Indicators of Insolvency

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Indicators of Insolvency

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With COVID-19 related restrictions easing in several states of Australia, many Australian businesses are returning to some sense of normal. That normal may be staff returning to offices, businesses being allowed to re-open or restrictions on capacity limits being lifted.

It has been said that the government assistance (such as JobKeeper, COVID-19 disaster payments, tax relief measures, COVID cash flow boost, moratorium on insolvent trading and tenants protected from eviction by the landlord) has delayed the inevitable for some Australian businesses.

With the return to “normal” and the reduction/withdrawal of many government assistance packages, it is no surprise that there has been a slight increase in the number of insolvency appointments.

There is no time like the present to review your company’s financial position and assess any associated risks in order to mitigate the same.

 
Total Number of Companies Entering External Administration and Controller Appointments
Month
2020/21
2021/22
July
373
423
August
275
354
September
298
313
October
279
325

 

How can you tell if a Company is Insolvent?

The Corporations Act 2001 defines a company as being insolvent if it “cannot pay its debts as and when they fall due and payable”.

The question as to whether a company is “unable to pay its debts as and when they become due and payable” is a question of fact to be determined by a number of specific circumstances. In general, a holistic review of a company’s financial affairs is required in the first instance.

The main case referenced by all insolvency practitioners when determining “insolvency” is ASIC v Plymin.

This case listed the following key indicators of insolvency:

    • Continuing losses
    • Liquidity ratios below 1
    • Overdue Commonwealth and State taxes
    • Poor relationship with the present bank, including the inability to borrow further funds
    • No access to alternative finance or inability to raise further equity capital
    • Suppliers placing the company on COD, or otherwise demanding special payments before resuming supply
    • Creditors unpaid outside trading terms
    • Issuing post-dated cheques or 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.

In practice, the common indicators of insolvency that we see are as follows:

    • The company has failed to remit payment of its superannuation contributions due to its employees as and when they fall due. It is worth noting that a company that does not pay an employee’s superannuation on time must lodge a superannuation guarantee charge statement with the ATO and pay the superannuation (together with any interest and administration charges) to the ATO.
    • The company reports trading losses within its formal/management accounts.
    • The company’s sales/revenue has decreased with no or limited expectations of it improving in the foreseeable future.
    • The company falls behind in its lodgment of statutory reports (i.e. BAS’, ITR’s, Payroll Tax etc) and consequently the payment of the corresponding statutory amounts due.
    • The company’s current assets (i.e. cash, stock, debtors etc) if all converted to cash would be insufficient to meet the company’s liabilities “as and when they fall due and payable”.
    • Directors/related parties/shareholders cease providing financial support to the company and the company is not in a position to obtain any further financial support from other avenues.
    • The Company receives legal correspondence from its creditors such as a Statutory Demand Notice, a Debt Collections Warning letter and/or a Director Penalty Notice (DPN) from the ATO.

 

Consequences of Insolvent Trading

A company’s director has a duty to prevent a company from trading whilst insolvent. A company director may be held personally liable for debts, which remain unpaid and were incurred between the date the company became “insolvent” and the date a liquidator is appointed over the company.

A liquidator is required to complete investigations into a company’s affairs and in particular, determine whether a company is insolvent and if so, if a claim exists against a director. The liquidator would be required to determine if there were reasonable grounds for the director to have suspected the company was insolvent.

A liquidator appointed over a company, ASIC or a creditor can commence compensation proceedings to recover amounts lost by creditors as a result of a company trading whilst insolvent.

Trading a company whilst it is insolvent is also an offence pursuant to the Corporations Act and civil penalties may also apply (up to $200,000). If dishonesty is found to be a factor in insolvent trading, a director may also be subject to criminal charges (up to 2,000 penalty units or imprisonment for up to 5 years, or both. One penalty unit is currently $222).

The question as to whether a company is “unable to pay its debts as and when they become due and payable” is a question of fact to be determined by a number of specific circumstances. In general, a holistic review of a company’s financial affairs is required in the first instance.

Who can a Liquidator pursue an Insolvent Trading claim against?

An insolvent trading claim can be pursued against a director, a shadow director or an Ultimate Holding Company. A Shadow Director is a person who effectively acts as a director, even if not formally appointed. An Ultimate Holding Company is a body corporate that is a holding company and is itself a subsidiary of no other body corporate.

What Defences are available to Directors for an Insolvent Trading Claim?

The Corporations Act provides the following defences to an Insolvent Trading Claim:

  • The person had reasonable grounds to expect and did expect, that the company was solvent.
  • The person had reasonable grounds to believe and did believe that a competent and reliable person was responsible for providing that person adequate information about whether the company was solvent.
  • Due to illness or some other good reason, the person did not take part in the management of the company.
  • The person took all reasonable steps to prevent the company from incurring debts.

Tips for Accountants who think their Client is facing Insolvency

  • Ensure company records including management accounts are up to date, accurate and a true reflection of the company’s financial position. This will assist in completing a holistic review of the company’s financial position.
  • Complete a pro-active review of ATO client portal records to determine if clients have completed lodgements and the extent of liabilities due.
  • An open conversation with the client regarding the potential issues (indicators of insolvency) they have identified.
  • Determine whether the client can rectify the issues identified (i.e. bring compliance up to date, find further funding to meet liabilities etc).
  • Should the issues not be able to be rectified, professional advice should be sought to avoid and/or reduce any personal liability exposure and maximise the chances of a company’s business continuing.

 

The Burden of Proving a Defence is on the Director

As with many things in life, being proactive and taking preventative measures is imperative to navigating these challenging times. Early intervention may help to avoid and/or reduce any personal liability exposure should a company be or become insolvent and may maximise the chances of a company’s business continuing.

 

Article was written by Lisa Isaac (Senior Manager) – SV Partners Melbourne

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