Federal Court finds company was insolvent under a contract despite trading six years later - Insolvency/Bankruptcy

This week's TGIF considers a recent decision of the Federal Court where a company was found to be 'insolvent' for the purposes of assessing breach and termination of a contract, despite its subsequent survival and ongoing trading.

Key Takeaways

When drafting agreements with termination clauses referable to a party's insolvency, lawyers should carefully consider the consequences that might flow if 'insolvency' is defined otherwise than by reference to the definition of that term in the Corporations Act 2001 (Cth) (Corporations Act).
Where parties to a contract choose to define insolvency in their own terms independent of the legislation, the court will generally consider whether the plain words of the clause have been satisfied as a matter of fact.
For the purposes of concluding a company is or was insolvent, the mere fact it survives for a period of time does not automatically preclude a finding that the company was insolvent from that earlier date, either under contract or at law.

The contract

Carna Group Pty Ltd (Carna) had entered a contract with Griffin Coal Mining Company Pty Ltd (Griffin) in early 2014 for the provision of mining services. The contract provided for termination by either party where the other party had committed an 'insolvency default'.

The contract defined when a party would be considered 'insolvent' for the purposes of default. The definition referred to both the statutory definition of insolvency under section 95A of the Corporations Act and, separately, the situation where a party was 'otherwise unable to pay its debts when they fall due'.

In December 2014, following failures by Griffin to meet its payment obligations under the contract, Carna issued a Notice of Termination on the basis of, among other things, 'insolvency default'.

Applicable law

The Court considered whether Griffin had been 'insolvent' for the purposes of breach of contract. Ordinarily, insolvency under the Corporations Act requires satisfaction of a relatively high threshold of proof in order to demonstrate a company's lack of cash flow and parlous financial position.

However, the contract referred to both the statutory definition of insolvency and, separately, a definition of 'insolvent' which largely reflected the plain words of the legislation. As a question of contract law, McKerracher J focused on principles of contractual interpretation to assess the scope of the insolvency definition in the contract and whether the second-mentioned limb ought to be read down to mirror the requirements of the legislation.

If the meaning of 'insolvent' was confined by the legislation, it would be more difficult for Carna to prove default under the contract. Additionally, Carna had to prove that despite its survival six years later, Griffin had been insolvent at the time the Notice of Termination was issued. If it was not, Carna would be liable for repudiation of the contract based on an invalid termination.

What did the Court decide?

McKerracher J first determined that the meaning of 'insolvent' under the second limb of the definition should not be read down. Although the first limb of the definition referred to the statutory definition, his Honour held that the text of the contract disclosed no reason to confine the plain meaning of the words used. As such, the relevant question was simply whether Griffin had been unable to pay its debts when they fell due at the relevant time.

In determining whether Griffin was factually insolvent in 2014, Griffin argued that its financial status in 2014 was a temporary liquidity issue, rather than an insurmountable shortage of working capital. This was said to be proved by the fact it was trading six years later, which precluded a finding of insolvency. Griffin also referred to its ability to obtain financial assistance from its parent company.

McKerracher J rejected this argument, observing that the mere fact a company survives for months or years after it becomes insolvent was not determinative. Additionally, because the contract only required proof that Griffin was unable to pay its debts when they fell due, the question of insolvency was to be answered by reference to the facts at the time. His Honour also referred to the fact that Griffin could not compel the parent company to provide financial support, nor was such support forthcoming. As such, Griffin did not have the necessary degree of assuredness that the parent company would assist in the payment of its debts.

Although his Honour noted a company's subsequent survival could be indicative of a lack of insolvency, the facts and circumstances established that Griffin had been unable to pay its debts when they fell due. As this was the key question, his Honour emphasised the consistent state of arrears Griffin had been in over the life of the contract. McKerracher J also referred to a number of traditional signs of insolvency including Griffin's ongoing losses, poor cash flow, and arrangements to pay creditors outside the usual terms.

His Honour therefore accepted Carna's argument that it had validly terminated the contract for 'insolvency default' and was entitled to damages.

Comment

The case suggests parties should carefully scrutinise clauses which allow for termination in the event of a party's insolvency. If the contract defines insolvency separately to the Corporations Act, this may allow a party to avoid having to demonstrate insolvency to the standard required by the statutory definition.

Similarly, where a company manages to survive quite significant financial challenges, this will not necessarily protect it from a finding of insolvency. Even where the statutory definition is being considered, the case suggests that the question is not whether the company continues to operate, although this may be relevant. The key question is always directed to whether a company can pay its debts as and when they fall due.

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.