When Is a Company Insolvent?

This is a very important question because there can be serious implications for the company itself and its directors if it continues in business while it is insolvent.

For the directors, allowing the company to continue incurring debts while it is insolvent is a criminal offence, it can lead to significant civil penalties, and it can result in the directors being made personally liable for these debts. For the company, if it does not properly rebut a formal assertion it is insolvent made in a statutory demand, the Court can order that it is put into liquidation.  

The Corporations Act 2001 defines the meaning of insolvent at its sections 95A(1) and (2), which record, “A person 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. A person who is not solvent is insolvent.”

While this seems a fairly straight forward cash flow test, the complications of business and finance can make solvency difficult to assess sometimes.

Guidance is also provided to directors by the Australian Investments and Securities Commission (ASIC), in its Information Sheet 42 available on the ASIC website: Insolvency for directors

Amongst other information, it provides a listing of what it describes as warnings signs of insolvency and advises that these include:

• ongoing losses
• poor cashflow
• absence of a business plan
• incomplete financial records or disorganised internal accounting procedures
• lack of cashflow forecasts and other budgets
• increasing debt (liabilities greater than assets)
• problems selling stock or collecting debts
• unrecoverable loans to associated parties
• creditors unpaid outside usual terms
• solicitors’ letters, demands, summonses, judgements or warrants issued against your company
• suppliers placing your company on cash-on-delivery terms
• special arrangements with selected creditors
• payments to creditors of rounded sums that are not reconcilable to specific invoices
• overdraft limit reached or defaults on loan or interest payments
• problems obtaining finance
• change of bank, lender or increased monitoring/involvement by financier
• inability to raise funds from shareholders
• overdue taxes and superannuation liabilities
• board disputes and director resignations, or loss of management personnel
• increased level of complaints or queries raised with suppliers
• an expectation that the ‘next’ big job/sale/contract will save the company.

Each of these warning signs indicates that there are problems with the business. The underlying cause of the problem could be insolvency, it could have a combination of causes including insolvency or the cause could be unrelated to the solvency of the company.

Clearly, expert assistance is necessary if a business exhibits these warning signs so that the right corrective measures can be implemented. There are a range of options now available to company directors if insolvency is an issue which needs to be addressed.

It has long been my view that the solvency of a company should be concluded having regard to all relevant circumstances of the company. That is, whether it is behind in its tax lodgements or payments, how much money it has in the bank, whether its assets are larger or smaller than its liabilities are all relevant considerations but none, of themselves, is conclusive to assessment of solvency or insolvency.

For example, what if company assets could be sold to pay amounts owing, what if loan funds can be assessed, what if the company’s directors can and will provide any additional funding which is needed? That is, to what extent are the resources available to a company able to be taken into account when determining solvency?

In the High Court decision in Sandell v Porter (1966) 115 CLR 66, the following explanation was given by Barwick CJ:

[Resources] “extend to moneys which he can procure by realization by sale or by mortgage or pledge of his assets 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. The conclusion of insolvency ought to be clear from a consideration of the debtor’s financial position in its entirety and generally speaking ought not to be drawn simply from evidence of a temporary lack of liquidity. It is the debtor's inability, utilizing such cash resources as he has or can command through the use of his assets, to meet his debts as they fall due which indicates insolvency.”

The overall circumstances of the company were considered to assess solvency in the recent decision of the Tasmanian Supreme Court in ARL2 Pty Ltd v Flex Realty Pty Ltd [2024] TASSC 5, which can be found at: ARL2 Pty Ltd v Flex Realty Pty Ltd [2024] TASSC 5 (27 February 2024)

We can help directors assess the warning signs identified by ASIC and formulate an action plan if insolvency is not an underlying cause. We can work with registered liquidators while looking after the interests of the directors if one of the several formal insolvency arrangements is appropriate.

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