Insolvent Trading Risk
Test for Insolvency
A company is insolvent under section 95A of the Corporations Act 2001 (the ‘Corporations Act’) if it is unable to pay its debts as and when they fall due.
This is a question of fact to be considered on a case by case basis.
There are two tests for insolvency.
Firstly, the balance sheet test.
The balance sheet test is that a company will be insolvent if liabilities exceed assets- in other words the liabilities of the company would not be met if all the assets of the company were liquidated and used to meet those liabilities. This test is difficult to apply when there is not an obvious market for assets of the debtor, and/or a value cannot easily be ascribed to those assets.
Finally, the cash flow test.
This is the preferred test and is, in effective, enshrined in section 95A of the Corporations Act above.
The cash flow test holds that the extent to which assets exceed liability is irrelevant. The basis is that the company is technically insolvent if it cannot meet its day to day commitments, and creditors should not be forced to wait while the debtor realises some of its assets to pay them, particularly if those assets cannot be easily liquidated. The view taken by the court is that (Southern Cross Interiors Pty Ltd v DCT (2001) 39 ACR 305):
“in considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable.”
Insolvent Trading
Insolvent trading occurs when a company incurs a debt when it is unable to pay its debts as and when they fall due pursuant with section 588G of the Corporations Act.
The following is summarised from the ASIC regulatory guide 217 (RG217). Resolv Lawyers strongly recommends that directors, irrespective of whether they are concerned as to the solvency of their company, review this document as it details their duties quite succinctly.
It is available here.
The Claim
Section 588G of the Corporations Act places a duty on directors of an insolvent company to prevent the company incurring debts where a director has grounds for suspecting that it is insolvent, or does actually suspect the company is insolvent.
An Insolvent Trading claim has the following elements:
The person is a director at the time when the company incurs that debt.
The company was insolvent at the time or became insolvent by incurring that debt, or by incurring at that time debts including that debt.
At that time there were reasonable grounds for suspecting the company was insolvent or would become insolvent.
By failing to prevent the debt from being incurred, a director contravenes section 588G(2) of the Corporations Act where, at the time the director was aware that there are such grounds for suspecting, or a reasonable person in a like position in the company, would have been aware that the company was insolvent.
The Evidence Required to Raise the Insolvent Trading Claim Against a Director
Before a director becomes liable it must be established that there were reasonable grounds to suspect that the company was insolvent or would become insolvent, to successfully invoke section 588G of the Corporations Act. The test requires that suspicion be based on reasonable grounds, thus making the test not only subjective, but also objective.
What Indicates Insolvency
ASIC v Plymin (No. 1) (2003) 46 ACSR 126 gives some considerations that may indicate insolvency in the context of director liability for insolvent trading:
Continuing losses.
Liquidity ratios under 1.
Overdue taxes.
Poor relationship with a bank resulting in inability to borrow further.
No access to alternative finance.
No ability to raise more capital.
Suppliers only providing goods ‘cash on delivery’.
Creditors unpaid outside trading terms.
Issuing post-dated cheques.
Dishonoured cheques.
Special arrangements for selected creditors.
Judgments, solicitors letters and similar issued against the company.
Payments to creditors of rounded amounts rather than payments of specific invoices.
Inability to produce timely and accurate financial statements.
The Penalties and/or Compensation for Insolvent Trading
The court has the power to disqualify a person from managing a corporation (ie, being a director) or imposing a fine up to $200,000.
However, a court may not order the disqualification if it is satisfied that, despite the contravention, the person is fit and proper to manage a corporation nor order a pecuniary penalty where it considers a contravention not to be a serious one.
The most common outcome of an insolvent trading claim is an award for damages against the director to creditors who suffered because the director ‘traded’ with them whilst insolvent.
For example, if the company was insolvent and a director incurred debts totalling $500,000 during the period it was insolvent, then the liquidator can sue the director for $500,000. The funds will go towards ordinary unsecured creditors and the costs of the liquidation pursuant with section 556 of the Corporations Act.
Defences
A director can avail themselves of a number of statutory defences contained in section 588H of the Corporations Act and will not be liable if:
There were reasonable grounds to expect the company was solvent;
There were reasonable grounds to rely on the information provided by another (for example, an accountant);
At the time debts were incurred the director can establish illness or other good reason; or
The director took all reasonable steps to prevent incurring the debt.
Alternatively, relief from liability may be granted in circumstances where the director has acted honestly or ought fairly to be excused from the contravention.
