Insolvency arises where a company is unable to pay its debts as they fall due and payable. A 'cash-flow test' is commonly used when determining the solvency of the company and is not determined simply on the basis of a surplus of assets over the liabilities. It is derived from a proper consideration of the company's financial position as a whole based on commercial reality.
A temporary lack of liquidity does not necessarily mean the company is insolvent, however – the ability of a company to pay the debts when they fall is due is crucial.
The Court has the discretion in determining a company insolvent and ultimately considers the presence of several indicators of insolvency, such as:
- continuing losses of the company;
- liquidity ratios below 1;
- overdue Commonwealth and/or State taxes;
- creditors being unpaid outside payment terms;
- poor relationship with present bank including the inability to borrow further funds;
- inability to raise further equity capital;
- no access to alternative finance;
- suppliers placing the company on cash on delivery (COD), or otherwise demanding special payments before resuming supply;
- special arrangements with selected creditors; and
- inability to produce timely and accurate financial information to display the company's trading performance and financial position, and provide reliable financial forecasts.
WHAT IF A COMPANY IS INSOLVENT?
Various people can make an application to the Court to wind up a company on the basis of insolvency, including:
- the company itself;
- a creditor (notwithstanding if the creditor is secured creditor or a contingent creditor);
- a contributory;
- a director of the company;
- a liquidator or provisional liquidator of the company; or
- the regulatory body i.e. Australian Securities & Investments Commission.
Unpaid creditors who are owed $4,000 or more often initially issue a statutory demand for payment of the debt before making an application to wind up a company. A statutory demand is a powerful tool because a company will be presumed to be insolvent for failure to comply with it. If a company is served with one, it will only have 21 days to either; pay the debt, secure the debt to the creditor's satisfaction or (if the debt is disputed) apply to the Court to set it aside.
Directors must actively monitor the solvency of the company and act in a timely manner. This is because directors have a statutory duty to prevent the company from incurring debts if there are reasonable grounds for suspecting that a company is insolvent. Consequences of contravention includes civil (and in some cases, criminal) penalties.
WHAT CAN I DO TO WHEN A COMPANY BECOMES (OR MAY SOON BECOME) INSOLVENT?
Unless it is possible to refinance or recapitalise the company, the most common ways to deal with an insolvent company is to:
- appoint a restructuring practitioner (if the company meets the eligibility criteria);
- appoint a voluntary administrator (if the company has multiple shareholders and / or a viable business to save); or
- appoint a liquidator.
If you have suspicions that a company may be insolvent, seek financial and legal help as soon as possible. Our Insolvency Team can provide legal advice that is appropriately tailored to each company's (and director's) circumstances.
The sooner action is taken, the better options will be available to companies and directors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.