Corporate Insolvency – Australia
This article answers key questions and provides guidance about insolvency for the managers of struggling businesses
When will your business be considered to
be insolvent?
What are your rights and obligations when
your business is insolvent?
What are the the risks and threats that arise
from insolvency?
What are your options when your business
is insolvent?
‘Insolvency’ occurs when a business is unable to pay its debts when they are due to be paid [1].
Insolvency is not a death sentence for a business but it is a very serious position that requires urgent attention and proactive decision making.
The consequences of insolvency depend on the structure of the business. Sole traders and partnerships of individuals are exposed to personal liability for the debts of the business at all times, whether or not the business is insolvent. Where an individual (alone or in partnership) is insolvent they are subject to personal bankruptcy legislation. In the case of companies the position is different, and the Corporations Act provides specific insolvency legislation relating to companies. This article deals exclusively with the insolvency of companies.
Continuing to trade a company that is insolvent is illegal[2] and may result in directors[3] having personal liability for debts incurred after the business becomes insolvent and, in some cases additional civil penalties[3] and criminal liability[4]. Directors may also be banned from managing a company if they breach the insolvent trading laws. As such, vigilance is required when a business is struggling to meet its financial commitments.
Companies are often used to provide protection from personal liability if a business fails. However, a company structure will not protect directors from personal liability and other potential penalties if the company is insolvent and the director knows, or should reasonably have suspected, that the company was insolvent when the debt was incurred or that incurring the debt would make the company insolvent.
A claim against a director for insolvent trading may be made by the Australian Securities & Investments Commission (‘ASIC’), a liquidator or a creditor of the company. The liability of a director for insolvent trading will always be determined by the Court.
The difficulty for company directors is that it can be quite difficult to determine exactly when a business becomes insolvent. The timing of the insolvency will be the trigger for personal liability or other possible penalties to arise. To make matters more difficult, the law relating to insolvent trading is complex. If you are a company director and you suspect that your company may be insolvent, you should ensure that you understand your legal obligations and seek independent advice.
Your obligations as a director
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You must ensure the company keeps proper financial records and remain informed of the financial position of the company
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You should take steps to investigate if you become aware of financial difficulties
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If you suspect that the company is in financial difficulty you should consider taking expert legal and / or financial advice
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You should act upon any advice received in a timely manner
Defences against the claim of insolvent trading
It is a defence against a claim of insolvent trading if any of the following circumstances can be proved:
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The director reasonably believed, and had reasonable grounds to expect that, the company was solvent at the time the debt was incurred and would remain solvent if the debt was incurred, or if multiple debts were incurred at the same time, that the company would remain solvent after all of those debts were incurred.
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The director had reasonable grounds to believe that a competent and reliable person was responsible for providing adequate information about the company’s solvency and that, based on the information provided to the director by that person, the director expected that the company was solvent and would remain solvent if the debt was, or debts were, incurred.
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The director was precluded from taking part in the management of the company when the debt was incurred due to illness or other good reason.
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The director took all reasonable steps to prevent the company from incurring the debt or debts
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The director acted honestly and the Court considers that, in all of the prevailing circumstances, the director ought to be excused
Options when your company is facing insolvency
Safe Harbour
In Australia company directors are afforded the opportunity, through what is known as ‘safe harbour’ laws, to work through a period of possible or actual insolvent trading without incurring personal liability or other penalties. There are strict conditions that need to be met to qualify for the safe harbour exemption.
Directors are excluded from personal liability for a debt if, after a director suspects the company is, or may become, insolvent:
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The director starts to develop and implement a plan that is likely to lead to a better outcome for the company, and
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The debt is incurred in the connection with that plan
There are preconditions for entering into the protections offered by the safe harbour provisions of the Corporations Act. The onus is on directors to demonstrate that they are entitled to the benefit of the safe harbour provisions of the Corporations Act and that they are compliant with the conditions that must be met to qualify for the safe harbour protections.
To enter safe harbour you must ensure that:
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you are acting honestly and diligently in connection with the activities of the company
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the company maintains proper books and records
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employee entitlements, including superannuation, are paid when they are payable
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tax reporting obligations are up-to-date
-
In addition, you need to be able to demonstrate that you are in the process of developing and / or implementing a plan is likely to lead to a better outcome for the company. In this regard you will need to:
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take reasonable steps to prevent misconduct by officers and employees;
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ensure that, or take steps to ensure that, proper financial records are maintained;
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take advice from an ‘appropriately qualified entity’ (this term is not defined but you can reasonably assume that it means someone with relevant qualifications and experience in assisting companies in financial distress)
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keep yourself informed of the company’s financial position;
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develop, document and implement a plan that is designed to improve the company’s financial position.
The onus of proving these matters falls on directors. You will need to be able to demonstrate that you are acting proactively and in an honest, diligent and genuine manner. That will require detailed records to be maintained, including the qualifications and experience of advisers, justifying why strategies and plans are adopted, the rationale for decisions, monitoring of the financial position of the business, and (importantly) the necessary connection between debts incurred and the turnaround plan
Safe harbour laws provide the directors with the opportunity to retain control of the business while a turnaround plan for the company is developed and implemented. The safe harbour provisions are also potentially cheaper and less disruptive to the company than alternative actions such as the appointment of a voluntary administrator or liquidation.
However, safe harbour laws do not prevent secured and unsecured creditors from seeking to enforce their rights or collect their debts. Accordingly, it will be necessary to engage with all relevant stakeholders to engage their support for a standstill on enforcement / collection while your plan is implemented.
It is also important to note that the protections of safe harbour laws, while not specifically time-limited, only apply while a plan is being developed or implemented and while it remains likely that the strategy being implemented will result in a better outcome than alternative options (such as voluntary administration or liquidation)
Voluntary Administration
Voluntary administration (‘VA’) is another option for directors to avoid personal liability and other insolvent trading risks. VA is also a protection from personal liability from certain tax debts when a Director Penalty Notice has been issued by the tax office.
A company enters VA when the directors resolve to appoint a voluntary administrator to the company (in some instances secured creditors can appoint an administrator but this is quite rare). VA differs from safe harbour in that directors lose immediate control of the company when a voluntary administrator is appointed. In a VA the administrator assumes control of the company, assesses the financial position of the company and reports to creditors. Key decisions are made by a meeting of creditors or a committee of creditors.
There are 2 possible outcomes from VA:
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The company is returned to the control of directors, usually via a deed of company arrangement (‘DoCA’), or
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The company is placed into liquidation
A DoCA is an arrangement agreed by the creditors that provides a pathway to restoring the business to a solvent position and returning it to the control of directors. Often, DoCAs involve a partial return of money owed to creditors in return for forgiveness of the remaining monies owed. DoCA’s are often accepted by creditors because they offer a better outcome for creditors than liquidation of the company. Once the terms of the DoCA are achieved the administrator resigns and the company is handed back to the control of directors. If the terms of the DoCA are not satisfied the company usually goes into liquidation. The company will also go into liquidation if the creditors do not agree to a DoCA.
Receiver / Receiver and Manager
This section is inserted for completeness to assist your understanding of possible consequences when your company is under financial strain and unable to meet its financial obligations to secured creditors.
Appointing a receiver or a receiver and manager (‘R&M’) is not usually an option available to, or used by, directors. These appointments are most commonly made by a secured creditor seeking to protect their interests following a default. The Court can also appoint a receiver or R&M to a company, although Courts more commonly appoint a liquidator.
A receiver differs from a R&M in that a receiver is appointed to specific assets of a company to take control of, and sell, the assets over which they have been appointed. This type of appointment usually occurs where a lender only holds security over specific assets of a company (such as items of plant and equipment). A R&M is usually appointed over most or all of the assets of a company and has wider powers, generally including the power to trade-on the business.
When a receiver is appointed to specific assets of a business the directors lose control of the assets over which the receiver is appointed but they retain control of the company. When a R&M is appointed directors lose control of the company. Receivers and R&Ms have a primary duty to their appointor, although their activities are also regulated by the Corporations Act.
Unless the default that triggered the appointment of a receiver or a R&M is cured or directors negotiate an alternative strategy with the secured creditor, receivers and R&Ms will seek to recover the secured debt by sale of assets or sale of the business. Any costs incurred in recovering and realising the assets, including the fees of the receiver or R&M, are secured debts and payable from the proceeds of the asset sales.
Liquidation
A company can be placed into liquidation by order of the Court (usually on the application of creditors), as a result of a decision of creditors in a Voluntary Administration, or voluntarily by a vote of the members (shareholders) of the company.
Liquidation is a process that will ultimately bring the existence of the company to an end. When a company placed into liquidation a registered liquidator assumes control of the company, and the liquidator’s role is to realise all of the assets of the company and distribute the proceeds to the creditors of the company.
When all of the assets have been realised and all of the proceeds have been paid out the liquidator will apply to the Australian Securities & Investments Commission to have the company wound up (effectively struck off the list of registered companies).
[1] A company is solvent if it can pay its debts as and when they fall due for payment (Corporations Act 2001, s.95A(1)). A company is insolvent if it is not solvent.
[2] Corporations Act s.588G.
[3] A person on whose instructions the company or the company’s directors usually act is also considered a director
[4] Civil penalties can be imposed by the Court where there is material detriment to the company as a result of the director’s actions. See ‘Australian Securities & Investments Commission - Regulatory Guide RG217’ for further information
[5] Criminal liability can arise where a director dishonestly incurs a debt knowing the business is insolvent (Corporations Act s.588G(3))