What Is Insolvent Trading?

Introduction

Under the Corporations Act 2001(C’th) it provides for directors having a duty to prevent insolvent trading, failing which they are personally liable for civil penalties and for personal compensation to the company (usually by liquidators bringing relevant proceedings).

Accordingly, it is vitally important for directors to be sensitive to determining whether the company can be seen to be trading insolvently.  Accordingly, it is important to be aware of the principles by which the Courts have considered a company is trading insolvently.

The Law

Section 95A of the Corporations Act 2001 provides:

“(1) A person [which meaning can include a corporation] 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”.

Further, Section 95A(2) provides:

“A person who is not solvent is insolvent”.  This seems to be stating the somewhat obvious.  However, it shows that the issues to be considered is whether, for the purposes of this article, a company is solvent.  Further, it also highlights that the law regards the question as being a clearcut question of either solvency or insolvency, not a sort of “semi-solvency” or “now insolvent but will be solvent later”.

The sections show that the test is not a simple balance sheet type of test of assets exceeding liabilities.  The test has been shown by Court authorities to be a cashflow test and a good explanation of this view can be seen as follows:

“The particular indications of insolvency … are all instances of commercial insolvency, that is, of the company being unable to meet current demands upon it.  … A company may be at the same time insolvent and wealthy.  It may have wealth locked up in investments not presently realisable; but although this be so, yet if it has not assets available to meet its current liabilities, it is commercially insolvent …”[1].

The question of the nature of the assets is important in determining whether (in this case) a company is able to pay its debts as and when they fall due from its own money, that its own monies are not limited to cash resources immediately available, but also to assets which are able to realise cash by sale readily or by mortgage or pledge within a relatively short time – relative to the nature and amount of the debts and to the circumstances, including the nature of the business of the debtor[2].

It is also important to note that the test is debts “as and when they fall due”.  Whilst it is common that invoices are not necessarily payable for at least 30 days or other periods imposed, such that they are not due immediately, but sometime in the future, the date of payment when it is due is the relevant factor.  However, the fact that creditors may give the company some time before they actually seek to enforce the remedies or not enforce it at all, such that the company may be able to pay those debtors within that greatly extended time, does not necessarily negative the notion that the company is unable to pay its debts as and when they fall due.

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[1] Re Tweed Garages Ltd [1962] Ch 406 at 410 (per Plowman J).

[2] Sandell v Porter (1966) 115 CLR 666 at 670-671 (per Bawick CJ).

How can a Director be aware that the Company can be considered to be trading insolvently?

The above principles speak for themselves, but for the average director who is not a lawyer, it can be said, “What factors can alert a director to a fact that the company may be trading insolvently?”, and “What steps should be taken for the company to be wound up or for other arrangements to be made to take the company out of insolvency?”.

It has been said that the common features indicating insolvency are matters such as:

1. Continuing losses;
2. Overdue Commonwealth and State taxes;
3. Poor relationship with the present bank, including inability to borrow further funds, or access to alternative finance or ability to raise further equity capital;
4. Suppliers placing the company on special payment terms, such as COD, before resuming supply;
5. Creditors unpaid outside the usual trading terms;
6. Issuing of post-dated cheques or dishonoured cheques;
7. Solicitors’ letters claiming monies owing.  It must be noted, however, that in this regard, there may be legitimate grounds to dispute the alleged debts;
8. Payments to creditors of rounded sums which are not reconcilable to specific invoices;
9. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.

It can be seen from the above that these are practical pointers towards whether a director should be alerted to the fact that the company may be trading insolvently.

What to do if concerned that a Company may be trading insolvently?

In circumstances that it is believed that a company may be trading insolvently, it is important to seek accounting advice based on whether the company can be deemed to be trading insolvently.  If so, it is important to then seek legal advice as to what options can be taken up in relation to the company, ie, whether to wind up the company forthwith before it can be said that debts have been incurred whilst the company is trading insolvently, or whether the company can undertake restructuring under the Corporations Act, such that it can proceed and trade solvently.

RMO Law can assist here in relation to any concerns that you have about Directors’ liabilities or other matters by which the company’s solvency may be an issue.

Contact Us

If you have questions in relation to Litigation matters, contact us to book an initial consultation with one of our experienced lawyers, and we will provide you with tailored advice with respect to your unique circumstances. call 1800 999 529, email mail@rmolaw.com.au or submit an enquiry on our website.

We are available to meet with you at any of our local offices (Brisbane, Gold Coast, Beenleigh, Cleveland and Jimboomba) or by telephone or video-conference.

This article is for your information and interest only. It is not intended to be comprehensive, and it does not constitute and must not be relied on as legal advice. You must seek specific advice tailored to your circumstances.

Roly O’Regan

Director