Why should you care about the insolvency of someone else’s company?

By Jacob Carswell-Doherty

We should all know that company directors owe a duty to prevent insolvent trading by their own company, but should you care about someone else’s solvency?

There is a risk that a creditor who is aware that a #company is insolvent might be required to repay sums paid to clear a #debt.

This scenario would not apply in relation to the instantaneous purchase and sale of goods or services, unless for undervalue.

If a company appears to have a history of paying invoices late and later goes into liquidation, it could be argued later by a liquidator that such payments were made in preference to other creditors and in circumstances where there was knowledge of the company’s insolvency.

In these circumstances, a #liquidator may very well demand payment of sums paid in relation to unfair preference claims under sections 588FA and 588FE (2B) of the Corporations Act 2001 (Cth).

Anyone who is collecting payment on their invoices from a company should be aware of the warning signs because liquidators can and do argue constructive knowledge of a company’s insolvency, if not actual knowledge.

A person will have “notice of facts”, regardless of any subjective view they may have taken, that a company is insolvent if:

“…the person has actual notice of facts which disclose that the company lacks the ability to pay its debts when they fall due…It is unnecessary to show that the person actually formed the view that the company lacked that ability. As the NSW Court of Appeal said in Hathaway Shirt Co Pty Ltd v B Rawe GmbH Co, it is “well established that there is a difference in law between receiving notice of a fact and being made fully and subjectively aware of the fact.”

There is a list of insolvency indicators at the end of this article.

What should you do to protect yourself from liquidator clawback?

The best way to ensure the money you receive is safe:

1.     Ensure any debts that the company owes you are “secured.” For instance, with a PPSR charge or a mortgage.

2.     Require pre-payment of your invoices.

3.     Require personal guarantees.

What is insolvency?

#Insolvency occurs when a debtor cannot pay their debts when they are due.

Insolvency at law

Section 95A(1) of the Corporations Act 2001 (“the Act”) states that “[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 common example of insolvency is when a corporation faces fiscal difficulty to the extent that they are unable to repay its creditors on time. In these circumstances, after an assessment of their financial situation, they may be insolvent.

According to s 95A(2) of the Act, a company or individual is either solvent or insolvent. This means the test for insolvency is definitive, and there is no ‘in between’.

There are two fundamental tests for insolvency.

The two tests involve looking at the person or company’s cash flow, as well as their balance sheet.

Cash Flow Test

The #cashflow test is assessed by looking at assets and liabilities and whether assets exceed liabilities. For companies, it examines whether they can financially carry on the day-to-day course of their business and whether the company is paying their debtors on time.

Remember: A temporary lack of financial resources (“liquidity”) is not to be confused with insolvency. This was discussed in Sandell v Porter [1966] HCA 28, where it was also established that an inability to pay is not confined to cash. An assessment for insolvency also refers to money that can be obtained by, for example, the value of assets and their ability to be pledged.

Balance Sheet Test

The #balancesheet test refers to an assessment of a person or company’s total assets and liabilities. If a company or person’s total liabilities are greater than its asset pool, this can lead to establishing insolvency. However, this will only be relied upon if proven that their assets are not enough to discharge their liabilities.

Indicators of insolvency

While in essence, it must be demonstrated that a company is unable to repay its debts on time due to financial inability, there is a multitude of specific factors that need to be considered.

With reference to the two tests for insolvency, below are some of the more common examples listed by CPA Australia:

–         a history of continuing trading losses;

–         cash flow difficulties;

–         difficulties selling stock, or collecting owed debts;

–         creditors unable to be paid on agreed trading terms;

–         not paying taxes when due;

–         cheques returned as dishonoured, or company holding back cheques for payment or issuing post-dated cheques;

–         legal action threatened or commenced against the company;

–         limits on funding facilities reached and is unable to obtain further finance for that purpose;

–         unable to produce accurate financial information in a timely manner to highlight the company’s trading performance and financial position;

–         company director/s resigned with concerns about company’s financial position;

–         company auditor has qualified their audit opinion on grounds of uncertainty that the company can continue;

–         company has defaulted, or is likely to default, on its agreements with its financier;

–         employees, or the company’s bookkeeper, accountant or financial controller, have raised concerns about the company’s ability to meet, and continue to meet, its financial obligations; and

–         not certain that there are assets that can be sold in a relatively short period of time to provide funds to help meet debts owed, without impacting future ability to continue trading with profits.

Disclaimer: Please note that the content of this article is for general informational purposes only and not for the purpose of providing specialised legal advice.