Liquidation or ‘winding up’ is either forced upon the company by creditors as a ‘compulsory’ liquidation, or is a choice made by the directors and shareholders of the company: a ‘voluntary’ liquidation. Our focus in this article is on the latter.
Estimated reading time: 10 minutes, Updated April 2020
Voluntary liquidations come in two forms: The first, a members’ voluntary liquidation or ‘MVL’, can be implemented when the company is still capable of paying its debts as they fall due (the company is ‘solvent’). The second, a creditors’ voluntary liquidation, or ‘CVL’, can be implemented when the company is insolvent.
In looking at when voluntary liquidators can be appointed, we consider:
- Why directors may wish to terminate a company;
- The meaning of solvency and insolvency in voluntary liquidation;
- The key elements of a members’ voluntary liquidation;
- The key elements of a creditors’ voluntary liquidation;
- How voluntary liquidations compare to other formal insolvency appointments;
- How to avoid appointment of a voluntary liquidator;
- When you shouldn’t appoint a liquidator – a checklist.
The overall message is that company directors should avoid getting themselves in the position where appointment of a voluntary liquidator is required. Instead, they should carefully consider the possibility of using the ‘standard’ safe harbour or the new COVID-19 temporary safe harbour in order to re-organise, re-structure and save the business.
Why end or terminate a company?
Under Australian company law, the director or directors of a company have ultimate ‘oversight’ over the company – the buck stops with them. This means, directly or indirectly, they are often the ones pushing to end a company through a liquidation process.
Other key players in the life and death of a company, are the ‘officers’ and the ‘members’. Officers manage, and carry out day-to-day business operations on behalf of directors (for example, the CEO and CFO are usually officers). ‘Members’ typically own shares in the company, and make decisions on important matters, such as changes to the company constitution and decisions to wind up a company. This is achieved via ‘special resolutions’ of the members.
Directors, officers and members all have rights and obligations under legislation, regulations, company constitutions and by-laws. The reality for small-to-medium-sized enterprises (businesses with less than 200 employees) is that the directors, officers and members are the same people or at least members of the same family.
There are many reasons why directors of an otherwise successful company may wish to end that business by appointing a qualified individual (a liquidator) to finalise the company’s affairs and liquidate its remaining assets: the legal procedure known as ‘liquidation’. For example,
- Sale of business through the sale and purchase of assets (as opposed to the sale of a business through the acquisition of shareholding) and the existing company no longer trading;
- The purpose for the existence of the company has ceased;
- A restructure of a group of companies whereby a subsidiary is voluntarily wound up.
At other times, the business may not be going so well. It may be insolvent, or on the brink of insolvency. At this point, directors are forced to seriously question the continued existence of the company. This is because:
- Directors can be found personally liable for continuing to trade while insolvent;
- Directors could have personal liability for tax debts via a ‘Director Penalty Notice’ issued by the Australian Tax Office.
Liquidation is not the only formal legal mechanism for ending the existence of a company: They can also be de-registered. However, while it is a relatively straightforward process, the following conditions must be met before doing so:
- All members must agree to doing so;
- The company must no longer be trading;
- Assets must be worth less than $1,000;
- There must be no outstanding debts or liabilities;
- The company must not be involved in any outstanding court proceedings; and,
- The company must have paid all outstanding fees and penalties.
As it is rarely the case that a recently trading company will be in this position, a voluntary liquidation is usually a necessary first step towards de-registration of the company.
For more information on this process see the Australian Securities & Investment Commission’s How to apply for voluntary deregistration.
If directors do not take seriously the decision to end the company and the question of solvency, there is a risk that a court will find them insolvent, and they will be subject to a compulsory liquidation. When this occurs, the court appoints a liquidator to supervise the winding up of the company by application of the creditors, members, the liquidator or a regulator.
Voluntary liquidation and insolvency
There are two types of voluntary liquidation: a members’ voluntary liquidation (‘MVL’) and a creditors’ voluntary liquidation (‘CVL’). Under section 494 of the Corporations Act 2001 (Cth), an MVL requires that a majority of directors make a ‘declaration of solvency’. If directors consider that the company is insolvent, and they seek to liquidate, they must initiate the CVL process, rather than the MVL process.
The question of solvency/insolvency is not just about which kind of liquidation must be carried out, however. It also impacts on the personal liability of directors for insolvent trading, and the possibility of another formal insolvency appointment such as a ‘voluntary administration’.
In light of the importance of solvency and insolvency, what exactly is the difference?
Section 95A of the Corporations Act 2001 (Cth) defines solvency and insolvency as follows:
- 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.
- A person who is not solvent is insolvent.
According to the decisions of Courts (‘common law’), there are two tests for insolvency.
- The cash-flow test: assesses the ability of a company to pay its debts (or sell its assets fast enough to pay its debts) as they become due and payable;
- The balance sheet test: assesses the solvency of a company in reference to the total external liabilities against the total value of company assets. If liabilities exceed assets, the company is insolvent.
The cash-flow test is the principal test used by the Courts because it follows more closely the section 95A definition above. It 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.
A key takeaway from the definition of insolvency is that it may not be obvious whether a company is solvent or insolvent. It is not enough to have a ‘temporary lack of liquidity’, there must be an ‘endemic shortage of working capital’ as per the decision in ASIC v Plymin (2003).
Note also that under recent COVID-19 insolvency law changes, there will usually be a longer period in which to ascertain whether a company is solvent or not. The increased time period (from 21 days to 6 months) for a business to respond to a statutory demand for payment from a creditor, means a much longer period before the company can be ‘deemed’ insolvent. This makes it more difficult for an unpaid creditor to establish insolvency and initiate a compulsory liquidation. But it might also be a relevant factor for directors themselves in establishing whether the business is solvent – capable of paying debts as they fall due.
For more information on the COVID-19 insolvency law changes, read our new blog post here.
The key elements of a members’ voluntary liquidation
As mentioned, in an MVL, the directors make a ‘declaration of solvency’ which gets the ball rolling. A meeting is then called of the members of the company to resolve by ‘special resolution’ (75% of members who attend the meeting voting in favour), to wind up the company: see section 491 of the Corporations Act 2001 (Cth).
Accompanying the declaration of solvency which is sent to members, must be a copy of the company’s statement of affairs. The declaration is required, pursuant to section 494(3) of the Corporations Act 2001 (Cth), to be:
- Made at the meeting that considers the MVL;
- Lodged with Australian Securities & Investments Commission (‘ASIC’) before the notice of the meeting is given; and,
- Made within 5 weeks of the date of the resolution to give effect to the MVL.
If these requirements are not met, the declaration of solvency will be ineffective and the winding up of the company will not be an MVL.
If the above requirements are met, and a company is successful in passing a resolution for a MVL to take place, a voluntary liquidator will be appointed. Normally, pursuant to section 532 (1) and (2) of the Corporations Act 2001 (Cth), an appointed liquidator of a company must be a registered liquidator and be independent of the company.
However, pursuant to section 532(4) of the Corporations Act 2001 (Cth), if a company is a proprietary company and the winding up is a MVL, the appointed voluntary liquidator is not required to be a registered liquidator and can be an officer of the company or other professional with the necessary expertise.
The key elements of a creditors’ voluntary liquidation (CVL)
A CVL, unlike a MVL, occurs when a voluntary liquidator is appointed to an insolvent company. Although a CVL is described as a ‘creditors’’ winding up, the creditors of a company are in fact unable to commence a CVL and they are usually instigated by the company director(s).
If a director forms the opinion that the company is insolvent (i.e. unable to pay debts as they become due and payable, see section 95A) and no declaration of solvency can be made, they can convene a meeting of members and resolve to pass a special resolution (75% of members after quorum is needed), to wind the company up. Creditors are not required to attend the meeting where it is resolved to wind up a company.
At the meeting, the company will appoint a voluntary liquidator. The appointed creditors’ voluntary liquidator in these circumstances, as referenced above, must comply with section 532 (1) and (2) and be a registered liquidator and independent from the company.
Although the appointment of a creditors’ voluntary liquidator through the determination of insolvency by a director is the most common type of CVL, there are other ways that the liquidator can be appointed. These include:
- The members’ voluntary liquidator appointed under a MVL determines that the company is actually insolvent and the appointment of a creditors’ voluntary liquidator is required;
- Transition from voluntary administration to a CVL; and
- ASIC appointment.
How MVLs and CVLs compare to other insolvency processes
Voluntary liquidation is not the only formal insolvency appointment available to directors when a company is financially struggling. Some might consider ‘voluntary administration’: A process where an independent professional takes control of an insolvent or near-insolvent company with the goal of coming to a successful ‘Deed of Company Arrangement’ or ‘DOCA’ with creditors to settle their outstanding claims.
The chart below compares the rates of different types of insolvency with voluntary administrations. As you can see, CVL is more-or-less four times more common than a voluntary administration.
Why is this? It might be that, by the time that a company seeks advice on a formal insolvency appointment, it is in so much difficulty that winding up is inevitable. Or, it could be that a voluntary administration is interpreted as a “glorified liquidation” anyway, in which case going straight to liquidation would reduce formal appointment costs. For more information see What are the Success Rates of Voluntary Administration?
Avoiding formal insolvency appointments
Whether a CVL, a voluntary administration or a compulsory liquidation, formal insolvency appointments usually mean the death of the business. So, what is the lesson here?
There are two key mechanisms currently available which may enable directors to put a plan together to save the company. These are:
- The COVID-19 Safe Harbour. The Coronavirus Economic Response Package Act also provides a new temporary ‘safe harbour’. Directors will not be personally liable for insolvent trading where they meet the following conditions:
- the debt is incurred in the ordinary course of business;
- the debt is incurred in the six-month period from when the law comes into effect;
- the debt is incurred before the appointment of the voluntary administrator or liquidator;
- Standard Safe Harbour. This safe harbour was introduced in 2017, but not all directors understand its implications well. It provides that the duty of a director not to trade while insolvent does not apply if:
- at a particular time after the director suspects insolvency, the director develops a course of action that is reasonably likely to lead to a better outcome for the company; and
- the company debt is incurred in connection with the course of action.
Both these mechanisms could be used in order to re-organise or restructure the business, such as through a ‘pre-packaged insolvency arrangement’ (‘pre-pack’). For more information see What you need to know before you pre-pack (to avoid phoenix activity)
When you shouldn’t appoint a voluntary liquidator – a checklist
We suggest that, before initiating the process for appointment of a voluntary liquidator, you consider the following checklist and do not appoint a voluntary liquidator if one of the criteria applies:
- As outlined above, if you plan to continue trading afterwards through buying assets from a liquidator. Instead, organise this before appointment through a pre-pack;
- If you have uncommercial transactions or unfair preference claims that can be made against you. In these cases, you need to see a lawyer first;
- If you have a directors’ loan account owing. This should be distributed as income first, or a lawyer should be engaged to look into it;
- If you haven’t vetted and qualified your proposed liquidator through a trusted source. For more information see How do you choose the right liquidator?;
- If you haven’t considered an informal restructure first as an option;
- If the COVID-19 insolvency law changes are still in place and you have not sought advice on their application to your situation.
- The decision whether or not to appoint a voluntary liquidator (or initiate the process), is a serious one for directors and it needs to be pursued with caution;
- The type of liquidation that is initiated, MVL or CVL, depends on whether the company is solvent (and whether directors are confident to make a declaration to that effect);
- A key difference between MVLs and CVLs is that the liquidator in an MVL is cheaper;
- Voluntary liquidations are four times as popular as voluntary administrations which may relate to the generally poor general success rates of voluntary administration;
- Directors should consider what steps they can take to avoid a voluntary liquidation and when they should pause before initiating this process;
- Directors should consider whether safe ‘standard’ safe harbour or ‘COVID-19’ safe harbour protections might be employed to pursue informal restructuring solutions such as ‘pre-pack’ arrangements.