1.0 WHAT IS INSOLVENT TRADING?
2.0 WHAT IS SOLVENCY?
(1) A person 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.”
Unfortunately, the usefulness of these definitions is limited except to the extent that the wording of the legislation recognises the availability of cash and credit resources as the primary determination of solvency. For further guidance in defining or recognising insolvency, it is necessary to refer to case law.
2.2 Assessing a Company’s Solvency
The assessment of the solvency of a company requires an analysis of the totality of the company’s circumstances, including industry norms and available credit. O’Brien Palmer was involved in the often reported case, Southern Cross Interiors Pty Ltd (In Liquidation) & Anor v The Deputy Commissioner of Taxation (2001) 188 ALR 114. In his judgment, His Honour Palmer J. stated that the following propositions could be drawn from the established authorities:
(i) A company’s solvency is a question of fact to be ascertained from considering its financial position as a whole.
(ii) In considering a company’s financial position as a whole, the Court must have regard to relevant commercial realities, such as what resources are available to a company to meet its liabilities as they fall due.
(iii) In assessing whether a company’s position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity, it is proper to have regard to the commercial reality that creditors will not always insist on payment strictly in accordance with their terms of trade but that does not constitute a cash or credit resource available to the company.
(iv) The commercial reality that creditors will normally allow some latitude for payment of their debts does not warrant a conclusion that the debts are not payable at the contracted time.
In assessing solvency, the Court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract.
These propositions, whilst informative, are somewhat broad. A further and useful commentary on solvency was given by His Honour Mandie J. in a judgement delivered in the high profile case of ASIC v Plymin & Anor (2003) 46 ACSR 126 (otherwise known as the Waterwheel Case). Justice Mandie adopted 14 indicia of insolvency which are now often utilised in assessing the solvency of a company. However, this list is not exhaustive. The Australian Securities & Investments Commission has also published a guide on the warning signs of Insolvency. O’Brien Palmer has previously published a newsletter entitled ‘Practical Signs of Insolvency’ that provides an analysis of the warning signs of insolvency that can be obtained from the O’Brien Palmer website (www.obp.com.au)
3.0 TEMPORARY OR ENDEMIC CASH FLOW INSOLVENCY
A company is insolvent where its available resources are insufficient to meet its debts. These resources include cash, assets readily convertible to cash and available credit such as an unused bank overdraft facility.
It is relevant to distinguish between a company that is insolvent and a company that is experiencing temporary cash flow issues. In the judgement of His Honour Jacobs J. in the matter of Hymix Concrete Pty Ltd v Garrity (1977) 13 ALR 321, it was acknowledged that:
An endemic shortage of working capital will be apparent where the company is utilising credit funds on terms that it cannot comply with or at debt levels beyond that which it can service. It would also be evident in circumstances where a company is otherwise displaying numerous signs of insolvency.
4.0 HOW A LIQUIDATOR PROVES INSOLVENCY
4.1 Steps to Prove the Date of Insolvency
In order to determine the date on which a Company is deemed to have become insolvent, an insolvency practitioner will review the available books and records of a company, as well as records obtained from third party sources such as creditors, banks and statutory authorities. In conducting this review, the practitioner is looking for evidence of indicia of insolvency. The key indicia of insolvency include the following;
(v) Payment of debts by way of instalments.
As a result of this review, it can become apparent that at a certain point in time, sufficient indicia of insolvency are present to justify a conclusion that the company was insolvent at that time.
Section 588E(3) of the Act provides that where the evidence supports a determination that a company became insolvent at a time within 12 months prior to the company being wound up, then it is presumed that the company was insolvent throughout the period between that time and the date that the company is wound up.
4.2 Debts Incurred
After a date of insolvency is established, the liquidator will then assess the debts incurred after that date, in order to determine the quantum of the personal liability of a director for trading whilst insolvent.
5.0 CLAIM FOR TRADING WHILST INSOLVENT
5.1 Prosecution of Insolvent Trading
Where it is determined that a company has traded whilst insolvent, an insolvency practitioner will, in the ordinary course, report this alleged contravention to the Australian Securities & Investments Commission (“ASIC”) in accordance with either sections 422,
438D or 533 of the Act.
A liquidator appointed may also take steps to seek compensation from the director(s) for the quantum of the debts incurred by the company after it became insolvent. These steps usually involve the issuance of a letter of demand to the director(s) for repayment of a fixed sum of money. The Liquidator may also instruct a solicitor to further pursue the claim where the initial demand is ignored or commercial settlement cannot be reached. The Liquidator may be required to commence proceedings against the director(s) to seek compensation orders. The commerciality of commencing such action may ultimately be dependent upon the ability of the director to meet any judgement that might be obtained.
In circumstances where there are multiple directors, the Liquidator is entitled to recover from whichever of the directors is most commercial to pursue. That director has a right of indemnity against their fellow directors to recover an equitable share of the amount recovered by the Liquidator.
5.2 Defences Available to Directors
Directors may have defences to a claim made for insolvent trading. Section 588H of the Act states that a director can claim a defence where he or she:
(i) had reasonable grounds to believe that the company was solvent at the time it incurred the debt, and that it would remain solvent even after incurring the debt;
(ii) can prove that the person in charge of providing accurate information concerning the company’s financial status and solvency was performing this task, and led the director to believe that the company was solvent and would remain to be so even after incurring the debt;
(iii) had good reasons not to be involved in the management of the company when it incurred the new debt, such as a result of a serious illness.
(iv) can prove that they took all reasonable steps to prevent the company from incurring the debt.
6.0 CONSEQUENCES OF INSOLVENT TRADING
6.1 Civil Penalties
6.2 Criminal Penalties
6.3 Compensation Orders
If a liquidator suspects a person may have breached their duty in preventing the company from trading whilst insolvent, then he or she, a creditor, or ASIC can take action against the director pursuant to Section 588M of the Act. A Court may order that the director repay the company to the value of the debts incurred from trading whilst insolvent.
It should be noted that a creditor can only take this action with the permission of the liquidator or leave of the court, and may only pursue the director for the value of its debt.
6.4 Holding Company Liability
Section 588V of the Act provides that a holding company may be liable for the insolvent trading of its subsidiary in circumstances where the directors of the holding company were aware, or should have been aware, of the insolvency of the subsidiary company.
7.0 SMITH V BONÉ, IN THE MATTER OF ACN 002 864 002 PTY LTD (IN LIQ)  FCA 319 – THE IMPACT OF REPAYMENT ARRANGEMENTS ON SOLVENCY
Mr Barry Boné was the sole company director of Petrolink Pty Ltd (“Petrolink”). In December 2011, Mr Smith was was appointed as Liquidator of the Company.
The Liquidator brought an action against the director seeking compensation for insolvent trading pursuant to section 588G of the Act for the losses suffered by Petrolink’s creditors.
IIn this dispute, the Liquidator claimed that Petrolink was insolvent from 30 June 2009 until the date on which the winding up commenced and that Petrolink continued to trade and incur debt throughout this period. However, the Director argued that his company was only insolvent from July 2011.
Relevant to the outcome of the case was the fact that Petrolink had entered into a payment arrangement with the Australian Tax Office (ATO), its main creditor, in order to discharge its outstanding debts.
7.2 The Director’s Defence
7.3 The Ruling
His Honour, Gleeson J, found that any reasonable person in the position of the director would have grounds to believe that the company was insolvent and that despite the revenue being generated by the company, its debts remained unpaid. In regard to the payment arrangement, the Court found that the;
“payment arrangements negotiated with the ATO did not have a material effect on the solvency of Petrolink because of the shortness of their duration and the fact that none of them had the effect that Petrolink was not required to pay its outstanding tax liability imminently. The payment arrangements in fact demonstrated that Petrolink was continuing to experience common features of insolvency”
Ultimately, His Honour determined that Petrolink was insolvent from 12 May 2010 and the director was found to be liable to the Liquidator for an amount of $669,582.86.
7.4 The Principle
Directors should be aware that entering into payment arrangements does not provide relief from the underlying debt being due and payable, and the arrangement may simply be considered an assistance mechanism for companies requiring shortterm relief.
Director’s should be aware that in entering into repayment arrangements with the ATO, they may be providing evidence to a subsequently appointed liquidator that the company was insolvent and that the director was aware of the insolvency. As such, caution should be exercised by directors when entering into repayment arrangements that they only take on repayment commitments that the company can comply with else they risk incurring a personal liability for insolvent trading.