In our previous article found here, we explained how the Federal Government has introduced certain measures safeguarding directors from personal liability in connection with insolvent trading.
While these temporary measures remain in place, it is still prudent for directors to be on the lookout for indicators of insolvency, and adequate seek assistance if required, especially as government assistance and the temporary measures are likely to start to be wound back in coming months.
What does it mean to be insolvent?
The Corporations Act 2001 (Cth) ("Corporations Act") confirms that a company is insolvent if it is unable to pay all its debts when they become due and payable. Essentially, when a company's cash flow is unable to meet its short term liabilities, provided there is no other means of obtaining financing, the company will likely be deemed insolvent.
When forming such a view, it is important to also take note of the industry and circumstances impacting the commerciality of the company. For example, many companies operate seasonally, whether that is during summer such as coastal take away businesses or during winter snow sport equipment hire businesses.
In addition to ongoing losses and poor cash flow, the Australian Investment and Securities Commission ("ASIC") notes there are a myriad of other key signs that indicate a company is at risk of becoming insolvent. If you are a creditor/supplier, look out for the following:
- being unpaid outside usual terms
- implementation of special arrangements with selected creditors - e.g. placing the company on cash-on-delivery terms
- payments of rounded sums that are not reconcilable to specific invoices
- overdraft limit reached or defaults on loan or interest payments
- change of bank, lender or increased monitoring/involvement by financier
- increased level of complaints or queries raised with suppliers
- post-dated cheques or dishonoured cheques being issued.
If you are a director, in addition to the above you should also look out for the following:
- incomplete financial records or disorganised internal accounting procedures
- lack of cash-flow forecasts and other budgets
- letters of demand, summonses, judgements or warrants issued against the company
- increasing debt (liabilities greater than assets)
- unrecoverable loans to associated parties
- overdue taxes and superannuation liabilities
- absence of a business plan
- problems obtaining finance
- inability to raise funds from shareholders.
The impact of insolvency and why it matters for creditors
It is undoubtedly evident that COVID-19 has had an unprecedented impact on the cash flow of companies in almost all industries and sectors.
While many companies may return to their previous state of profitability as the stay at home restrictions are starting to be relaxed and some stability returns to the economy, creditors must be aware that this may not always be the case. In these circumstances, creditors must be regularly assessing whether they wish to continue to trade with a company at risk of insolvency.
Prevention is always best, and legally enforceable terms and conditions incorporating a retention of title clause (for those who are supplying goods), together with timely registration on the PPSR will provide a solid basis for enforcement should your customers face insolvency at some time in the relationship.
The latter is especially important if a company is later wound up, as a liquidator has the power to order repayment from certain unsecured creditors within the last 6 months of the liquidator's appointment if deemed an unfair preference payment under the Corporations Act.
The impact of insolvency and why it matters for directors
As a director of a company, the Corporations Act prescribes a number of key duties to ultimately ensure you are acting in the best interests of the company. One of these duties is to ensure the company does not trade while insolvent.
There are various penalties and consequences for directors found guilty of insolvent trading, including civil penalties, compensation proceedings and in some cases criminal charges.
While the extended 'safe harbour' provisions are currently in operation, there is no holiday for directors for their other obligations under the Corporations Act and at common law.
- As a result of the current economic climate, right now more than ever companies are at risk of becoming insolvent.
- There are a number of key factors that will indicate when a company is at risk of or has in fact become insolvent.
- Companies should be diligently monitored for the presence of these factors, as insolvency can have a major impact both legally and financially for creditors and directors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.