No doubt you will have heard of insolvency throughout your initial years of practice, but do you really know what it means?
This article breaks down some of the key concepts and processes that every junior lawyer should understand before engaging in the world of corporate distress. The consequences of insolvency are significant, so it is important that practitioners are aware of insolvency risks when advising clients across all areas of law.
At the outset, it is important to note the distinction between insolvency and bankruptcy. The term insolvency is applied towards corporate insolvencies – that is, those relating to corporate entities. The term bankruptcy is more commonly applied towards personal circumstances – that is, those relating to an individual person.
This article focusses on the core principles of insolvency. Keep an eye out for our subsequent article regarding personal bankruptcy, should you be interested in learning more about how these concepts apply to individuals.
What does insolvency mean?
The definition of insolvency is: an inability to pay debts as and when they fall due.
The test for insolvency is not as simple as a “balance sheet” test. In other words, just because a company has more assets than liabilities on the balance sheet, that does not necessarily mean that the company is solvent.
The test applies at the point in time when the debt becomes payable. So, to avoid falling into insolvency, a company needs to maintain sufficient liquid assets (in other words, assets that can be used immediately to pay debts when they are due). This means that companies which are asset rich, but cash poor, can sometimes inadvertently fall into the technical definition of insolvency where debts become due and payable, but the cash reserves are not there to satisfy the debts. This type of assessment is commonly known as a “cash flow test”.
Why does it matter if a company is insolvent?
There are public policy considerations which underpin insolvency concepts.
Put simply, one of the most important public policy factors is the need to deter companies from trading in the open market when they are unable to pay other parties for goods and services rendered. Which, when you think about it, makes a lot of sense – it’s not fair for a company to continue trading in the market if they can’t pay their bills. The insolvency scheme aims to protect innocent third party creditors from unknowingly engaging in business with insolvent companies.
What happens when a company is insolvent?
This question can be considered from three perspectives:
1. The company.
For the company, insolvency could result in the entity being wound up. See below under the heading “Types of insolvencies” for further information in that regard.
2. The director(s).
In some circumstances, directors can bear personal liability for debts owed by the company. Most commonly, those debts arise due to certain unpaid tax debts owed by the company - for example, unpaid PAYG withholding, GST, and employee superannuation. Personal liability can also arise as a result of the director’s conduct – for example, by entering into personal guarantees during the course of conducting the business, or by continuing to trade even though the director knew (or even suspected) the company was insolvent.
3. The creditor(s).
If a company cannot pay its debts when they fall due, there will no doubt be multiple creditors that are left trying to recover unpaid invoices from that same company.
Often, the creditors will not recover the full amount of the debts owed to them if they are dealing with an insolvent company. The creditors at greatest risk are those who are unsecured, that is, those who have not taken security for payment of the debt (as opposed to a bank which would register a mortgage over a property as security for a loan). Unsecured creditors often include those involved in day-to-day trading with the business, but most commonly, the Australian Tax Office.
Types of external administration
When a company is insolvent, it will generally be placed into some form of external administration. The process of external administration involves the appointment of an insolvency practitioner, who will then perform certain functions based on the type of administration which they are appointed to carry out. However, at their core, all external administrations are performed for the purpose of maximising the return to creditors.
The most common types of external administration are set out below:
Liquidation
A liquidation describes the formal process of winding up the affairs of a company. The process involves a liquidator selling off any assets owned by the company in order to recover as much money as possible. Any funds recovered are then applied to the liquidator’s fees and expenses, then the balance is distributed to creditors (if there is anything left).
The manner in which the funds are allocated to creditors is typically on a “cents in the dollar” basis – that is, if Creditor A is owed $10,000 and there is a total of $100,000 owed to all creditors of the company, then Creditor A will be paid 10% of any amount which is available for distribution by the liquidator (because Company A’s debt made up 10% of the total creditor pool).
There are other factors which complicate this process, such as whether the creditor is secured, unsecured, or perhaps where the liquidator might have a set-off against the creditor; but those matters extend beyond the scope of this article.
Voluntary Administration
A voluntary administration describes the formal process where an insolvency practitioner is appointed to a company to take control and assess the company’s future, with a particular focus on whether the business can be preserved in order to protect the best interests of creditors.
A voluntary administrator will investigate the company’s financial position, report to creditors, and make a recommendation as to next steps, which often include recommendations regarding: entry into a Deed of Company Arrangement (a binding agreement between a company and its creditors that sets out how the company’s debts will be managed, with a view to allow the company to continue trading); returning control to directors; or, placing the company into liquidation.
Small Business Restructure
As an alternative to liquidation or voluntary administrations, some companies are eligible to participate in a Small Business Restructure (SBR).
The SBR process is a simplified version of a liquidation or voluntary administration. If successful, the SBR process can be a useful tool to deliver a fast return to creditors and hand control of the company back to directors.
Some of the key eligibility for a SBR criteria include:
- Total liabilities not exceeding $1,000,000.
- A requirement for all tax lodgements to be up to date (for example, tax returns and Business Activity Statements).
- A requirement for all employee entitlements to be paid up in full – including superannuation.
Again, the best interests of creditors remain paramount, and the primary role of the small business restructuring practitioner is to ensure that the best possible outcome is being achieved for creditors.
Key takeaways
So, the next time the topic of insolvency is raised, be sure to remember that:
- A company is insolvent when it cannot pay its debts when they are due.
- Insolvency impacts the company, the director(s) and creditors in different ways.
- There are different processes that are applied to insolvent companies, such as liquidations, voluntary administrations and SBRs.
Be sure to keep an eye out for the next article in this series: Bankruptcy 101.
Brendan Reidy
Behlau Murakami Grant