Insolvency

A company is insolvent if it is unable to pay its debts as and when they fall due. The cashflow test is primarily used under Australian law as the criterion for solvency.

The cash flow test focuses on income sources available to the company and its expenditure obligations. If income sources fall short of expenditure obligations then the company is insolvent.

Courts have also found the balance sheet test, though subsidiary, is relevant to the question of solvency. Under the balance sheet test, a company is insolvent if its total liabilities exceed its total assets.

Insolvency and directors’ duties

Under Australian law, directors have an obligation to prevent a company from trading while insolvent. Before allowing a company to incur a debt, directors must consider if there are reasonable grounds to suspect it is insolvent or would become insolvent by incurring the debt. Directors must constantly be aware of the financial position of their company.

Directors face civil penalties for trading while insolvent and are liable for the debts incurred while the company was insolvent. They may also face criminal charges if dishonesty was a factor in insolvent trading.

The Australian Securities and Investments Commission (ASIC) advises directors if they suspect their company is in danger of insolvency to get professional accounting and legal advice as early as possible. “One of the most common reasons for the inability to save a company in financial distress is that professional advice was sought too late,” ASIC says.

Find out more about insolvency and directors' duties with our Director Tool on insolvent trading.

Signs of insolvency

ASIC’s guide to insolvency for directors lists the following as some warning signs of insolvency:

• ongoing losses

• poor cash flow

• absence of a business plan

• incomplete financial records or disorganised internal accounting procedures

• lack of cash-flow 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

• issuing post-dated cheques or dishonouring cheques

• 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.

Types of insolvency

Usually in a corporate insolvency, the company will be entered into external administration or a secured creditor will appoint a receiver to control some or all of the assets of a company.

There are two types of external administration: voluntary administration or liquidation.

Typically in a voluntary administration, the board of directors of a financially troubled company will appoint an administrator and cede control of the company. The administrator investigates the company’s finances and reports to creditors who then vote on whether to restructure the affairs of the company through a deed of company arrangement, to enter the company into liquidation or to return control to directors.

A liquidation involves the winding up of a company through the sale of its assets with proceeds distributed among creditors and any residual going to shareholders. A liquidation commences either by the order of a court, a vote by the shareholders of a company to wind it up, or a vote by creditors of a company in administration.

A secured creditor can appoint a receiver to assets over which it has a charge when certain events occur usually associated with financial distress. For instance, a secured creditor may have a right to appoint a receiver if the company fails to make a repayment to the creditor on the date it’s due. A receiver will then typically sell the assets they control using proceeds to repay the debts to the creditor.

What are the penalties for insolvent trading?

Insolvent trading leaves a director open to civil and criminal penalties, and to being personally liable to compensate for losses. Directors are defined as those duly appointed, including de facto and shadow directors and those managing while disqualified.

If insolvency occurs, directors must take the interests of creditors into account. This includes helping the administrators in every required way. Creditors make the decision as to whether to save the company.

The liability for debts after a company becomes insolvent lies with those who were directors at the time of acquiring the debt.

ASIC can exact civil penalties against directors. These include:

• Disqualification from managing a company;
• Substantial fines; and
• Paying compensation to the company equivalent to the loss suffered by the creditors.

Criminal proceedings for insolvent trading may be brought if dishonesty is involved. Directors can be ordered to pay compensation to the company for the loss suffered by the creditor.

Insolvency safe harbour

In 2017, the Corporations Act 2001 (Cth) (Corporations Act) was amended to introduce a 'safe harbour' for directors from personal civil liability for insolvent trading — under certain circumstances.

The safe harbour is designed to support company directors to pursue an active turnaround or recovery strategy with protection from civil insolvent trading liability. It provides honest, diligent directors with an opportunity to remain in control of the company and attempt reasonable innovative and entrepreneurial solutions to solve financial difficulties. A company director will not be civilly liable for insolvent trading if they start developing one or more courses of action “reasonably likely” to lead to a “better outcome” for the company than the immediate appointment of an administrator or liquidator.

Importantly, all existing Corporations Act duties continue to apply, including that of directors to exercise their powers in good faith with care and diligence in the best interests of the corporation.

See the AICD’s Insolvency Safe Harbour Director Tool for more information.

COVID-19 insolvent trading relief

As part of a range of economic measures in response to COVID-19, the government introduced six-month temporary relief for directors from personal liability for trading while insolvent.

The temporary safe harbour is designed to give directors the confidence to continue to trade, pay their bills and retain staff through the COVID-19 crisis without pressure to enter their organisation into administration if there is a chance it might be insolvent.

Directors will be able rely on the temporary relief in relation to a debt incurred by the company from 24 March, when the new law commenced, if the debt is incurred in the “ordinary course of the company’s business”.

COVID-19 insolvent trading relief for not-for-profits and charities

The ACNC has confirmed that the temporary insolvent trading safe harbour will extend to directors of not-for-profits and all charities (not just those that operate as companies limited by guarantee), provided charities:

• Have an achievable aim to return to viability once the crisis has passed; and
• Inform members and the ACNC if trading insolvent.

Directors of charities and NFPs structured as companies limited by guarantee will benefit from the temporary insolvent trading safe harbour, which provides temporary relief for directors from personal liability for trading while insolvent.