When is an Australian company considered to be insolvent?
The answer to that question can have significant ramifications for affected business owners, directors, regulators, employees and creditors, whose interests in the outcome of that determination may directly conflict.
Section 95A of the Corporations Act 2001 (“the Act”) sets out the test of insolvency in this way: “(1) a person is solvent if, and only if, the person is able to pay all of the person’s debts, as and when they become due and payable. (2) A person who is not solvent is insolvent.” The reference here to a “person” includes a company.
When the court is called upon to determine whether or not a company is (or was) insolvent, or when it became insolvent, the court is often faced with a complex task. To assist the courts in determining the answer to these questions, the courts have developed a number of principles that it will consider and apply. Helpfully, these were recently set out by the Federal Court in Pearce v Gulmohar Pty Ltd[1] as follows:
- Insolvency is a question of fact to be ascertained from a consideration of the company’s financial position taken as a whole. In doing so, the court must have regard to commercial realities, which 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.
- The definition focuses on a “cash flow test” of insolvency, and not simply a “balance sheet test”. However, a company’s balance sheet remains relevant, because the cash flow position must be assessed by reference to the company’s financial position as a whole.
- Insolvency is an “endemic shortage of work capital”. Such a position is to be distinguished from a temporary lack of liquidity. Thus, a temporary lack of liquidity is not equivalent to insolvency and, conversely, neither is availability of surplus assets at a particular point in time conclusive of solvency.
- In assessing when debts are due and payable, the test is what debts are legally due, having regard to the agreement between the parties. This approach allows for situations where there is sufficient evidence of waiver of legal requirements, but reluctance by creditors to enforce legal rights is not sufficient. It does not matter that a creditor is unlikely to enforce its debt because the statutory test is whether the debt is due and payable at law.
- On this test, it is immaterial that a company disputes a claimed debt. Such a dispute may require some form of determination, but does not alter whether the debt is legally due. The defendants have not contended to the contrary.
- Where there are contract debts, it is for the party asserting that those debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence.
- The words “as and when they become due” are forward looking. That is, consideration is given to not only debts presently payable, but those that will become payable in the near future.
- In assessing the assets available to pay the company’s debts, the relevant question is as to what assets are capable of realisation within time to meet the company’s indebtedness.
- Where the company is trading with no intention of selling stock-in-trade or inventory outside the ordinary course of business, the value of that inventory should be excluded from the solvency analysis.
- Similarly, assets required to operate the business as a going concern (such as plant and equipment) are also excluded. In Re Timbatec Pty Ltd,[2] Bowen CJ said that a debtor cannot rely on realising assets that would involve a cessation or breaking up of its business. If a company has to resort to selling assets that are essential to the continuation of its business, those assets are not to be included in a determination of solvency.
- In proving insolvency, expert evidence from the liquidator may be relied upon.
- In ASIC v Plymin (No 1),[3] the Court identified a number of common, albeit not essential, features in insolvency situations. That judgment has been referred to with approval in many subsequent decisions. The features are:
- Continuing losses.
- Liquidity ratios below 1.
- Overdue Commonwealth and State taxes.
- Poor relationship with present Bank, including inability to borrow further funds.
- No access to alternative finance.
- Inability to raise further equity capital.
- Suppliers placing [company] on COD, or 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’ letters, summonses, judgments or warrants issued against the company.
- Payments to creditors of rounded sums which are not reconcilable 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.
- Importantly, this is a guide, not a checklist. It is merely a list of factors, the presence of one or more of which may indicate insolvency. Likewise, not all factors need be present. Further, certain factors present in a given case may carry different weight according to the circumstances of the particular case.
Courts in Australia are bound to the above principles, although the above summary is not exhaustive. Those principles are to be applied by a court when considering the evidence and submissions present to it by the parties. Application of the facts to those principles is often a complex task. Therefore it is essential that lawyers acting for parties involved in such disputes are familiar with these principles and able to apply them when representing clients in a dispute regarding a company’s solvency or insolvency.
At Boss Lawyers, we have
experience in assisting liquidators and other clients with insolvency
disputes. For practical legal advice, support and assistance regarding
your particular circumstances, contact Boss Lawyers. We are ready to step
in and assist you.
About David Grant | Senior Associate
David has practiced exclusively in commercial litigation and dispute resolution since 2010. David is a distinguished litigator among his peers and his approach to commercial disputes is pragmatic and outcome-orientated.
Article citations:
[1][2017] FCA 660. In text citations omitted.
[2] [1974] 1 NSWLR 613.
[3] (2003) 46 ACSR 126 at [386].
