Insolvency is defined in section 95A of the Corporations Act. It
works in reverse. First, "solvency" is defined
as when a person is able to pay all their debts as and when they
become due and payable. A person (including a company) who is not
"solvent", is then deemed to be
insolvent. This is a cash flow based test, not a
balance sheet test. It sounds an easy test to apply, but in reality
it can be difficult – especially when you need to determine
the exact time of insolvency. A number of important legal
consequences are tied to the date of insolvency – including
the risk that directors of insolvent companies may be personally
liable for the company's debts.
However, while being precise as to the exact insolvency
time/date is important for directors, what is more important is
that they need to recognise a likely insolvency early enough to
take steps to try to overcome it. If additional funding is not
immediately available, those steps will include the appointment an
administrator, or causing a voluntary liquidation.
There are some well recognised indicia of a company's likely
insolvency. These include:
A poor aged creditors position, with pressing creditors;
Breach of the bank's lending terms;
Overdue state or federal taxes and in particular BAS, PAYG or
ASIC Information Sheet 42 [set out link to the ASIC website]
provides an extensive insolvency warning checklist. It follows that
a potential insolvency should not be too hard to recognise.
Once a company experiences any or all of the above indicia,
directors often seek external advice on the company's financial
position – what to do about it and how to manage their own
personal risks. They may turn to their accountant, solicitor or an
insolvency or turnaround expert. Traps exist for the director and
the advisor however.
If the advisor advises the company when it may be insolvent, the
advisors fees may be at risk if the company fails and they are
unpaid. Even if the advisor is paid pre-liquidation, the fees may
be an unfair preference payment and recoverable if the company goes
into liquidation shortly thereafter. The advisor should consider
taking some third party security or guarantee in this situation.
The advisor's advice is also readily obtainable by a liquidator
if the company fails, as it will be an advice given to the company.
The director(s) will not want advice about possible insolvent
trading falling into the liquidator's hands.
If a legal advisor advises a director as his client, then the
advice will usually be subject to legal professional privilege and
so not available to the liquidator. The advisor may have a better
prospect of being paid for their advice as well.
Personal liability for ATO payments
If the company is likely to be insolvent and it owes the ATO
substantial money, including PAYG, and it pays what is owed, then
if the company then fails within 6 months a director can face
personal liability for those payments.
If the company is placed into liquidation and the liquidator
later seeks to recover those payments from the ATO as unfair
preferences in a court action, then pursuant to a peculiar
director's personal indemnity provided to the ATO in the
Corporations Act, the director(s) may have to pay whatever sum of
money is recovered from the ATO. The ATO is a fairly common target
for such unfair preference claims, particularly if a failed payment
plan existed at the date the company was placed in to liquidation.
The liquidator usually obtains the ATO files for the relevant time
under a Freedom of Information request. These files might reveal
the extent of the ATO's suspicion of insolvency and so limit
its potential to be able to defend the claim.
The Corporations Act permits the ATO to join directors as
parties to such an unfair preference proceeding, and seek a
personal indemnity from them for the claimed sum. The indemnity
extends to an indemnity for costs. This statutory indemnity is
unique to the ATO. These claims are usually unwieldy and costly.
Three sets of lawyers will become involved, or more if there are
other directors. There are some statutory defences available. The
director may also have to take on the running of any available ATO
defences to the unfair preference claim, if the ATO sits on the
sidelines and takes no active role in that defence.
We successfully settled such an indemnity claim, acting for a
director recently. It was a time consuming process which produced
an acceptable negotiated settlement.
We have noted one legal author's recent comments that the
existence of this personal indemnity may cause directors to leave
the ATO unpaid during an insolvency crisis. In that event the
director may risk receiving a Director's Penalty Notice, or add
to the risk of insolvent trading.
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.
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This Update highlights two recent cases that considered circumstances where liens could take priority over a registered security interest.
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