In Australia there is a ‘one size fits all’ approach to determining the definition of corporate insolvency. The absence of a clear cut definition can lead to ramifications in the practical management of companies that are in financial distress.
Section 95A of the Corporations Act 2001 (Cth), attempts to provide a statutory definition of what constitutes solvency and insolvency:
(1) 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; and
(2) A person who is not solvent is insolvent.
Strict interpretation of this legislation deems that a company is insolvent if it is unable to pay all of its debts, as and when they become due and payable. However, judicial interpretation over the years has provided that a company, not able to pay a debt when it falls due, may not in fact be insolvent but may be merely suffering from a temporary lack of liquidity.
Case law has provided that the conclusion of insolvency should be established from a thorough consideration of the debtor’s financial position in its entirety and ought not to be drawn simply from evidence of a temporary lack of liquidity. It should be the debtor’s inability, utilising such cash resources as it has or can command through the use of its assets, to meet his debts as they fall due which indicates insolvency (refer to the case of Sandell v Porter (1966)).
A temporary lack of liquidity must be distinguished from an endemic shortage of working capital. In the case of ASIC v Plymin (2003), Mandie J of the Victorian Supreme Court listed fourteen indicators of insolvency that should be implemented as a beacon to any company that may be looking down the tunnel of insolvency as opposed to merely trading through a temporary phase of illiquidity (although not all of these indicators need to be present for a company to be insolvent). These indicators are:
- The company is experiencing continuing losses;
- The company’s liquidity ratio is below 1;
- The company is subject to overdue Commonwealth and State taxes;
- The company has evidence of poor relationship with its Bank, including the inability to borrow further funds from it;
- The company does not have access to alternative finance;
- The company has an inability to be able to raise further equity capital;
- The company’s suppliers place the company on cancellation of debt, or otherwise demanding special payments before resuming supply;
- The company’s creditors are unpaid outside of the trading terms;
- Issuing of post-dated cheques by the company;
- Issuing of dishonoured cheques by the company;
- The company is required to enter into special arrangements with selected creditors;
- The company becomes the recipient of solicitors’ letters, summons, judgments or warrants issued against it;
- Payments to creditors of rounded sums which are not reconcilable to specific invoices; and
- The company has an inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.
The absence of a clear cut definition of corporate insolvency has, and will continue to, lead to ramifications in the practical management of companies that are in distress. Should you have any concerns about the financial position of your company contact us today.