insolvency

What is the legal meaning of Insolvency?

Insolvency is the term that is used to describe the position of a company when it is unable to pay its debts as they become due and payable (section 95A of the Corporations Act 2001 (Cth)). It is interpreted by the Courts using what is known as the “cash-flow test”. If directors of a company suspect that the company is or may become insolvent, they may be trading whilst insolvent.

Section 95A of the Corporations Act

“Insolvency” is the term that is used to describe the position of a company when it is unable to pay its debts as they become due and payable.
Section 95A of the Act defines insolvency by providing a definition of what insolvency is not (i.e. 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.

Cash flow versus balance sheet

At common law there are two tests that measure whether a company is insolvent. These tests are known as the “cash-flow test” and the “balance sheet test”. The cash-flow test refers to the assessment of the ability of a company to pay its debts (or sell its assets fast enough to satisfy its debts) as they become due and payable.

On the other hand, the balance-sheet test assesses the solvency of a company in reference to the total external liabilities against the total value of company assets. Therefore, if a company’s liabilities are greater than the total sum of its assets, the company is insolvent.
The cash-flow test is the principal test that is used by the Courts when determining whether a company is solvent. 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. Justice Owen in The Bell Group Limited (In Liquidation) v Westpac Banking Corporation [No.9] (2008) WASC 239 describes the threshold as 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 “debt” under section 95A?

The meaning of a “debt” under section 95A of the Act is not expressly defined so we need to look at common law. 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).

What are the indicators of insolvency?

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:

  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 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 could 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.

Presumptions of insolvency

Pursuant to section 459C (2) there are various circumstances that 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 presumptions of insolvency are:

  1. A company has failed 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.

Key takeaway

If directors of a company suspect that the company is or may become insolvent it is vital that steps are taken to ensure that action is not commenced either against the company or them in their personal capacity (e.g. 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 the above 3 options.

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