Solving the Mystery of Insolvency
By Alex Milne
For Directors and other company members, it is important to be aware of the corporate regulatory regime, where rules apply to determine whether a company is solvent. It is incumbent on Directors to make themselves aware of the financial situation of their company. Where a company continues to trade in circumstances where a reasonable Director would have suspected that the company was insolvent, they may breach Insolvent Trading Provisions in section 588G of the Corporations Act 2001. In this way Directors may find themselves personally liable for civil and criminal penalties.
Standard Test for Insolvency:
The basic test of whether A company is solvent is whether it can pay its debts as they become due and payable. One can however distinguish insolvency from a temporary lack of liquidity by taking into account a company’s ability to raise the funds to pay by selling assets or giving security over assets.
The standard position is that debts become due and payable after 30 days. The fact that creditors will normally allow some latitude in time to pay debts does not affect the due date for the purposes of the insolvency test. It is only relevant to take into account creditor leniency where there is an actual agreed extension, or where a representation is made by the creditor that the company can have longer to pay. Other than that a 30 day period applies unless it is notorious custom within the relevant industry for a period longer than 30 days when the phrase ‘payable on demand’ is used.
Statutory Presumptions that a Company is Insolvent:
Failure to comply with a Creditor’s Statutory Demand will create a presumption that the company is insolvent. Of course a Statutory Demand where the debt alleged is disputed can be challenged and set aside.
Under s588E(4) of the Corporations Act, if it is proved that a company has, failed to keep financial records in relation to a period as required by subsection 286(1), or has failed to retain financial records in relation to a period for the 7 years required by subsection 286(2), then the company is to be presumed to have been insolvent throughout the period. An exception is made, however, for any technical or minor breaches of record-keeping.
Voluntary Options for a Company Approaching Insolvency:
By resolution of the Directors under s436A of the Corporations Act an external Administrator can be brought in to run the company with the goal of helping it survive. The Administrator will run the business for the duration of the Administration, taking over the powers of company officers. Members will be unable to transfer their shares during this time.
One benefit for a company is that during the Administration there is a moratorium on legal proceedings and on any proceeding to wind up the company under sections 440A and 440D of the Corporations Act respectively.
Creditors are endowed with significant power at this stage. They initially have the power to replace the Administrator, and after 20 days of Administration, the Creditors must vote whether to enter a Deed of Company Arrangement, resolve that the company be wound up, or resolve that the administration is simply ended.
A Deed of Company arrangement is essentially a plan drafted for how the company will pay off its debts as fully as possible, and may specify to the company a moratorium period while this ‘plan’ is put into action. The formation of this kind of Deed gives the administrator and the creditors a chance to be part of a process where an agreement is reached so that the company can survive, and creditors can recover a greater percentage of what they are owed than they would by simply applying to have the company wound up.
Informal Creditor Arrangement with Unanimity:
If it is possible to achieve a kind of agreement similar to a Deed of Company Arrangement, but without the need for the formalities of a Voluntary Administration. This can only be achieved where one has a group of creditors that are unanimously willing to be part of the process.
Voluntary Winding Up:
Some people decide to voluntarily wind up the company. If one is reconciled to the idea that the company has no future, then under section 491 of the Corporations Act, the Directors of a company can pass a motion for voluntary winding up by special resolution. They will have to appoint a liquidator, although their choice can be overruled by the creditors.
The consequences are that usually there is a moratorium on all proceedings against the company. The effect of a winding up is still realistically that a company has to cease carrying on business except to the extent deemed appropriate by the liquidator, who will now have control of all the functions preciously exercised by company officers. Eventually a winding up process ends with the deregistration of the company.
Being Pushed if you don’t Decide to Jump:
If a company is involuntarily wound up, it will usually be at the behest of a creditor. A creditor has standing to apply to have the company wound up in insolvency under s459P of the Corporations Act. The applicant must show that the company is insolvent, and can rely on the failure to comply with a statutory demand as evidence of this.
Consequences of a Winding Up:
The company will have to cease carrying on business except for the purposes of winding up. Officers of the company lose their powers and the Liquidator will decide whether to proceed with performance of any current contracts. Any transfers of property by the company are generally void unless the liquidator approves the transaction and custody of the property is vested in the liquidator.
The ‘Clawback Provisions’:
The so-called ‘clawback provisions’ are provisions in the Corporations Act which can void certain transactions entered by a company prior to winding up. In the event that a transaction is void then it the money can essentially be called-back from the other transacting party, and added to the pool of funds for division amongst the creditors.
These kind of transactions are tempting, but insolvent transactions are an area where company Directors can occasionally try to be too clever for their own good. Section 588FE of the Act makes certain transactions voidable if the company is being wound up, and as above, trading while insolvent can have consequences for Directors personally.
What Kinds of Transactions may be Voidable?
Where a company makes an insolvent transaction, this transaction can be clawed back. An insolvent transaction is defined in section 588FC of the Act as a transaction which is an uncommercial transaction or an unfair preference, and at the time the transaction is entered or given effect to, the company is insolvent or becomes insolvent.
An uncommercial transaction is defined under section 588FB of the Act as one where a reasonable person would not have entered that transaction based on the relevant commercial benefits and detriments to the company
A transaction is an ‘unfair preference’ given by a company to a creditor if the transaction between the company and the creditor results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive in a winding up of the company.
An insolvent transaction up to 6 months before winding up can be clawed back, while an insolvent transaction which is also an ‘uncommercial transaction’ can be clawed back up to 24 months before the date of winding up. An insolvent transaction with a related company can be clawed back from up to 4 years before the date of winding up.
An Insolvent Transaction which is specifically entered into with the purpose of defeating or delaying creditors can be voidable under section 588FE(5) of the Act if it was entered or given effect to up to 10 years before the date of winding up. This is definitely a warning to any supposedly savvy Directors who seek to “hollow out” a company prior to becoming insolvent.
Clearly in these economically unsettled times we live in, insolvency is a prospect creeping unwelcomely into the minds of some company Directors. The challenge is for Directors to steel themselves and consider their options before things get to the stage where they unwillingly have to cede control.
An alternative to winding up can provide a solution which minimises the damage, and can potentially keep the company alive. Other ‘creative’ solutions, which sometimes enter the minds of Directors need to be discouraged, and should be pursued only after obtaining legal advice, lest Directors fall foul of insolvent trading provisions, or the ‘clawback provisions.’