Are you insolvent, and what does that mean for your company?

The following article was published by Lexology on 27 March 2023:

Presently, there is a lot of talk about insolvency and the legal test for corporate insolvency. In simple terms, insolvency or bankruptcy means a company or an individual cannot pay its debts when they are due. In Australia, bankruptcy refers to individuals, and insolvency refers to a company.

In this article, we will focus on corporate insolvency. What is the legal test for solvency? When are you insolvent vs having a short-term liquidity problem? What is the presumption of insolvency, and how can you rebut the presumption and prove solvency?

The definition of insolvency

Corporate insolvency is governed by the Corporations Act 2001 and is defined as follows in section 95A of the Act. 

(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.

A "person" in sec 95A includes a company. Strictly speaking, the law defines insolvency as the opposite. In practice, a company is insolvent when it is UNABLE to pay its debts when they become due and payable.

What does this mean on a practical level? When is a company unable to pay its debts? 

Are you insolvent when you don't have the cash to pay the debt (the cash-flow test)? Or are you only insolvent when your total liabilities exceed your assets (the balance sheet test)? What happens if you have more assets than liabilities but can't pay the debt due to cash-flow issues? 

Besides telling us that you are "insolvent when you are not solvent", the Act does not answer our everyday practical questions about insolvency. 

When is a company insolvent? 

The Australian courts favour the common law cash-flow test as opposed to the balance sheet test. When applying the cash-flow test, the courts will look at the following factors: 

• The existing debts - when is it due? Any prospective debts? 

• The company's current cash resources and when/if expected cash will be received.

In Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation ((2001) 39 ACSR 305), the judge defines the test as follows: 

"the test of insolvency is dependent on inability to pay all debts " as and when they become due and payable".

The court gave some guidelines to assess solvency. It included the following: 

"whether or not a company is insolvent is a question of fact to be ascertained from a consideration of the company's financial position taken as a whole… in considering the company's financial position as a whole, the court must have regard to commercial realities."

So, in practice, the courts regard commercial realities when assessing solvency. It is not just a black-and-white test. Ultimately, the test remains whether the company can pay its debts when due and payable.

What resources are available to pay debts when they are due?

If you can show that you can find the funds to pay the debts, or a contract debt is owed to you on a specific date, you can escape a finding of insolvency.

In other words, the court will examine whether this is just a temporary liquidity problem, meaning the company is not insolvent, or whether we are dealing with a general lack of funds. If the court finds the latter, the court will consider the company insolvent.

When deciding whether it is a temporary liquidity problem vs insolvency, the Australian courts have developed a list of indicators pointing to insolvency. Lawyers, directors, and liquidators use this indicator checklist to decide when a company is at risk of insolvency.

Insolvency indicators

The list of insolvency indicators was set out in ASIC v Plymin (2003) 46 ACSR 126 and included the following: 

1. Continuing losses.
2. Liquidity ratio below 1.0.
3. Overdue Commonwealth & State taxes and statutory obligations.
4. Poor relationship with the present bank, including an inability to borrow additional funds.
5. No access to alternative finance.
6. Inability to raise further equity capital.
7. Supplier placing the debtor on cash on delivery (COD) terms or otherwise demanding special payments before resuming supply.
8. Creditors' unpaid outside trading terms.
9. Issuing of post-dated cheques.
10. Dishonouring cheques.
11. Special arrangements with selected creditors.
12. Payments to creditors of rounded sums, which are not reconcilable to specific invoices.
13.  Solicitors' letters, summonses, judgements, or warrants issued against the company.
14. Inability to produce timely and accurate financial information to display the company's trading performance and financial position, plus make reliable forecasts.

These 14 indicators reflect on the availability of money, the ability to raise funds or loans, and ultimately, the ability to pay debts when due. If you are a company director, you must monitor these factors. One of your director's duties is not trading when the company is insolvent. Breaching this duty can lead to serious personal consequences.

However, the list is not exhaustive, and a single indicator does not necessarily warrant a finding of insolvency. Each case is assessed on its own facts and merit. 

As we can see, your solvency status is not always a black-and-white matter. There are many grey areas to complicate matters. One such tricky area involves a presumption of insolvency under section 459C of the Corporations Act.

Presumption of Insolvency

Under section 459C, the court must presume a company is insolvent, meaning the creditor does not need to prove insolvency in certain scenarios.

This presumption kicks in when any of the following occurs during or after three months from the day an application was made for winding up the company: 

• The company failed to comply with a statutory demand.
• A judgment execution process or other order was returned wholly or partly unsatisfied.
• A receiver was appointed, or an order was made for such appointment, or a person assumed control of the company property, or such a person was appointed to take control.

Serving a statutory demand is a popular way to "prove" that a company is insolvent. Failing to pay the debt or not applying to set aside the statutory demand within 21 days sets the sec 459C presumption in motion. 

However, the presumption is rebuttable. 

Setting the presumption in motion is not the same as proving insolvency. It merely means the onus shifts to the company to prove that it is not insolvent, i.e., to rebut the presumption.

Rebutting the presumption - proving solvency

The Act does not provide much guidance on how to rebut the presumption. It merely says: "…the presumption operates except so far as the contrary is proved…."

So how does one prove the contrary? 

When the Court of Appeal described the task of proving solvency in Expile Pty Ltd v Jabb's Excavations Pty Ltd [2003] NSWCA 163, it said the following: 

"It must be emphasised (at [16]) that proper verification of assets and liabilities is critical to rebut the presumption of insolvency".

The FCA in Ace Contractors & Staff Pty Ltd v Westgarth Development Pty Ltd [1999] FCA 728 set out several propositions to rebut the presumption, including the following:  

1. To rebut the presumption, the company must present the "fullest and best" evidence of the company's financial position.

2. Unaudited accounts, unverified valuations, and bald assertions of insolvency arising from a general review of accounts (even if made by a qualified accountant with detailed knowledge of the accounts) have all been held not "best" evidence by the courts. The proof must be verified and audited. 

3. There is a distinction between solvency and a surplus of assets. Having vast and surplus assets might not be sufficient to prove solvency. The court wants to know if those assets can be converted to cash quickly enough to meet all the debts as and when they are due.

4. The company's assets may be relevant when considering credit resources available to the company. Are they available as surety against a loan? 

5. Although the court assesses the company's solvency on the date of the rebuttal hearing, the court could consider future events, i.e., finalising a big deal in the near future that will bring in cash, etc.

Typically, discharging the onus to prove solvency and rebutting the presumption could be a challenging forensic exercise. It clearly involves more than just producing a balance sheet.

Can we expect corporate insolvency reforms in 2023? 

In September 2022, Parliament began a new inquiry (the PJC Inquiry) into corporate insolvency in Australia. The committee will look at existing legislation and options for reform. 

Whether we will be left with "A person who is not solvent is insolvent" remains to be seen. 

Until then, navigating corporate insolvency can be complex. If you are still determining whether your company is legally solvent or insolvent, seek professional advice immediately.