposes of an application to set aside a statutory demand, but no application was made.

The Court will not allow leave unless it is satisfied that the grounds mentioned above are material to prove that a company is in fact solvent.

Further, an affidavit accompanying notice of grounds of opposition may also include the reasons why the debt was not paid and, if a company is able to pay the debt, the court may be minded to adjourn the application to allow this to occur.

What may happen at the hearing?

The hearing of winding up applications are usually before registrars who have wide discretionary powers to deal with an application in the following ways:

  • Grant order under section 459A to wind up the company;
  • Dismiss the application;
  • Adjourn the application; or
  • Make an interim order.

If there is a significant contest (such as actual solvency) the case will likely be referred to a judge.

What happens if a company is wound up?

If a company is wound up the Court will appoint a liquidator that has been nominated by the creditor (applicant). The liquidator must consent to the appointment, by way of filing a written Consent of Liquidator to Act. Once the order has been made and the liquidator appointed, an applicant has two business days to lodge the order with ASIC along with the name and address of the appointed liquidator.

The applicant must also serve a copy of the sealed order on the liquidator and the company, along with ASIC Form 519 (Notification of court action relating to winding up application).

The liquidator will then proceed to wind up the company.

What does ASIC v Plymin tell us about corporate insolvency indicators?

What is corporate insolvency?

The case of ASIC v Plymin is significant for lawyers because it sets out a list of indicators that can help us understand when a company will be found to be insolvent. The general rule in law is that company insolvency is proven by a cash-flow test not a balance sheet test (can you pay all your debts as they fall due and payable?). Beyond this, a significant amount of case law has developed over time and a throw-away line by lawyers is that corporate insolvency is decided “case-by-case”. This obviously isn’t helpful for company directors if they face illiquidity and want to make sure they aren’t liable for insolvent trading.

The case is also noteworthy because it involved the former corporate high-flyer John Elliott being found to have breached his director’s duties. He was ordered to pay compensation of $1.4 million and was banned from managing corporations for four years.

The case is also known as the Water Wheel case.

What is ASIC v Plymin about?

The summary of the players and the business is:

  • Name of business: The Waterwheel Group
  • Dates: Entered rice industry in 1997 and was placed in voluntary administration in February 2000
  • Companies: Water Wheel Mills Pty Ltd and Water Wheel Holdings Limited
  • Business: Milling rice
  • Business issue causing insolvency: Milling rice at 40% capacity due to NSW Rice Growers monopoly
  • Defendants: Elliott (non-executive director), Plymin (Managing Director) and Harrison (Chairman)
  • Plaintiff: Australian Securities and Investments Commission (ASIC)
  • Date of insolvency: Found by Court to be 14 September 1999

The Court found that the companies traded whilst insolvent from at least 14 September 1999 up until a voluntary administrator was appointed in February 2000. The directors were liable to compensate creditors for debts incurred (in breach of their duties as directors) during that period.

What are the indicators of insolvency?

The ASIC v Plymin case is relied upon to guide potential defendants (ie. company directors) and their professional advisers about indicators of corporate insolvency. No single indicator is determinative of a finding of insolvency but in the Water Wheel Case, the Court found that all the indicators of insolvency were proven by the plaintiff (ASIC) to have occurred.

The indicators of insolvency are:

  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.

The fourteen indicators of insolvency have withstood the test of time and it is the standard list of indicators that liquidators use to justify assertions of insolvency.

The bad news is that Courts still make findings of insolvency ‘on the facts’ of each case and so these indicators are just that; indicators. This also means that the liquidators don’t 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.

Breach of directors duties

Mr Elliot was a non-executive director and the case found that he still had director’s duties to keep himself appraised of the financial position of the company.

Regarding the duties of non-executive directors, Justice Mandie said:

A non-executive director is expected to take steps to put himself in a position to monitor the company and to exercise and form an independent judgment and to take a diligent and intelligent interest in the information either available to him or which he might with fairness demand from the executives or other employees and agents of the company.

This basically means that turning a blind eye is not a defence even if you are non-executive director and the company isn’t very forthright with giving you up-to-date financial information.

Don’t forget there is now a safe harbour from insolvent trading outlined in section 588G(2) of the Corporations Act. The new safe harbour from insolvent trading became law in 2017 and it can be used to protect directors from insolvent trading allegations. The test is generally whether the company starts to develop a plan that is likely to deliver a greater return than voluntary administration or liquidation. This means that a company (if it is in the safe harbour) can legally continue to trade whilst insolvent if it qualifies for the safe harbour at least for a short time.

How does an individual go bankrupt?

Bankruptcy is the term used to describe when an individual becomes insolvent and goes into a formal process of sequestration in Australia. The process of bankruptcy only applies to individual persons and when referring to the insolvency of a corporation or other registered entity, the term and associated process of insolvency will instead be applicable. In the United States of America bankruptcy refers to both personal and corporate insolvency.

A person will be bankrupt when they become insolvent, in other words when they are unable to pay their debts as and when they fall due and payable. However, bankruptcy is not necessarily the inevitable result of insolvency. A range of options are available to individuals who find themselves insolvent. For example, an individual may be able to enter into a debt agreement, as provided by Pt X of the Bankruptcy Act. Alternatively, an individual may be able to use a more informal solution such as debt rescheduling, wherein an agreement will be reached external to the strict processes and restrictions of bankruptcy. This is also called a private treaty. These options will be discussed later in this article. However, individuals may be left with no other choice if their position cannot be realistically achieved and creditors are unwilling to move forward with less formal solutions, and will therefore have to turn to bankruptcy.

There are two primary modes of becoming a bankrupt; involuntary bankruptcy and voluntary bankruptcy. 

Involuntary bankruptcy

The Australian Financial Security Authority have estimated that only about 10% of bankruptcies result from court orders. Although only a small portion of bankruptcies are initiated in this manner, the process remains important in reflecting the overarching right of creditors to force bankruptcy on a debtor if a debt remains unpaid and has no prospect of repayment.

The process will begin with a debtor’s inability or refusal to repay a debt owed to a creditor. If such a scenario has occurred, any creditor can then initiate proceedings by presenting a creditor’s petition to the court. The creditor’s petition will seek a sequestration order against the debtor’s estate. 

For this process to be successful, the creditor must establish a number of factors:

  • That the act of bankruptcy (the failure to repay the debt) was committed by the debtor.
  • The petition be filed to the court within 6 months of the act of bankruptcy.
  • The debt (or debts) owed must be for the sum of at least $10,000.

If the above is proven, the court (the Federal Circuit Court of Australia or the Federal Court of Australia) will make a sequestration order and the debtor will then become bankrupt. 

There are only limited defences available when challenging an involuntary bankruptcy court proceeding. A debtor may contest the act of bankruptcy by proving that none of the number of events listed in section 40 of the Bankruptcy Act have occurred and that the debtor is actually solvent. The debtor may alternatively apply for the notice of bankruptcy to be set aside. The purpose of a bankruptcy notice is to create a presumption that the subject is bankrupt, and as such, the court focuses on the procedure and not the legitimacy of the alleged debt. The court assumes that because a bankruptcy notice is based on a judgment debt that it is valid. There are very limited grounds upon which a court will look into a judgment debt. Therefore, the process for setting aside a bankruptcy notice occurs at the procedural level, eg. if it was not adequately served. The court will look at some variation of these considerations when determining whether to set aside a bankruptcy notice:

  1. Was the notice defective or irregular?
  2. If so, is the defect or irregularity substantive or formal?
  3. If the defect is formal only, is it substantial and not able to be remedied by the court?

A debtor has 21 days from the date of being served with a bankruptcy notice to apply to the court for it to be set aside. A debtor may apply to the court to set aside the bankruptcy notice on multiple grounds as set out in the Bankruptcy Act, such as sections 41(6A)(a), 41(6A)(b), 41(6C), 40(1)(g) and 41(7).

Voluntary bankruptcy 

According to Australian Financial Security Authority, the other 90% of bankruptcies are voluntary. Individuals owing debts can decide to voluntarily initiate the bankruptcy process by presenting a debtor’s petition to the Official Receiver. As outlined by Michael Murray and Professor Jason Harris, this option accords with the long-established policy that insolvent debtors may seek the protection offered by bankruptcy, without reference to their creditors or the court.

For this process to be successful, the individual must establish a number of factors:

  • The individual must appear to be insolvent.
  • The petition must be personally presented by the insolvent individual (voluntarily).
  • The individual presenting the petition must show a connection to Australia (such as domicile).  

The process is now much easier than previously since it can be done online. Debtors unable to pay their debts can simply go to the Australian Financial Security Authority website and directly apply for bankruptcy through the website for free. Debtors will need to complete and submit a Bankruptcy Form through the Insolvency Services portal on the website. If AFSA accept the bankruptcy application, they will send the debtor and creditors confirmation in writing, which will contain the relevant AFSA administration number. If AFSA do not accept the debtor application, they notify that debtor in writing with the reason why. 

The link to initiate this process is as follows: https://www.afsa.gov.au/insolvency/cant-pay-my-debts/apply-bankruptcy

Outcome: freedom or failure?

Once either involuntary or voluntary bankruptcy has been accepted by the court or Official Receiver respectively, the individual who is the subject of the order or petition becomes bankrupt. They will now be considered a ‘bankrupt’ and will usually remain in legal terms as a bankrupt for a minimum period of 3 years. At this stage, property will be passed to, or vested in, the trustee in bankruptcy who will collect and sell it for the benefit of the creditors.

The outcome can either reflect freedom or failure. Freedom from debt will likely be achieved because the bankrupt is released from their unsecured debt. An unsecured debt is a debt in respect of which the debtor has given no security over collateral property, which could be forfeited upon default to recoup the loan capital. The issuer of an unsecured debt is known as an unsecured creditor. In the event that the recipient of the loan becomes bankrupt or insolvent, unsecured debts will be paid back at a low priority, and practically, this often means they are never fully repaid, or sometimes, not repaid at all (ie. the creditor gets nothing). In this scenario the debtor is free from any ongoing consequences of paying unsecured debts.

This is in contrast to failure. Aspects of failure will likely include the bankrupt being the subject of an investigation and a public notice being issued precluding the bankrupt from managing a business for a certain period of time or freely travelling overseas. At a public examination or in a private session, a bankrupt is required to answer all questions, even where they may give rise to self-incriminating answers. Transcripts of the public examination may be used as evidence in subsequent civil or criminal proceedings as per section 81 of the Bankruptcy Act. The court can order that any of the bankrupt’s associates, business or personal, who can be reasonably presumed to have relevant knowledge of their affairs be compelled to participate in the public examination. This is an extremely strenuous process, the implications of which will continue to hinder any bankrupt’s life well beyond the defined period of bankruptcy. It is designed to recover improperly disposed of assets and protect the interests of creditors and the community.

Differences between corporate and personal insolvency

There are separate legal regimes for personal and corporate insolvency. 

When the insolvent debtor is an individual (a natural person, not a company), they are regulated by the Bankruptcy Act and any litigation will be determined by the Federal Court or the Federal Circuit Court, with regulatory oversight provided by the Australian Financial Security Authority. 

When the insolvent debtor is a company, it is regulated by the Corporations Act and litigation will be determined by the Federal Court or the Supreme Court, with assistance, recourse and regulation provided by the Australian Securities and Investments Commission. 

Although many provisions in the Corporations Act are similar to those contained in the Bankruptcy Act, each has its own particular process of dealing with insolvency. The divergence between the two regimes has increased over time due to the differing governmental administration of each body of law. Professor Jason Harris and Michael Murray reflected upon the outcome of this divergence, noting that “the regime exists and works reasonably well in spite of this structure but in a developed nation, where issues of impediments to productivity and undue and inconsistent regulation can be quantified and dealt with, it should matter, particularly in relation to insolvency where issues of costs and efficiency are heightened”.

Personal insolvency

Personal insolvency, more commonly referred to as bankruptcy, occurs when an individual goes bankrupt. This process is outlined in detail above. 

Corporate insolvency

Corporate insolvency occurs when a company goes into a liquidation or voluntary administration. A company may or may not be insolvent if a receiver is appointed by a secured creditor or a court because insolvency is not an essential condition of these appointments. The liquidation of an insolvent company somewhat mirrors the process of bankruptcy, with many of the broader purposes of insolvency being relevant to both processes. Primary objectives of a corporate liquidation include ensuring an equitable and fair distribution of assets amongst creditors, providing for the winding up of insolvent companies and allowing an analysis of the circumstances that precipitated the company’s liquidation.

A company will be wound up in one of two ways. 

  1. Compulsory liquidation: A creditor forces the liquidation of a company using a court order. Obtaining a court order usually relies upon a finding that the company is insolvent through its failure to comply with a statutory demand for payment as outlined in s 459 of the Corporations Act.
  2. Voluntary liquidation: Members of the company will decide to liquidate their own company. A court need not necessarily be involved in this process. The company may be solvent (members voluntary liquidation) or insolvent (creditors voluntary liquidation).

The company will continue to exist and retain ownership of its assets but the company will now be under the control of the liquidator, rather than the directors. The liquidator is required to realise any company property and distribute the cash realised amongst the creditors according to the priority required by the Corporations Act. To assist in this process, the liquidator will be given wide powers to investigate and inquire into company affairs, as well as powers to recover and secure any property owned by the company. 

A liquidation effectively ends once the liquidator has dealt with all of the company’s assets and distributed all its money to the creditors. Once the liquidation is completed the company will be deregistered and it will cease to exist.

Personal insolvency options

There are a number of options available to individuals experiencing personal insolvency. The three primary options include bankruptcy, a personal insolvency agreement or a debt agreement.

Bankruptcy 

Bankruptcy is the legal process by which a person is declared unable to pay their debts and subject to a discharge of their debts. Once an individual is declared to be bankrupt, either through a debtor or creditor’s petition, a trust estate will be created and the property of the bankrupt individual will be vested in the trustee. The trustee will either be a private registered trustee in bankruptcy or the government Official Trustee in Bankruptcy. All property is then vested in the trustee, except for those types of property specifically exempted by section 116 of the Bankruptcy Act. The trustee is also tasked with recovering any property that may have been unfairly disposed of prior to the initiation of the process of bankruptcy. 

Once all property is vested in the trustee, the trustee is required to realise the property into cash. This involves selling the property and dividing the proceeds amongst the bankrupt’s creditors. This process of dispersion is governed by a number of guidelines. First and foremost, the trustee’s renumeration and expenses, as well as other statutory charges, will be paid out first before any other creditors receive funds. From there, the proceeds will be distributed according to the pari passu principle. This means that after secured creditors have their debts repaid, the remaining creditors will have the remaining assets distributed among them equally and proportionally. 

Personal insolvency agreement (Part X)

Rather than entering into the bankruptcy process, it may be more beneficial to propose a personal insolvency agreement under Part X of the Bankruptcy Act. A personal insolvency agreement is a legally binding agreement between an indebted person and their creditors. It involves the appointment of a trustee to take control of the indebted person’s property, the trustee will then make an offer to their creditors. Access to this mechanism is however restricted to debtors with limited assets, liabilities and income. 

This process is advantageous for a number of reasons. For debtors, it allows the creation of a flexible arrangement that could be suited to that debtor’s particular circumstances. For example, if they are a professional it may allow them to continue to operate their business. It also allows the debtor to be released from their debts and responsibilities without the extensive and restrictive consequences of bankruptcy or the associated stigma. Finally, a personal insolvency agreement minimises the debtor’s exposure to examination and criminal prosecution and avoids the dissolution of a debtor’s business partnership. It is also advantageous for creditors. This solution is far more cooperative and flexible than bankruptcy and often makes funds available to the creditor that may not have been available if the formal bankruptcy process had been initiated. The main advantage for creditors is that third parties may pay cash into a fund and thereby increase returns to creditors.

The process of obtaining a personal insolvency agreement is as follows. The trustee in bankruptcy will be vested with the debtor’s property and will then undertake an investigation into the debtor’s affairs and come to a recommendation for the creditors to consider. Creditors will then consider the recommendation and vote on whether to move forward with the proposal. It should be noted that the agreement must be accepted by a special resolution (at least 50% in number and 75% in value). If the proposal is accepted, the trustee will put the recommendation into action. Once the agreement terms are fulfilled, the debtor will be discharged from their liability. There is no need for any court involvement within, or approval of, the process for it to be valid. 

The personal insolvency agreement will be set aside when the debtor has successfully fulfilled their obligations. Alternatively, the personal insolvency agreement can be terminated by the court under section 222C, the trustee under section 222A, the creditors under section 222B or as a result of the occurrence of some event nominated in the agreement itself under section 222D.

Debt agreements (Part IX)

An insolvent individual may opt to enter into a debt agreement, as outlined within Part IX of the Bankruptcy Act. A debt agreement is a binding agreement between an entity owing and their creditors where the entity owing pays a set amount over a set period of time to settle larger debts that could not be paid because the entity owing did not have sufficient funds. Repayments are made to a debt agreement administrator, as opposed to the creditors directly, and after the payments are completed and the agreement ends, the creditors cannot recover the rest of the money originally owed. Debt agreements have a lower threshold designed for consumers with smaller debts such as credit card debts. The maximum debt amount that a person can have to utilise a debt agreement is set by section 185C(4)(b) and is $118,063.40.

A debt agreement can be a flexible way to settle debts without becoming bankrupt. This is an option entirely separate from bankruptcy and is typically used when the debt in question is relatively small or the individual has a low income or little property. The decision to pursue a debt agreement must be made by the creditors and the process does not have to involve the courts. This option typically provides better returns for creditors than bankruptcy and has thus been an effective personal insolvency mechanism. 

The process for obtaining a debt agreement is as follows. A debt agreement is made under section 185H of the Bankruptcy Act resulting from the acceptance of a debt agreement proposal by creditors. A debt agreement proposal is a written proposal by the debtor under subsection 185C(1) of the Bankruptcy Act. Section 185H(2) states ‘If: (a) a debt agreement proposal is accepted; and (b) the proposal is not expressed to be subject to the occurrence of a specified event within a specified period after the proposal is accepted; then: (c) the Official Receiver must enter details of the debt agreement concerned on the National Personal Insolvency Index; and (d) the debt agreement is made in the terms of the proposal when those details are so entered.’

An insolvent individual will be disqualified from obtaining a debt agreement if they fall within the criteria listed in section 185C(4). This includes if they have been bankrupt or a party to a debt agreement in the past 10 years, have unsecured debts that are greater than the threshold amount which is currently $118,063.40, the debtor’s property is greater in value than the threshold amount or the debtor’s after-tax income is more than half of the threshold amount.

The debt agreement will either end because it has been successfully completed, there has been some failure in the process or because the debtor has been unable to comply with it. 

The debt agreement can be terminated without the involvement of the court. This can occur either by a written proposal under section 185P, by a special resolution of creditors under section 185QA or by the bankruptcy of the debtor under section 185R. A court can however, declare a debt agreement to be void under section 185T or section 185U or opt to terminate the agreement under section 185Q. 

No recognised turnaround professionals in Australia 

What is a turnaround professional?

Turnaround professionals are individuals engaged in the process of saving financially troubled businesses. They will undertake an in-depth analysis of a company focusing on the management structures and any root causes of failure. Using this information, a turnaround profession will then tailor a strategic plan with the ultimate aim being to restructure the business and ensure its ongoing viability. Turnaround professionals also assist in the implementation of any strategic plan, usually undertaking continual reviews and updates until the turnaround is finally achieved. 

The turnaround profession has been developing in the US market for a number of years. To begin with, the Turnaround Management Association (TMA) was established in the US in 1988. This was the first professional community dedicated to turnaround management and corporate renewal. Then, the Certified Turnaround Professional (CTP) accreditation was established in 1993. This effectively created an objective measure of the experience, knowledge and integrity necessary to conduct turnaround work. These introductions have assisted in promoting the work done by turnaround professionals across the US.

In contrast, the Australian turnaround industry is far less mature. The Australian chapter of the TMA was only established in 2003. However, the industry is undoubtedly growing. In 2010 the TMA established a CTP certification specifically tailored to the Australian market. Furthermore, a non-profit organisation focused upon bringing recognition, credibility and professional standards to the Australian restructuring and turnaround industry has been established. This organisation is called the Association for Business Restructuring & Turnaround (ABRT). But despite these developments, at this point in time there is a limited amount of turnaround professionals in Australia and the profession remains separate from the insolvency industry. This begs the question of whether turnaround professionals should be integrated into the Australian insolvency system?

Integrating turnaround professionals into Australian business practices

Michael Murray and Professor Jason Harris note that an area of potential change in insolvency is to have companies try to avoid the formal regime itself, by way of taking pre-emptive and earlier action to address their financial difficulties. However, the issue remains contentious.

Proponents claim that CTP accredited members have the necessary qualifications and experience to act as restructuring advisers. They also argue that the TMA Code of Conduct binds members to high standards of conduct which safeguards companies. Finally, proponents argue that a significant number of companies would be able avoid insolvency if they were able to obtain effective advice early on. 

However, opponents argue that potential dangers arise if pre-emptive processes become debased. Furthermore, any pre-emptive processes will require support from the law and from professionals, which is yet to be seen. 

Directors duties when a company is insolvent

It should be noted that it is not only those persons who are formally appointed as directors that fit within the definition of a ‘director’. The definition of director in section 9 of the Corporations Act includes persons who are occupying or acting in the position of director even though not appointed as such (a de facto director), and those who have influence over the board of directors such that the board is accustomed to act in accordance with their wishes or instructions (a shadow director). The application of section 9 is ultimately a question of degree that requires consideration of the duties and the context within which they have been performed.

Being a company director means that you assume personal legal duties. These duties cannot be delegated and the law is designed to limit the excuses for breach that directors have to avoid sanctions or paying compensation. In an insolvency scenario, a liquidator may look to enforce these claims (on behalf of the company and creditors) against the former directors and recover economic loss.

The duties of company directors include both common law and statutory duties. These duties are set out below:

Common law (or fiduciary) duties:

  • Duty of care – negligence
  • Duty to act in good faith
  • Duty to exercise powers for a proper purpose
  • Duty to retain discretion
  • Duty to avoid conflicts of interest 
Duty of care – negligence 

A director must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they were a director or officer of a corporation in the corporation’s circumstances and occupied the office held by, and had the same responsibilities within the corporation as, the director or officer. This duty of care is a based in common law and is further outlined in section 180 of the Corporations Act

An example of this duty in practice can be found in Australian Securities and Investments Commission v Hellicar (2012) 247 CLR 345. ASIC alleged that the directors of a publicly listed company breached section 180 of the Corporations Act by approving a draft Australian Stock Exchange announcement that was misleading and thereby breached their duty to the company. The NSW Supreme Court imposed fines and made disqualification orders against the directors for their breaches of section 180. This verdict was later confirmed by the High Court of Australia. 

Duty to act in good faith

Directors have a duty to act in good faith in the interests of the company as a whole. The test as to whether this duty has been complied with is a subjective test of ‘honesty or good faith’. Directors are in breach of this duty where they fail to give proper consideration to the company’s interests. When considering the interests of the company, a director must take into account the interests of shareholders and creditors (in the case of an insolvent company). 

The test was established in Re Smith and Fawcett Ltd [1942] Ch 304 which concerned the refusal by company directors to register share transfers. The court found that the directors’ powers were limited by their duty to act in good faith in the interests of the company. Since the directors had considered the interests of the company as a whole, their refusal to register share transfers was not invalid. The duty is now codified in the Corporations Act in section 184. 

Duty to exercise powers for a proper purpose

Directors must not use their powers for an improper purpose. The test of whether a director has used their powers for an improper purpose is an objective test. Improper purposes may include when a director uses their power to gain an advantage for themselves, or by manipulating voting power. Regardless of whether the improper purpose is the dominant cause or one of a number of contributing causes to a director’s decision, the act will be invalid if, but for the improper purpose, the decision would not have been made. This is called the ‘but for’ test. The duty is now codified in the Corporations Act in section 184.

An example of this duty in practice can be found in Australian Metropolitan Life Assurance Co Ltd v Ure (1923) 33 CLR 199. This case concerned a contest for control over an insurance company. The court asserted that when directors exert their powers for extraneous reasons, that act will be invalid. However, in this instance there was no extraneous or improper purpose so the directors were acting within their power.

Duty to retain discretion

Directors must not put themselves in a position where they are unable to act in the best interests of the company. For example, a director cannot contract with a third party to vote in a certain direction at board meetings. This duty is now incorporated into the Corporations Act through the various conflict of interest provisions mentioned below. 

The court considered this duty in Jenkins v Enterprise Gold Mines NL (1992) 6 ACSR 539. The case revolved around claims that common directors of two companies had breached their duty. The claims alleged that by allowing company A to enter into a number of transactions for the benefit of another company (company B) rather than considering the actual benefit to company A, the directors had breached their duty to retain discretion. The court found that the directors had breached their duty. 

Duty to avoid conflicts of interest

Directors must not put themselves in situations where their personal interests conflict with the interests of the company. If a director’s duty to avoid conflicts is breached the director becomes liable to the company for any benefit derived, or to indemnify the company’s loss. In addition, the company may void any contract that was entered into as a result of the conflict of interest. Chapter 2E of the Corporations Act now strictly limits the financial benefits that can be given to directors and sections 191, 194 and 195 deal with disclosure of directors’ interests and restrictions on voting at board meetings.

This duty was breached in ASIC v Adler (2002) 41 ACSR 72. In this case an insurance company purchased a unit of a trust controlled by one of the company’s directors. The NSW Supreme Court held that the transaction breached the duty to avoid conflicts of interest.

Statutory duties under the Corporations Act:

  • Section 180(1) – Duty to act with care and diligence
  • Section 181(1) – Duty to act in good faith
  • Section 182 – Duty not to make improper use of position
  • Section 183 – Duty not to make improper use of information
  • Section 588G – Duty not to trade whilst insolvent
  • Section 191 – Disclosure of material personal interests
  • Section 286 – Financial records
  • Section 588GAB – Officer’s duty to prevent creditor-defeating dispositions
Section 180(1) – Duty to act with care and diligence

Section 180 (1) reinforces the common law duty of the same name. Section 180(1) requires an objective standard of care, stipulating that a director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they:

  • were a director or officer of a corporation in the corporation’s circumstances; and
  • occupied the office held by, and had the same responsibilities within the corporation as a director or officer.

Additionally, a director will be considered to have acted with the due care and diligence required when they have complied with the ‘business judgment rule’ in making decisions relevant to the business of the company. The business judgment rule provides that a director must:

  • make the judgment in good faith or for a proper purpose; and
  • not have a material personal interest in the subject matter of the judgment; and
  • inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and
  • rationally believe that the judgment is in the best interests of the corporation.
Section 181(1) – Duty to act in good faith

This duty is consistent with the equivalent common law duty. Section 181(1) requires a director or other officer of a corporation to exercise their powers and discharge their duties:

  • in good faith in the best interests of the corporation; and
  • for a proper purpose.
Section 182 – Duty not to make improper use of position

This section provides that a director must not improperly use their position to gain an advantage for themselves or someone else, or to cause a detriment to the corporation.

This duty is breached if a director has the intention and purpose of obtaining an advantage or causing a detriment, regardless of whether an actual benefit or detriment occurs in fact.

Section 183 – Duty not to make improper use of information

This section provides that a person who obtains information because they are, or have been, a director of a corporation must not improperly use the information to:

  • gain an advantage for themselves or someone else; or
  • cause detriment to the corporation.

This duty continues after the person stops being an officer or employee of the corporation.

Section 588G – Duty not to trade whilst insolvent

This section provides that directors must ensure that the company does not incur a debt while insolvent. A person breaches this duty where:

  1. he or she is a director of the company when it incurs a debt;
  2. the company is insolvent at the time, or becomes insolvent by incurring the debt;
  3. at that time, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent by incurring the debt; and;
  4. he or she failed to prevent the company from incurring the debt.

A director may also face criminal penalties for breaching this duty if his or her failure to prevent the debt was dishonest.

Section 191 – Disclosure of material personal interests

This section provides that a director of a company who has a material personal interest in a matter that relates to the affairs of the company must give the other directors notice of their interest.

There are various exceptions to this rule, including section 191(5), where companies with only one director are excluded. 

Section 286 – Financial records

This section provides that a company must keep written financial records. This requirement relates to a director’s duty of care and diligence and provides that directors may be subject to a penalty for failing to maintain proper financial records. 

Section 588GAB– Officer’s duty to prevent creditor-defeating dispositions

An officer of a company must not engage in conduct that results in the company making a creditor-defeating disposition of property of the company.

Criminal offences against company directors for breaching the Corporations Act

A key function of the Corporations Act is to hold company directors to account for any criminal transgressions committed whilst undertaking their role. The act has the power to impose criminal liability on directors. This means that a court can hold a company director as personally responsible for their breaches of the Corporations Act and may in turn impose a range of penalties including fines or even imprisonment. 

Directors may be criminally liable for breaching sections 181-183 of the Corporations Act if the criteria within section 184 is met. A director will be criminally liable if:

  • The director is reckless or intentionally dishonest and fails to exercise their powers and discharge their duties in good faith in the best interests of the corporation or for a proper purpose.
  • The director uses their position dishonestly with the intention of directly or indirectly gaining an advantage for themselves, or someone else, or causing detriment to the corporation or is reckless as to whether the use may result in themselves or someone else directly or indirectly gaining an advantage, or in causing detriment to the corporation.
  • The director uses information with the intention of directly or indirectly gaining an advantage for themselves, or someone else, or causing detriment to the corporation or is reckless as to whether the use may result in themselves or someone else directly or indirectly gaining an advantage, or in causing detriment to the corporation.

Schedule 3 of the Corporations Act provides that for a breach of section 184 as outlined above, directors may face fines of up to $360,000 or 5 years imprisonment, or both. Furthermore, section 206B of the Corporations Act provides for the automatic disqualification of directors from managing corporations if they are convicted of a criminal offence related to the company. Both the Office of the Commonwealth Director of Public Prosecutions and ASIC have the ability to prosecute directors for breaches of these sections. 

Directors may also face criminal liability if they fail to assist an insolvency administrator. This liability is provided for within sections 475 and 530A. The Australian Institute of Criminology noted that between 2004-2010, 70% of those convicted of crimes under the Corporations Act had committed these two distinct criminal breaches; one under s 475 and one under s 530A. Furthermore, most of the fines imposed under the Corporations Act stemmed from these offences. For each of these offences the average fine imposed in 2010 were as follows:

  • s 475 – $816.84
  • s 530A – $876.89

In addition, the new creditor-defeating disposition reforms introduced criminal and civil penalties for individuals (including directors). Under the reforms, an officer of a company must not engage in conduct that results in the company making a creditor-defeating disposition of property of the company. Creditor-defeating dispositions are outlined in s 588FDB of the Corporations Act. The section dictates that a disposition of property is a creditor-defeating disposition if:

  1. The consideration payable to the company for the disposition was less than the lesser of the following at the time the relevant agreement for the disposition was made or, if there was no such agreement, at the time of the disposition:
    • the market value of the property; or
    • the best price that was reasonably obtainable for the property, having regard to the circumstances existing at that time.
  2. The disposition has the effect of:
    • preventing the property from becoming available for the benefit of the company’s creditors in the winding-up of the company; or
    • hindering, or significantly delaying, the process of making the property available for the benefit of the company’s creditors in the winding-up of the company.

The legislation further extends the concept of a disposition by providing that:

  • If a company does something that results in another person becoming the owner of property that did not previously exist, the company is taken to have made a disposition of the property.
  • If a company makes a disposition of property to another person and the other person gives some or all of the consideration for the disposition to a person (third party) other than the company, then the company is taken to have made a disposition of the property constituting so much of the consideration as was given to the third party.

A creditor-defeating disposition will be voidable under s 588FE(6B) of the Corporations Act if three criteria are met:

  1. The transaction is a creditor-defeating disposition of property of the company.
  2. At least one of the following applies:
    • the transaction was entered into, or an act was done for the purposes of giving effect to it, when the company was insolvent, during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
    • the company became insolvent because of the transaction or an act done for the purposes of giving effect to the transaction during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
    • less than 12 months after the transaction or an act done for the purposes of giving effect to the transaction, the start of an external administration of the company occurs as a direct or indirect result of the transaction or act; and
  3. The transaction, or the act done for the purpose of giving effect to it, was not entered into, or done:
    • under a compromise or arrangement approved by a Court under s 411; or
    • under a deed of company arrangement executed by the company; or
    • by an administrator of the company; or
    • by a liquidator of the company; or
    • by a provisional liquidator of the company.

To be held criminally liable, the individual or body must have been reckless as to the result of their conduct. To be held civilly liable, the individual or body must have been unreasonable in their conduct. If such a standard is proven, hefty penalties can be enforced by the court including fines of up to 4,500 penalty units for individuals and 45,000 penalty units for corporations. Individuals can also be imprisoned for up to 10 years and corporations can be fined up to 10% of their annual turnover. 

Enforcement statistics

According to the Australian Institute of Criminology, between 2005-2010 ASIC successfully prosecuted 2,343 defendants Australia-wide, the vast majority of whom resided in NSW (68%). These 2,343 defendants committed a total of 4,429 contraventions of the Corporations Act, indicating that most had committed two or more criminal acts. 

In regards to the penalties handed out for these breaches, the Australian Institute of Criminology reported that nearly all of the breaches resulted in fines, with only two resulting in imprisonment. In 4% of the cases during this period, good behaviour bonds or community service orders were given. The fines imposed totalled approximately $3,896,293, with the average fine imposed for a summary offence prosecuted by ASIC decreasing from $1,030 to $955. Analysis of the fines imposed solely in 2010 showed that:

  • 40 percent were for less than $500.
  • 28 percent were between $501 and $1,000.
  • 20 percent were between $1,001 and $1,500.
  • 12 percent were greater than $1,500.
  • The largest single fine that year was $6,000.
  • The average QLD fine in 2010 was $1,271, compared with $901 in NSW and $903 in VIC.

What can creditors do if a debtor company is insolvent?

An unsecured creditor may be able to apply to a court to obtain a compulsory winding up order. Section 459A of the Corporations Act provides that on an application under section 459P, the court may order that an insolvent company be wound up in insolvency and section 459P lists the persons who may apply for a company to be wound up. 

Section 459P of the Corporations Act confers standing on creditors to apply to the court for a winding up order and this is the most frequent situation in which a company is wound up – the creditor must be owed a valid debt that is capable of legal enforcement even if the time for payment has not yet arisen.

Creditors have three main options when a debtor company is insolvent. Firstly, a creditor may opt to appoint a receiver if they have a security interest, thereby initiating the process known as receivership. Secondly, a creditor may opt to appoint a liquidator who will conduct the liquidation of the company. Finally, a secured creditor may opt to appoint a voluntary administrator and begin a voluntary administration.

Receivership for secured creditors

A receiver is a neutral, qualified, external administrator, appointed by a secured creditor or a court to take charge of the affairs and property of a company until its debts are paid or a court matter is settled. The receiver is given custodial responsibility for the subject’s property, including tangible and intangible assets and rights.

The duty of a receiver is to secure the amount of money owed to the creditors (primarily the secured one/s who appointed them) of a company which is in receivership usually because it is experiencing financial difficulty. The receiver must then pay out the money they collect. The receiver must also notify ASIC of any possible offences they discover during the receivership.

The receiver’s powers are stipulated by the court or by the terms of the creditor’s security and the document appointing the receiver. The appointment of a receiver is an old equitable remedy, though appointment by a court is now authorised.

Sometimes, the receiver is also given power to take control of the company – in that case, they’re known as a receiver and manager.

The receiver must send ASIC an annual administration return (a detailed list of their receipts and payments) each year on the anniversary of their appointment.

The receiver is not required to provide detailed reports to unsecured creditors.

The primary difference between receivership and other methods of managing an insolvent company is that a secured creditor chooses the receiver, to ensure they are paid. Thus, the main role of the receiver is to act on behalf of the secured creditor, potentially to the detriment of other creditors because of the priority rule. Receivers are often appointed under provisions of a security instrument which outlines their specific functions.

Liquidation (compulsory) for unsecured creditors 

Liquidation is the legal process by which a company is prepared for dissolution, involving cessation of its operations, realisation of its assets, payment of its debts and distribution of any balance to its members. Liquidation occurs when a company is formally wound up, generally after becoming insolvent, although a solvent company may be liquidated if the relevant parties decide that it should be closed. Liquidation can therefore be voluntary or involuntary. Increasingly, solvent business closures are being achieved through voluntary deregulation or allowing ASIC to complete strike-off action.

When an insolvent company enters liquidation, the winding-up process is overseen by an independent, qualified outsider known as the liquidator. In this scenario, the liquidator takes control of the company and aims to wind it up in such a way that the company’s creditors receive the maximum possible return. If there is a trading business, the liquidator almost always ceases trading because they risk personal liability for unpaid trading debts during their appointment. The liquidator may be proposed to the court by whoever put the company into liquidation (ie. members, directors, creditors or the court).

Appointment of the liquidator:

  • Appointed by either the members or creditors after consenting to do so 
  • In compulsory liquidation the court appoints the liquidator 
  • Liquidator is nominated by the person applying for the winding up order, to which the liquidator must also have given consent to act 
  • Reliant on liquidator agreeing to take an appointment as liquidator 

The responsibilities of a liquidator during an insolvent liquidation include:

  • Providing reports to creditors
  • Establishing the company’s financial position
  • Selling its assets
  • Investigating why the company failed
  • Investigating if any offences were committed by directors or staff
  • Making payments to creditors

There are three ways a liquidation may be initiated:

  • Creditors’ voluntary liquidation (insolvency) – where the company’s members elect to liquidate: see sections 497, 499 and 500 of the Corporations Act.
  • Court liquidation – where the court orders the liquidation of the business: see sections 233, 459A, 459B and 461 of the Corporations Act.
  • Members’ voluntary liquidation – where the members (shareholders) elect to liquidate a company must be solvent: see sections 495 and 496 of the Corporations Act.

There is no set timeframe for a liquidation. Most liquidations end about a year from the date of commencement, although some can take multiple years. A liquidation effectively ends once the liquidator has dealt with all of the company’s assets and distributed all its money to the creditors. However, there are still two formalities to be completed before the liquidation can officially end. First, the liquidator must provide ASIC with an end of administration return (which is a final account of receipts and payments). Second, ASIC must deregister the company, which occurs three months after the end of administration return is lodged.

Voluntary administration for security holders over a whole company

A company enters voluntary administration when a voluntary administrator is appointed to the company, generally by a company’s directors (or a liquidator or secured creditor), after they decide that the company is insolvent or likely to become insolvent.

Voluntary administration was introduced in Australia in 1993, and is relatively unpopular – in the 2016-17 financial year, of the 8,031 companies entering into external administration, 15% of those were voluntary administrations. 

Voluntary administration is a wholly legislative form of intervention – its procedure, practice and purpose are codified in Pt 5.3A of the Corporations Act.

The aim of voluntary administration is to assess the processes and financial prospects of a company with a view to continuing a company’s operations (if feasible).

In a voluntary administration, the voluntary administrator (an independent, qualified outsider) takes control from the directors and has full power over the company to determine its future. The voluntary administrator will use their position to gain an understanding of the company’s assets, liabilities and business prospects. Following their review, the voluntary administrator will do one of three things:

  • Place the directors back in control; or
  • Implement a deed of company arrangement; or
  • Put the company into liquidation.

What not to do when your company is insolvent

If your company becomes insolvent it is absolutely critical to uphold some base line standard practices, any failure to do so could be highly detrimental to your company or yourself as director. 

Do not neglect your financial records

Reliable financial information will help prevent a business from choosing the wrong strategy by giving the directors insight into why the business isn’t achieving the required rate of return. There are three ways to ensure a business has reliable financial information:

  1. Draw up an annual budget and cash flow forecast and as the year goes on compare the budget cash flow with actual figures;
  2. Ensure you know what your product/service costs to produce and what affect it would have on profits if for example, sales were increased or decreased by 10%; and
  3. Make sure your assets are valued correctly. 

When a business is failing it can be tempting to get ‘creative’ with accounting and this is one symptom of impending business failure. Avoid the temptation to:

  • Delay producing financial statements;
  • Continue paying dividends (ie. drawings) through incurring debt rather than retained earnings;
  • Cut expenditure on routine maintenance;
  • Start treating extraordinary income as ordinary income and vice versa;
  • Change the ownership title of main assets of the business;
  • Value assets at inflated figures;
  • Meet company debts out of your own pocket; and
  • Value stock of finished products at the current market selling price rather than at cost.

Do not delay obtaining professional advice

Insolvency is a complicated process. It is in your best interests to obtain professional advice as soon as you suspect that your business is, or will be, insolvent. Any delay will only worsen the outcome. 

Effective insolvency advisers usually include:

  • Insolvency practitioners – well versed in the insolvency industry and have many years of study and accreditation behind them. 
  • Insolvency lawyers – able to provide a suite of services, including debt recovery and management, restructuring and turnaround consultancy and legal advice and representation. This means they can see your matter through from start to finish.
  • Experienced businesspeople – experienced individuals in the fields of business and law make excellent turnaround advisers.
  • Small business financial counsellors – aim to identify a course of action which will equip the director/s and the business to better manage their circumstances.

Avoid insolvency advisers from the following categories:

  • Public accountants – likely unable or unwilling to devote the necessary time to manage an insolvent client and are not specifically trained in or experienced with insolvency and all of the legal and regulatory hurdles that come along with it. 
  • Failed liquidators – if these individuals have failed as liquidators, it likely indicates poor commercial acumen and an inability to recognise value and achieve the best outcomes for businesses. 
  • Commercial lawyers – commercial lawyers do not have the specialised skills and experience required to navigate business insolvency. 
  • Receivables financiers and short-term lenders – unlikely to have any turnaround experience and will only be able to provide a band-aid solution to cash flow problems, which will later turn into a bigger issue when it comes to paying them back. 
  • Unqualified advisers – those who do not have the appropriate affiliations or credentials are unlikely to have the contacts and the authority to act on your behalf, and those who do not have experience in insolvency scenarios will not be able to provide meaningful advice. 
  • You – to properly evaluate a business you need a ‘helicopter view’, and it is almost impossible for directors to get this kind of perspective when they are so closely invested in the business. 
  • Technicians generally – specialised technicians are unlikely to possess the breadth of industry knowledge necessary to orchestrate a turnaround or organise a successful formal appointment. 

Do not fall victim to untrustworthy advisers 

There are a range of different types of pre-insolvency advisers but unfortunately, it is a poorly regulated area. It is important to do your research on the different pre-insolvency advisers before engaging anyone. Look for real world experience, accreditations, a history of employment in the industry, transparent pricing structures, strong ethics, good strategic plans, no conflicts of interest and adequate recourses and time available to dedicate to your matter. 

The Association for Business Restructuring & Turnaround (ABRT) is one organisation working to ensure trustworthy advisors are operating in this area. The ABRT is a non-profit organisation established by restructuring and turnaround practitioners for the purposes of bringing recognition, credibility and professional standards to the industry. The organisation is using its collective expertise to promote economic regeneration, resolve financial distress for small and family businesses, save jobs and create the confidence and public trust which underpins the continuation of trade and sustainable economic growth. 

The Australian Financial Security Authority set out some of the warning signs of untrustworthy advisers to look out for:

  • They contact you out of the blue. 
  • They suggest you transfer assets owned by you, or your company, to another person or company without that person or company paying for them. 
  • They may be reluctant to provide their advice in writing. 
  • They may tell you to withhold or delay providing your records to your trustee or the company’s books and records to the liquidator. 

Do not continue trading whilst insolvent

Directors are under a duty to prevent insolvent trading under section 588G of the Corporations Act. A claim under section 588G is only available to a liquidator after a company has been placed into liquidation.

For a liquidator to make a claim for insolvent trading against a director or former director the following elements must be satisfied: 

  • the person was a director at the time that the debt was incurred;
  • the company was insolvent at that time, or became insolvent by incurring the debt;
  • at the time, there were reasonable grounds for suspecting insolvency, or that the company would become insolvent by incurring the debt; and
  • at the time, the director was aware that there might be grounds for suspecting insolvency or that a reasonable person in their position would be so aware.  

If the director suspects that the company was insolvent at the time the debt was incurred and their failure to prevent the debt was dishonest, they may be liable for criminal punishment.  

Note that the duty to prevent insolvent trading does not apply when a director is able to claim protection under the safe harbour from insolvent trading (section 588GA of the Corporations Act).

Do not breach director duties

Being a company director means that you assume personal legal duties. These duties cannot be delegated and the law is designed to limit the excuses for breach that directors have to avoid sanctions or paying compensation. In an insolvency scenario, a liquidator may look to enforce these claims (on behalf of the company and creditors) against the former directors.

The duties of company directors include both common law and statutory duties. These duties are set out above.

Do not transfer any assets for less than fair value

A creditor-defeating disposition occurs when an insolvent company transfers property for less than its reasonable market value. Liquidators have the power to claw back creditor-defeating dispositions by suing both the director and any professional advisor. If a creditor-defeating disposition has occurred, and that disposition is determined by a court to be voidable, a range of remedies will be available to creditors and liquidators. The primary remedy is the recovery of the property that has been transferred, which intends to restore the liquidator to the position they would have been in but for the disposition (ie. return of the property or physical compensation). 

Liquidators make a request under section 588FGAA that ASIC make an administrative order stating that the property involved in a creditor-defeating disposition be returned, that the amount representing the benefit be paid or that an amount that ‘fairly represents’ the proceeds be paid. Any failure to comply with the order is an offence which carries a fine of up to 30 penalty units or imprisonment of up to six months, or both. There are no examples of this being used at the date of writing but this is more efficient for liquidators compared to a court application.

Insolvency statistics – what type of enterprises are most likely to be insolvent?

General insolvency trends

According to ASIC, in the 2017-18 financial year, 11,057 companies were reported as being in external administration under the Corporations Act. This indicates that total corporate insolvency activity is on the decline.

  • NSW – 31%
  • VIC – 27%
  • QLD – 20%
  • WA – 13%
  • SA – 5%
  • ACT – 2%
  • NT – 1%
  • TAS – 1%

Furthermore, most external administrations are of small to medium businesses 

  • < 5 employees – 92% of company exits 
  • < 20 employees – 98% of company exits 

Insolvency by industry

ASIC further provides data pertaining to insolvency by industry between 2017 and 2018.

  • Other (business and personal) services 37% 
  • Construction 17% 
  • Accommodation and food services 12% 
  • Retail trade 8% 
  • Transport, postal and warehousing 5% 
  • Manufacturing 3% 
  • Rental, hiring and real estate services 2% 
  • Agriculture, forestry and fishing 2% 
  • Information media and tele-communications 2% 
  • Professional, scientific and technical services 2% 
  • Wholesale trade 1% 
  • FIS 1% 
  • Electricity, gas, water and waste services 1%
  • Unknown 1% 
  • Mining 1%
  • Education and training 1% 
  • Health care and social assistance >1%
  • Arts and recreation services >1%
  • Administrative and support services <1%
  • Public administration and safety <1%

How Australia compares internationally

The 2015 Australian Productivity Commission’s report titled ‘Business Set-up, Transfer and Closure’ provides a good insight into how Australia fares internationally in terms of insolvency.

The Productivity Commission reported that Australia has a relatively high entry rate that has largely been maintained while rates is some other countries have declined.

Chart: Entry rate for employing businesses, selected OECD countries, 2005 to 2013

Furthermore, Australia’s exit rate has declined marginally and remains low compared with some other countries.

Chart: Exit rate for employing businesses, selected OECD countries, 2005 to 2011

A final point of note, is that new businesses in Australia tend to have a higher rate of survival than those in other countries.

Chert: New business survival rates, selected OECD countries, 2007 to 2009

When is a construction company insolvent?

The construction industry in Australia

The construction industry in Australia has its own peculiar challenges. Each project requires significant estimation, rather than precise calculation, before the project begins. This is why quantity surveyors and project managers are so integral to the industry. It also means that it is difficult for construction companies to size up jobs and work out what their total costs will be.

This challenge is compounded by the prominence of sub-contracting in the industry. The client (often a property developer) enters into agreements with a contractor or contractors who have overall responsibility for the work on the project. That ‘head’ contractor then delegates work to sub-contractors who provide the ‘boots on the ground’. In the past, it has been estimated that up to 90 per cent of construction work is carried out by sub-contractors.

Construction is a competitive industry – this may mean that sub-contractors under-price their services in order to beat the competition. However, it is likely that the unpredictability of payment places ‘subbies’ in the toughest position. They are often signed up to a small number of large contracts which are carried out over an extended period of time. As ongoing payment is their source of cash flow, there is little buffer room if things go wrong. Furthermore, it’s often the case that they lack access to alternative sources of funding that may help them weather cashflow issues. Ultimately, the solvency of the subcontractor’s business is dependent on each large project being a success.

Compounding matters, the Australian property boom has propped up the construction industry for a long time. This means there has been a tendency for construction companies to assume that this will continue indefinitely and that payments will always be forthcoming. A housing slowdown (especially in NSW) would show this assumption to be unwise.

Consequences of the current operating model

The challenges faced by construction companies means that insolvency and liquidation rates are high. In September 2019, it was reported that liquidation rates were the highest they had been since September 2015. In addition, a heavy reliance on sub-contractors means that the industry as a whole is vulnerable to a ‘domino’ effect. The insolvency of the ‘head’ contractor may mean that sub-contractors reliant on that income are forced into liquidation.

Further compounding the insolvency risks in the construction industry is the impact of unscrupulous ‘phoenix operators’. The Inquiry by the Senate Standing Committee on Economics (Senate Inquiry) examined the extent to which pre-insolvency advisors were recommending ‘phoenix activity’ (an activity which, in its illegal form, means transferring assets for less than fair market value to another company before liquidation). Through this mechanism, it is alleged that some construction companies have been intentionally liquidating in order to avoid paying their debts. The Senate Inquiry looked in-depth into Walton Constructions (Qld) Pty Ltd (Walton’s), a company that collapsed in October 2013. In that case, the Senate Inquiry expressed concern over whether there had been professional advice which had facilitated phoenix activity. The Senate Inquiry ultimately concluded that hard-wired illegality is a deep feature of the construction industry.

There may be legal structuring options that mitigate insolvency risk. For example, some construction businesses have considered setting up a separate legal entity for each construction job. However, this is not always possible. It is often a requirement of a developer’s procurement process that contractors and sub-contractors have a history of solvency.

It is difficult to apply general standards of insolvency in the construction industry where it is the nature of the work that there is a significant lag between work completed and payment.  Accrual accounting is misleading – cash flow is king. Consequently, the cash flow test is the most commonly used test in Australia and is the de facto test for building sub-contractors.  Construction companies are banking on the prompt payment of each account and have few alternative sources of financing.

Employing the cashflow test, how do we determine whether a company is solvent or insolvent? It is a holistic judgment, but the most important financial ratio to be considered is the current ratio; comparing the companies short-term (current) assets with its short-term (current) liabilities. Relatedly, it is important to consider the Accounts Receivable Aging Schedule. If it is shown that accounts are being collected slower than usual or expected, this is a sign that cashflow problems are on the horizon.

The reality for subcontractors is that they are dependent on every job being a success. If one major job were to collapse they would still be on the hook for the employee and tax obligations flowing from their operations. A better indicator may be the quality of their developer clients and the integrity of their future payment arrangements.

External indicators of insolvency

The cashflow test is important for construction companies themselves to consider, but other parties won’t have access to that private financial information. As an independent third party, what indicators are there that building contractor might be having solvency issues?

In ASIC v Plymin & Ors (2003) 46 ASCR 126, Justice Mandy of the Supreme Court of Victoria referred to a checklist of 14 indicators of insolvency. In addition to liquidity issues, companies involved in the construction industry should ask whether there are any signs that the construction companies it is dealing with are experiencing the following problems:

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

Subcontracts have zero chance of obtaining any information from their developers that may give them prior warning of the above. The best pre-contract investigations likely involve contacting the developer’s former subcontractors to check their prior dealings.

How should construction companies anticipate and deal with potential solvency issues?

While it is inevitable that some construction companies do end up being liquidated, the poor returns to creditors mean that this is an outcome to be avoided, if possible. A range of options that might be considered include:

  • Alternative financing. Receivables Finance based on incoming payments could be used to bridge the gap between work and payment, but this can have high costs that soak up potential profits. While historically sub-contractors might have considered a mortgage facility on their own home, this has high risks and the latest generation of sub-contractors are less likely to have the necessary equity.
  • Voluntary administration. This is a process where a troubled company appoints an independent professional to come to a ‘Deed of Company Arrangement’ (‘DOCA’) with creditors and, hopefully, save the business as a going concern. However, in Australia, the outcomes of this process are extremely poor for both the company itself (it usually ends up liquidated) and creditors (returns on a DOCA are usually paltry). 
  • Pre-insolvency advice and restructuring. Companies should consider whether ‘safe harbour’ provisions of the Corporations Act could be used to legitimately restructure a struggling business.

The writer’s view is that 95% of voluntary administrations fail to meet the stated objective of the regime, being saving goodwill value of insolvent businesses, saving jobs and repaying a decent percentage of unsecured creditor debts (in double digits).

The most important step to take in order to avoid insolvency in the construction industry is preventative. Construction companies, and especially sub-contractors, need to consider how they can organise their business better from the beginning to avoid the identified pitfalls. This includes, for example:

  • Investing in better accounting support – quicker information is best for identifying the correct response to cashflow problems while they can still be addressed.
  • Engaging a counsellor if the directors or key staff have drug, alcohol or gambling problems or are suffering from a relationship breakdown.
  • Optimal company structuring to best separate risk and ownership (eg. determining that a separate trust should hold the plant and equipment).
  • More conservative growth ambitions to ensure that jobs aren’t under-priced or risky developers taken on.
  • Manage by objectives and set Key Performance Indicators for all staff.

When is a transport company insolvent?

The transport industry in Australia

According to the Australian Industry and Skills Committee (AISC) the Australian transport and logistics sector has ‘an estimated annual revenue of $102.87 billion, with an operating profit of $10.14 billion’. Furthermore, AISC state that across the major subsectors of road transport, warehousing and stevedoring, the sector employs more than 500,000 people. 

The transport industry is very distinct and is characterised by a number of unique factors. For example, according to Macks Advisory, the Australian transport industry is characterised by low barriers to entry including low capital requirements, low skilled operator requirements and a diverse customer and supplier base. As a consequence of this, the industry is fragmented, price driven with low profit margins, restricted opportunities for service differentiation and developing slowly cpmpared to other sectors. As such the industry is heavily dependent on the economy’s health and in general very low margins are expected throughout the industry. This poses a number of issues moving forward. 

Challenges moving forward

Moving forward, Infrastructure Australia estimates that between 2011 and 2031, the total domestic land freight task will grow by 80%. This will be driven by unprecedented population growth, increased demand from Asian trading partners and rapid changes in technology, e-commerce and consumer behaviour. Faced with this projected advancement the Australian Government projects that national supply chains and infrastructure will need to evolve in order to ensure that economic productivity within the sector can be maintained. However, a number of challenges will likely arise. For example, continuing population growth and technological advances throughout the sector will pose new challenges for businesses operating within the industry. 

Consequences of the current operating model

The challenges faced by transport companies mean that insolvency and liquidation rates are high. According to ASIC report number 596, titled ‘Insolvency statistics: External administrators’ reports (July 2017 to June 2018)’, the transport, postal and warehouse industry is the fifth highest ranking industry on the basis of external administrator reports lodged. 

How should transport companies anticipate and deal with potential solvency issues?

While it is inevitable that some transport companies do end up being liquidated, the poor returns to creditors mean that this is an outcome to be avoided, if possible. A range of options that might be considered include:

  • Alternative financing. Receivables Finance based on incoming payments could be used to bridge the gap between work and payment, but this can have high costs that soak up potential profits.
  • Voluntary administration. This is a process where a troubled company appoints an independent professional to come to a ‘Deed of Company Arrangement’ (‘DOCA’) with creditors and, hopefully, save the business as a going concern. However, in Australia, the outcomes of this process are extremely poor for both the company itself (it usually ends up liquidated) and creditors (returns on a DOCA are usually paltry). 
  • Pre-insolvency advice and restructuring. Transport companies should consider whether ‘safe harbour’ provisions of the Corporations Act could be used to legitimately restructure a struggling business.

The writer’s view is that 95% of voluntary administrations fail to meet the stated objective of the regime, being saving goodwill value of insolvent businesses, saving jobs and repaying a decent percentage of unsecured creditor debts (in double digits).

The most important step to take in order to avoid insolvency in the transport industry is preventative. Transport companies need to consider how they can organise their business better from the beginning to avoid the identified pitfalls. This includes, for example:

  • Investing in better accounting support – quicker information is best for identifying the correct response to cashflow problems while they can still be addressed.
  • Engaging a counsellor if the directors or key staff have drug, alcohol or gambling problems or are suffering from a relationship breakdown.
  • Optimal company structuring to best separate risk and ownership (eg. determining that a separate trust should hold the plant and equipment).
  • More conservative growth ambitions to ensure that jobs aren’t under-priced or risky.
  • Manage by objectives and set Key Performance Indicators for all staff.

Insolvency statistics

ASIC has outlined that the ‘transport, postal and warehousing’ category recorded 379 insolvencies between July 2017 and June 2018, which made up 5 per cent of the 7,613 cases across 24 industries.

ASIC recorded that the main causes of business collapse included: 

Inadequate cash flow or high cash use191
Poor strategic management of business174
Poor financial control, including lack of records165
Trading losses136
Other121
Under-capitalisation84
Poor management of accounts receivable50
Poor economic conditions45
Fraud11
Industry restructuring7
Dispute among directors6
Natural disaster2
Deed of company arrangement failed1
Total993

Additional findings from ASIC:

  • In regards to assets, the transport industry ranked third in terms of the those with the greatest percentage of reports estimating assets of $10,000 or less with 60.4%. The transport industry also made up 38.8% of assetless administrations.
  • In regards to liabilities, the transport industry ranked second in terms of the those with the greatest percentage of companies with estimated liabilities of $250,000 with 43.8%. 
  • Most transport companies going into administration owed less than $500,000 with 226 transport, postal and warehousing companies owing $0. Only 36 of the total 379 transport, postal and warehousing companies owed more than $500,000.
  • Most transport companies (241) owed between $1–$250,000 in unpaid taxes and charges.
  • Most transport companies (321) had less than 25 unsecured creditors, with the amount owed totalling less than $250,000 50% of the time.
  • In 92% of the total 379 transport, postal and warehousing external administrations, the amount payable to unsecured creditors was 0 cents.

What happens after personal bankruptcy is over?

Whilst an individual is bankrupt, they must fulfil various obligations and abide by various restrictions for a period of at least 3 years (undischarged bankrupt). These obligations and restrictions have numerous implications upon both the bankrupt and their family. For instance, amongst many other impacts, bankrupts are required to cooperate in protracted administrative and legal processes that may involve extensive questioning. The bankrupt will also be required to surrender their passport, disclose that they are bankrupt when applying for credit and deliver all relevant documents and evidence before examinations. Working restrictions may be imposed and partnerships will be dissolved. The family of the bankrupt will also be required to cooperate with onerous and demanding examinations, the failure to do so is an offence. 

But personal bankruptcy is only imposed upon an individual for a defined period of time, it is not meant to be a permanent status. When the period of bankruptcy is over, the individual will be able to resume conducting their normal consumer and business life. Bankruptcy will end in one of two ways; either through an automatic discharge or an annulment. 

Discharge

A discharge from bankruptcy is an order from the court discharging a bankrupt from bankruptcy. It means that the period of bankruptcy has concluded and the person is no longer an undischarged bankrupt. Discharge also completes the process of releasing the bankrupt from all pre-bankruptcy provable debts (regardless of whether creditors have been paid). This typically occurs automatically, three years and one day after the person’s statement of affairs is accepted, although this can be extended for non-compliance. Objections to automatic discharge can be lodged by the trustee to induce further compliance from a bankrupt. These typically extend the period of bankruptcy by either five or eight years. The provisions for discharge are outlined under section 149 of the Bankruptcy Act. After they are discharged, the bankrupt is no longer required to comply with most of the provisions of the Act, but they retain some ongoing obligations to assist the trustee in bankruptcy who was assigned to manage their affairs.

When the bankrupt is discharged, most pre-bankruptcy debts are extinguished. Exceptions include:

  • Court imposed fines for offences against the law
  • Damages claims from accidents
  • Debts under maintenance agreements/orders
  • Some student loan debts
  • Fraudulently incurred debts

Annulment

Pursuant to the Bankruptcy Act a person’s bankruptcy can be annulled, meaning that the bankruptcy would be treated as though it had never occurred (however a bankrupt’s name will still appear on the National Personal Insolvency Index). There are three main ways that a bankruptcy can be annulled:

  1. By proposal;
  2. By payment of debts; and
  3. By court order.

Proposal

Pursuant to section 74(1) of the Bankruptcy Act, a proposal can be made by a creditor under section 73 for a composition of the satisfaction of debts (ie. an alternate arrangement). This type of proposal must only be put to and accepted by a bankrupt’s creditors and usually will only be accepted if the composition would put the creditors in a better position vis-à-vis a person being bankrupt.

Payment of debts

Pursuant to section 153A of the Bankruptcy Act a person’s bankruptcy can be annulled if the trustee is satisfied that all of the bankrupt’s debts have been paid in full (if the debt includes interest the interest must be paid up until the date that the debt is satisfied).

Court order

Pursuant to section 153B of the Bankruptcy Act, if the court is satisfied that the sequestration order made to bankrupt a person ought not to have been, or a debtor’s petition for a sequestration order ought not to have been presented or accepted, a court can make an order for the annulment of bankruptcy. Annulment places the bankrupt in the same position as they were in prior to the bankruptcy.

If a bankruptcy is annulled any surplus assets that are left after the payment of the trustee’s remuneration will be given back to the bankrupt. However, all creditors who have security interests over these assets will retain their rights in relation to those assets and the bankrupt will still be liable for all the debts payable that were not provable in bankruptcy.

What type of transactions get clawed back after bankruptcy or winding up?

Insolvent or ‘voidable’ transactions are payments or transfers from an individual’s or a company’s asset pool to a third party that are made whilst insolvent. They are often referred to as antecedent transactions, which means they have been made before an individual becomes bankrupt or before a company becomes insolvent. These transactions are provided for in both the Bankruptcy Act and the Corporations Act

There are several defences that can be mounted against an attempt to claw back a voidable transaction:

  • Good faith
  • Running account balance
  • Secured creditor status
  • Ultimate effect doctrine (a.k.a. landlord defence) for unfair preference claims

Unfair preferences

Unfair preferences are the most common type of voidable transaction. They occur where a creditor has received payment (or another advantageous transaction) for a debt they are owed, giving them an advantage over other creditors who weren’t paid. The funds from unfair preference payments will only be able to be clawed back where they were received by a creditor who knew, or ought to have known, that the company was insolvent.

Unfair preference claims in corporate insolvency 

Section 588FA of the Corporations Act governs unfair preference claims made against insolvent corporations. This section treats a transaction as an unfair preference where it meets certain criteria.

(1) A transaction is an unfair preference given by a company to a creditor of the company if, and only if:

(a) the company and the creditor are parties to the transaction (even if someone else is also a party); and
(b) the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company; even if the transaction is entered into, is given effect to, or is required to be given effect to, because of an order of an Australian Court or direction by an agency.

A preference claim is generally pursued by the liquidators of an insolvent company to claw back funds for the purpose of disbursing them among the creditors.

Unfair preference claims in bankruptcy 

Section 122 of the Bankruptcy Act governs unfair preference claims made against bankrupt individuals. The section outlines the following:

(1)  A transfer of property by a person who is insolvent (the debtor) in favour of a creditor is void against the trustee in the debtor’s bankruptcy if the transfer:

(a)  had the effect of giving the creditor a preference, priority or advantage over other creditors; and

(b)  was made in the period that relates to the debtor, as indicated in the following table.

Periods during which transfers of property may be void

Description of petition leading to debtor’s bankruptcyPeriod during which the transfer was made
Creditor’s petitionPeriod beginning 6 months before the presentation of the petition and ending immediately before the date of the bankruptcy of the debtor
Debtor’s petition presented when at least one creditor’s petition was pending against a petitioning debtor or a member of a partnership against which the debtor’s petition was presentedPeriod beginning on the commencement of the debtor’s bankruptcy and ending immediately before the date of the bankruptcy of the debtor
Debtor’s petition presented in any other circumstancesPeriod beginning 6 months before the presentation of the petition and ending immediately before the date of the bankruptcy of the debtor

Uncommercial transactions or undervalued transactions

Uncommercial transactions (terminology used within corporate insolvency) or undervalued transactions (terminology used within personal bankruptcy) are recoverable. The purpose of classifying and clawing back uncommercial transactions is to prevent and rectify transactions that involve clear inequality of exchange.

Uncommercial transactions (in the context of corporate insolvency)

An uncommercial transaction is defined under section 588FB of the Corporations Act:

(1) A transaction of a company is an uncommercial transaction of the company if, and only if, it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction having regard to:

(a) the benefits (if any) to the company of entering into the transaction; and
(b) the detriment to the company of entering into the transaction; and
(c) the respective benefits to other parties to the transaction of entering into it; and
(d) any other relevant matter

This section applies where:

  • A gift of property is given for no consideration
  • Property is sold at an amount below market value
  • An agreement to pay far greater than market value for property or services is brokered

Undervalued transactions (in the context of bankruptcy)

Undervalued transactions occur where a bankrupt gives away their assets or sells them at a low price prior to being declared bankrupt. Section 120 of the Bankruptcy Act focuses on the effect of the transaction on the creditors rather than the type of transaction, and as such, it is unnecessary to show that the bankrupt had any intent to avoid creditors.

Section 120 states that undervalued transactions are recoverable (recoverable on the court’s order) if it took place in the period of the five years before the bankruptcy commenced, and the transferee gave no or under market value consideration for the property. There are certain further qualifications on time and nature as to the transferee.

(1) A transfer of property by a person who later becomes a bankrupt (the transferor) to another person (the transferee) is void against the trustee in the transferor’s bankruptcy if:

(a) the transfer took place in the period beginning 5 years before the commencement of the bankruptcy and ending on the date of the bankruptcy; and
(b) the transferee gave no consideration for the transfer or gave consideration of less than the market value of the property.

There are also several exceptions under section 120(2):

(a) a payment of tax payable under a law of the Commonwealth or of a State or Territory; or
(b) a transfer to meet all or part of a liability under a maintenance agreement or a maintenance order; or
(c) a transfer of property under a debt agreement; or
(d) a transfer of property if the transfer is of a kind described in the regulations.

Creditor-defeating dispositions

A creditor-defeating disposition occurs when property is transferred for less than its reasonable market value. This process typically occurs during the winding up of a company, and may take place as part of a broader process of illegal phoenixing. This has the effect of preventing, hindering or significantly delaying assets from becoming available to meet the demands of creditors. 

Creditor-defeating dispositions in the context of corporate insolvency

Creditor-defeating dispositions in the context of company insolvency are outlined in section 588FDB of the Corporations Act. The section dictates that a disposition of property is a creditor-defeating disposition if:

  1. The consideration payable to the company for the disposition was less than the lesser of the following at the time the relevant agreement for the disposition was made or, if there was no such agreement, at the time of the disposition:
    • the market value of the property; or
    • the best price that was reasonably obtainable for the property, having regard to the circumstances existing at that time.
  2. The disposition has the effect of:
    • preventing the property from becoming available for the benefit of the company’s creditors in the winding-up of the company; or
    • hindering, or significantly delaying, the process of making the property available for the benefit of the company’s creditors in the winding-up of the company.

The legislation further extends the concept of a disposition by providing that:

  • If a company does something that results in another person becoming the owner of property that did not previously exist, the company is taken to have made a disposition of the property.
  • If a company makes a disposition of property to another person and the other person gives some or all of the consideration for the disposition to a person (third party) other than the company, then the company is taken to have made a disposition of the property constituting so much of the consideration as was given to the third party.

A creditor-defeating disposition will be voidable under section 588FE(6B) of the Corporations Act if three criteria are met:

  1. The transaction is a creditor-defeating disposition of property of the company.
  2. At least one of the following applies:
    • the transaction was entered into, or an act was done for the purposes of giving effect to it, when the company was insolvent, during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
    • the company became insolvent because of the transaction or an act done for the purposes of giving effect to the transaction during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
    • less than 12 months after the transaction or an act done for the purposes of giving effect to the transaction, the start of an external administration of the company occurs as a direct or indirect result of the transaction or act; and
  3. The transaction, or the act done for the purpose of giving effect to it, was not entered into, or done:
    • under a compromise or arrangement approved by a Court under s 411; or
    • under a deed of company arrangement executed by the company; or
    • by an administrator of the company; or
    • by a liquidator of the company; or
    • by a provisional liquidator of the company.

The Corporations Act also sets out a range of new duties to prevent creditor-defeating dispositions. In particular it sets out that:

  • An officer of a company must not engage in conduct that results in the company making a creditor-defeating disposition of property of the company.
  • A person must not engage in conduct of procuring, inciting, inducing or encouraging the making by a company of a disposition of property that results in the company making the disposition of the property.

The key takeaway here is that liability now extends to other persons who facilitate a company making a creditor-defeating disposition, including professional advisers such as solicitors. This widens the scope to better deter phoenix activity and provides greater recourse for liquidators to receive compensation.

If a creditor-defeating disposition has occurred, and that disposition is determined by a court to be voidable, a range of remedies will be available to creditors and liquidators. The primary remedy is the recovery of the property that has been transferred, which intends to restore the parties to the position they would have been in but for the disposition. In addition, a court may also provide that compensation be paid to creditors or liquidators where necessary. It would be expected that liquidators would prefer a claim for cash compensation.

Furthermore, the new regime introduces criminal and civil penalties for individuals and corporate bodies that contravene the duties outlined above. To be held criminally liable, the individual or body must have been reckless as to the result of their conduct. To be held civilly liable, the individual or body must have been unreasonable in their conduct. If such a standard is proven, hefty penalties can be enforced by the court including fines of up to 4,500 penalty units for individuals and 45,000 penalty units for corporations. Individuals can also be imprisoned for up to 10 years and corporations can be fined up to 10% of their annual turnover. 

Creditor-defeating dispositions in the context of bankruptcy

Creditor-defeating dispositions in the context of personal bankruptcy are outlined in section 121 of the Bankruptcy Act. The section dictates that a disposition of property is a creditor-defeating disposition and therefore void if:

(a)  the property would probably have become part of the transferor’s estate or would probably have been available to creditors if the property had not been transferred; and

(b)  the transferor’s main purpose in making the transfer was:

(i)  to prevent the transferred property from becoming divisible among the transferor’s creditors; or

(ii)  to hinder or delay the process of making property available for division among the transferor’s creditors.

The Bankruptcy Act further dictates that the consideration must be refunded. The trustee must pay to the transferee an amount equal to the value of any consideration that the transferee gave for a transfer that is void against the trustee.

While the corporate veil usually separates a director from the separate legal entity that is their company, directors may be liable to claims for recovery of property or assets where financial transactions have occurred between a director’s personal assets and company assets in a four year period prior to a company’s winding up which was to the detriment of the company and creditors.

Unreasonable director related transactions are voidable, and may be clawed back in order to properly and fairly satisfy the debts of an insolvent company, ensuring creditors are paid back in the correct order of priority at law.

Section 588FDA of the Corporations Act defines unreasonable director-related transactions:

(1) A transaction of a company is an unreasonable director-related transaction of the company if, and only if:

(a) the transaction is:
(i) a payment made by the company; or
(ii) a conveyance, transfer or other disposition by the company of property of the company; or
(iii) the issue of securities by the company; or
(iv) the incurring by the company of an obligation to make such a payment, disposition or issue; and

(b) the payment, disposition or issue is, or is to be, made to: (i) a director of the company; or
(ii) a close associate of a director of the company; or
(iii) a person on behalf of, or for the benefit of, a person mentioned in subparagraph (i) or (ii); and

(c) it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to:
(i) the benefits (if any) to the company of entering into the transaction; and (ii) the detriment to the company of entering into the transaction; and
(iii) the respective benefits to other parties to the transaction of entering into it; and
(iv) any other relevant matter.

Equitable fraud

Equitable fraud is defined by Black’s Law Dictionary as unintentional deception or misrepresentation that causes injury to another. This is a very broad conception of fraud that it somewhat vague and ambiguous in its application since unlike most other bodies of law, equity is not generally codified in statute. This sentiment was reflected by Branham and Kutash in their Encyclopaedia of Criminology, wherein they noted that ‘in equity the term fraud has a wider sense, and includes all acts, omissions, or concealments by which one person obtains an advantage against conscience over another, or which equity or public policy forbids as being to another’s prejudice; as acts in violation of trust or equitable fraud, or fraud in equity’. 

Equitable fraud may be used as a mechanism through which to claw back transactions after bankruptcy or winding up if the court feels that the transaction in question provides an undue advantage, prejudices another or is in breach of the vague and wide-ranging principles of equity. 

Equitable fraud was considered in the case of Barnes v Addy (1874) LR 9 Ch App 244. The case involved the misappropriation of trust funds by a trustee. The case’s ongoing significance revolves around its determination regarding the two limbs of third-party liability in relation to a breach of trust or fiduciary duty. The first limb concerns ‘knowing receipt’. Under this limb, a recipient of property transferred in breach of fiduciary obligation, or of the proceeds of such property, is liable to account as constructive trustee to the party to whom the fiduciary obligation is owed if 3 conditions have been met. The conditions are met if there has been a breach of fiduciary duty or trust, there has been a receipt by a third party and there has been a requisite level of knowledge proven on the facts. The second limb concerns ‘knowing assistance’. Under this limb, liability will be imposed for knowingly assisting the commission of a breach of fiduciary duty if the following 3 criteria are met. Firstly, there must be a dishonest and fraudulent breach of trust. The accessory must have assisted in a significant way to the commission of the breach. Finally, it must be established on the facts that a requisite level of knowledge was present. 

This case was pivotal in extending equitable fraud to third-parties and continues to be implemented in Australian law as a result of the fact that the High Court of Australia has accepted the Barnes v Addy principle.

Footnotes:

  1. Murray, Michael and Jason R Harris, Keay’s Insolvency: Personal and Corporate Law and Practice (Lawbook Co., 10th ed., 2018).
  2. van Zwieten, Kristin, Goode on Principles of Corporate Insolvency Law (Thomson Reuters, 5th ed., 2019).
  3. Garner, Bryan A and Henry Campbell Black, Black’s Law Dictionary (Thomson/West, 8th ed., 2004).
  4. AFSA Administration Statistics 2016-2017.
  5. AFSA Administration Statistics 2016-2017.
  6. Murray, Michael and Jason R Harris, Keay’s Insolvency: Personal and Corporate Law and Practice (Lawbook Co., 10th ed., 2018).
  7. Murray, Michael and Jason R Harris, Keay’s Insolvency: Personal and Corporate Law and Practice (Lawbook Co., 10th ed., 2018).
  8. Murray, Michael and Jason R Harris, Keay’s Insolvency: Personal and Corporate Law and Practice (Lawbook Co., 10th ed., 2018).
  9. Australian Institute of Criminology, Convictions for summary insolvency offences committed by company directors (2013) https://www.aic.gov.au/publications/rip/rip30.
  10. AFSA, Untrustworthy debt advisors (2016) https://www.afsa.gov.au/insolvency/cant-pay-my-debts/untrustworthy-debt-advisors.
  11. ASIC, Australian insolvency statistics (2020) https://download.asic.gov.au/media/5807403/asic-insolvency-statistics-series-2-published-october-2020.pdf.
  12.  ASIC, Australian insolvency statistics (2021) https://download.asic.gov.au/media/5946024/asic-insolvency-statistics-series-1a-published-february-2021.pdf.
  13.  Productivity Commission, Business Set-up, Transfer and Closure (2015) https://www.pc.gov.au/inquiries/completed/business#report.
  14. NSW Parliamentary Research Service, Construction Industry in NSW: Background to the Insolvency Inquiry (2013) https://www.parliament.nsw.gov.au/researchpapers/Documents/construction-industry-in-nsw-background-to-the-i/E-Brief%20Construction%20Industry%20in%20NSW.pdf.
  15. ABC News, Construction companies in NSW collapsing at record rate as building slowdown bites (2019) https://www.abc.net.au/news/2019-09-26/nsw-construction-companies-liquidated-in-record-numbers/11512002
  16. Australian Industry and Skills Committee, Transport and Logistics (2020) https://nationalindustryinsights.aisc.net.au/industries/transport/transport-and-logistics.
  17.  Macks Advisory, Transport industry risk analysis, https://www.macksadvisory.com.au/engage/practical-information/practice-pointers/transport-industry-risk-analysis/.
  18.  Infrastructure Australia, Australia’s growing freight task: Challenges and opportunities (2018) https://www.infrastructureaustralia.gov.au/listing/speech/australias-growing-freight-task-challenges-and-opportunities.
  19. ASIC, Report 596: Insolvency statistics: External administrators’ reports (2018) https://download.asic.gov.au/media/4936726/rep596-published-14-november-2018.pdf.
  20. ASIC, Report 596: Insolvency statistics: External administrators’ reports (2018) https://download.asic.gov.au/media/4936726/rep596-published-14-november-2018.pdf.
  21. Branham, Vernon C. and Kutash, Samuel B., Encyclopedia of criminology (New York: Philosophical Library 1949).

Others

Running Account Defence to an Unfair Preference Claim

What is the Running Account Defence to an Unfair Preference Claim?

Estimated reading time: 0 minutes

In insolvency, a liquidator sometimes seeks to recover money from a creditor on the grounds that the creditor has received an ‘unfair preference’ in a payment from the debtor company. Here we explain how the ‘running account’ principle can be used by a creditor to push back against a liquidator’s claim of unfair preference.