Recognising and dealing with financial distress and insolvency in your business

Top tips

• A company is insolvent when it cannot pay all of its debts as and when they fall due.
• Directors are legally obliged to be aware of their company’s financial position at all times, to ensure there are sufficient cash flow and assets to pay creditors. If they are not, and the company is liquidated, they may be personally liable or penalised.
• If you suspect that your company may be at risk of insolvency, enlist professional assistance to help you assess the financial position and implement risk-minimising measures, or utilise the various insolvency appointment options available and best suited to your situation.

In our seventh episode in this series, we consider the concept of insolvency, what corporate insolvency might look like, and what steps can be taken to identify and then manage insolvency when it arises.

What is insolvency?

Section 95 of the Corporations Act 2001 (Cth) (Act) states that a company is solvent if, and only if, it can pay all of its debts as and when they fall due.  Therefore, insolvency is defined by the inverse – an inability to pay all debts as and when they fall due.

As with many legal concepts, it is not quite that simple. Consideration is given to questions about what constitutes a “debt”, and what is ‘due and payable’, and cashflow and balance sheet tests are applied. There must be more than a temporary lack of liquidity, where a company may not have enough cash and other marketable financial assets to meet its short-term obligations.  It is necessary to look at a company’s financial position, considering commercial realities, to determine if the company’s liquidity issue is temporary, or if it is genuinely insolvent, and it is not always an easy conclusion.

Nevertheless, the assessment of insolvency is important, as there is a statutory duty upon directors to prevent a company from trading when insolvent.  If a director is found to have breached that duty, they can be personally liable for the debts incurred while insolvent as well as criminal and civil sanctions, including substantial fines or imprisonment.  Consequently, directors should be aware of the key signs of insolvency, so they can take appropriate steps to minimise risk to the company and creditors, and limit their personal liability.

Indicators of insolvency

While ascertaining whether a company is technically insolvent can be difficult, the following are indicators which, when appearing simultaneously, tend to suggest corporate insolvency.

• Continuing trading losses.
• Experiencing cash flow difficulties.
• Overdue state and Commonwealth taxes (i.e., PAYG, GST and superannuation guarantee contributions).
• Operating outside its trading terms with creditors or loan terms with lenders and/or suppliers imposing onerous trading terms (for example COD).
• Making special payment arrangements with certain creditors.
• No access to further or alternative finance and unable to raise equity.
• Payments to creditors of round sums, which are not reconcilable to specific invoices.
• An inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.
• Dishonoured cheques.
• Receiving repeated demands for payment, solicitor’s letters, summonses, and director penalty notices.
• Changes in key office holders such as directors and managers.

Managing potential insolvency in your company

If some of these indicators of insolvency are present, it is prudent to implement certain steps in an effort to minimise risk and losses to the company, its creditors and director/s. Such steps can include the following.

1. Stay informed and increase monitoring: monitor profit and cash flow budgets, review financial statements, review the company’s level of lending facilities, and keep an eye on creditor payments and arrangements.
2. Engage early with creditors and financiers: be as open and transparent as possible.  You want to avoid your key stakeholders getting nasty surprises.  Seek any necessary moratorium on payments by way of manageable instalments to assist the company in overcoming any temporary lack of liquidity.
3. Get professional advice: experienced insolvency practitioners and lawyers can help you assess your company’s financial position and viability, and understand the various insolvency appointment options available and best suited to your situation. 
4. Act quickly: not acting as soon as you suspect insolvency can be fatal to the company and expose you to personal liability.  Proactive management of financial distress can be the difference between a good and a bad outcome. A great example of this is the “safe harbour” provisions of the Act, which provide a defence to insolvent trading for directors who, when faced with insolvency, seek advice from an appropriately qualified advisor and implement a plan that would reasonably likely lead to a better outcome for the company.

Formal insolvency options and appointments

There are a number of options available if your company is insolvent. They differ in application and purpose, and what is best for your company will depend on the specific circumstances.  The most common types of insolvency appointment are as follows.

1. Voluntary administration – a process designed to give ‘breathing space’ to a company facing insolvency. The company can appoint an administrator to take control of the company, investigate the financial affairs, and make a recommendation to creditors to either hand control of the company back to directors, approve a deed of company arrangement, or wind up the company and appoint a liquidator.  Voluntary administration is an interim process intended to take no longer than 2-3 months.
2. Deed of company arrangement (DOCA) – a DOCA is a binding agreement between a company and its creditors usually to facilitate the company’s recovery. It will usually provide a fund into which realised assets or income is paid, and from which creditors will receive a distribution.  A proposal for a DOCA can be made during voluntary administration and the administrator will assess whether it will result in a better return to creditors, who will then vote whether to execute the deed or not.
3. Liquidation – if there is no prospect of recovery, the most common option is winding up the company and appointing a liquidator, whose main responsibility is to convert any remaining assets or property of the company into cash to repay as many creditors as possible and then to deregister the company.  Liquidators will also investigate the affairs of the company and are empowered to pursue recovery action against creditors, debtors and directors of the company for voidable transactions and insolvent trading (among other things).
4. Small business restructuring – a simplified debt restructuring process specifically for small businesses, allowing directors to retain control while working with a restructuring practitioner to improve the financial position of the company. A number of eligibility criteria apply, including debts of less than $1 million and having all tax lodgements up to date.
5. Receivership – this is a non-voluntary process initiated by a secured creditor, who appoints a receiver to take control of, and realise, the secured assets. Receivers act only in the interest of the secured creditor by whom they are appointed and do not control the company as a whole (unlike administrators and liquidators). 

Conclusion

While there are differing outcomes and avenues open when faced with the prospect of an insolvent company, the critical point is not to ignore the warning signs and trade on without obtaining professional advice on the actual financial position of the company and appropriate next steps.

In our next episode, we discuss how to identify insolvency or financial distress in your customers or creditors, the impacts that situation can have on your business, and how you can minimise your risk in those circumstances.