What is Insolvency?

Disclaimer:  The following article is for information purposes only and should not be relied upon in any manner without first seeking legal advice. 

 

Tests of Insolvency

Insolvency generally refers to one’s ability to be able to repay debts as they fall due.

In Australia, a company is insolvent under the Corporations Act 2001 (the ‘Act’) if it is unable to pay its debts as and when they fall due.

Two primary tests are used by insolvency practitioners and the Courts to determine this position being the Cash Flow Test and Balance Sheet Test.

A Court may also take into consideration other factors, including Contingent and Prospective Debts.

Cash Flow Test

Generally, the Court will assess the company’s ability to pay its debts by reference to the actual circumstances of the company.  Ordinarily, this analysis involves applying a cash flow test.  In other words, the court will focus on the ratio of current assets to current liabilities as such an assessment is likely to inform the Court as to the company’s immediate prospects, “having regard to the assets which are available and the liabilities which will be payable within a horizon of so many months”. [1]

Jackson J. in Cube Footwear Pty Ltd [2012] QSC 398, stated at paragraph [1] that:

“… the inquiry as to solvency is primarily directed to the short term cash flow position of the respondent company. In general, it is no answer for the company which is unable to meet current liabilities to say that its assets exceed the liabilities overall.  The time aspect of the test of solvency – “as they become due and payable” – will not be satisfied.”

It is important to note that temporary financial difficulties that may result in negative cash flow do not necessarily render a company insolvent if it has greater resources it can draw upon, for example: realises certain assets; has the ability to loan funds; undertakes certain fundraising; or enters into extended payment terms with certain creditors.

Balance Sheet Test

In addition, the Court may assess a variety of commercial factors and the financial position of the company as a whole when determining solvency. This is commonly known as the balance sheet test and it requires an assessment of the company’s ability to:

  1. gather additional money in a realistic manner – quickly, from the issue of additional share capital, or from future borrowings; and
  2. pay its debts without affecting the company’s overall ability to trade (and pay all its debts), provided that there are surplus of assets that can be sold.

 

Other Factors taken into Account by the Court

The company’s commercial reality is considered to determine if that company is solvent or not:

“The company’s ability to borrow is an aspect of the overall facts and commercial reality: see Lewis v Doran at [106]-[114]. The ability of [the] company to borrow and the willingness of creditors to continue lending may be significant factors. The likelihood that directors and shareholders will continue to support the company by lending money is relevant: see Mulherin v Bank of Western Australia Ltd [113]-[115]. The terms on which funds are available are also important…” [2]

Consistent with that analysis, in the matter of Cube Footwear Pty Ltd [2012] QSC 398 at paragraph [17] and [18[, Jackson J. stated that:

“…available unsecured borrowings may be considered as a source of the funds to pay debts, debts placed on deferred payment terms may be considered as a source of credit available to the company and the support of directors (or shareholders) by unsecured loans may also be taken into account in that way.”.[3]

Further, it has been held in a number of decisions that the support of major creditors can be a decisive fact in supporting solvency. [4]

 

Contingent and Relative Prospective Debts

Another relevant consideration that the Court will take into account when determining insolvency is the company’s capacity to meet contingent and relatively prospective debts.

Giles JA in Lewis (as liquidator of Doran Constructions Pty Ltd) v Doran stated: [6]

“… how far into the future will depend on the circumstances including the nature of the company’s business and, if it is known, of the future liabilities.”

However, there is no formula which exists (at law), to assist the Court in determining the relevant period over which the assessment should extend – the period has been as short as one month;  or as long as two and a half years.

If you believe your company may be at risk of being insolvent, please contact us for an obligation free discussion.

 

 


[1] Cube Footwear Pty Ltd [2012] QSC 398 at [50].

[2] Georgiou Building Pty Ltd v Perrinepod Pty Ltd [2012] WASC 72 at [41].

[3] These conclusions are directly supported by Lewis v Doran (2005) 219 ALR 555 at [109] and indirectly supported by Mulherin v Bank of Western Australia Ltd [2006] QCA 175 at [112]-[115].

[4] See Southern Cross Interiors Pty Ltd (in liq) v DCT (2001) 53 NSWLR 213 per Palmer J at [54]; Georgiou Building Pty Ltd v Perrinepod Pty Ltd (2012) ACSR 713 at [39]; Australian Securities and investments Commission v Plyminn (No1) (2003) 46 ACSR 126 at {378} per Mandie J.

[6] (2005) 54 ACSR 410; [2005] NSWCA 243 at para [103], referring to Bank of Australasia v Hall (1907) 4 CLR 1514 as per Griffiths C.J at 1528.


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Scott D. Taylor

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