How is Insolvency Calculated

September 26, 2019

When a company is experiencing financial difficulties and is later placed into liquidation, the appointed liquidator must undertake a detailed forensic investigation into the affairs of the Company and the conduct of its officers to explain the reasons for the Company’s failure.

This will include a determination as to whether the Company was allowed to continue to trade while insolvent.

Company Directors will often ask how does a liquidator prove insolvent trading – and what does the liquidator look for when performing this role.

What is Solvency?

One should understand the definition of solvency is set out in section 95A of the Corporations Act. It states;

  • 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.

What is insolvent trading?

Insolvent trading occurs when a Company Director allows their company to trade and incur debts when it is insolvent and unable to pay those debts as and when they fall due for payment.

What Sections of the Corporations Act deal with Insolvent Trading?

Section 588G of the Corporations Act 2001 (Cth) states a Director has a positive duty to prevent insolvent trading by a company and that the section will apply if:

  • A person is a director of a company at the time when it incurs a debt;
  • The company is insolvent at the time, or becomes insolvent by incurring that debt;
  • At the time, there are reasonable grounds for suspecting the company is insolvent or would become insolvent

A person contravenes the section if:

  • They are aware at the time there are such grounds for suspecting insolvency
  • A reasonable person in a like position in a company in the company’s circumstances would be so aware.

Section 588M provides for recovery of compensation for loss resulting from insolvent trading from a director personally for a breach of this duty.

Insolvent Trading – penalties apply

If a director allows a new debt to be incurred knowing the company is insolvent and unable to pay those debts, the director may be guilty of insolvent trading and may become personally liable for the repayment of debts to the company or its individual creditors.

  1. A liquidator or an individual creditor may commence legal proceedings for an order that a director pay compensation for the damages incurred by the company or an individual creditor.
  2. A director may be disqualified from acting as a director if they are found guilty of insolvent trading.
  3. Further, fines of up to $200,000 may be applied as well as a gaol term for up to 5 years.

To determine whether a Company was solvent or insolvent and unable to pay its debts as and when debts fell due for payment, a liquidator will collect and examine the books of the company.

The liquidator will look for evidence of insolvency such as;

  • suppliers stopping credit and placing the company on COD.
  • suppliers demanding payment of the outstanding debt before resuming supply
  • whether at the time the company was generating ongoing and unsustainable losses
  • the company has poor cash flow and does not have sufficient funds to meet its short term needs
  • the company has exceeded its overdraft limit
  • the company is unable to obtain or access further credit or finance
  • creditors are demanding payment and threatening to commence legal recovery action
  • creditors are not being paid or are paid well outside of usual terms
  • debt continues to increase
  • unable to pay statutory obligations such as debts to the Australian Taxation Office for overdue taxes
  • asset being sold to fund trading
  • high staff turnover
  • incomplete books and Financial Records
  • essential maintenance of assets being postponed or ignored
  • issuing post-dated cheques and dishonoured cheques

If you are worried that your company may be showing signs of insolvency, contact The Insolvency Experts.

Call 1300 767 525

Directors have a positive duty to avoid insolvent trading

Directors must:

  1. stay constantly aware of the financial affairs and position of the company.
  2. prepare the books of the company and review its financial information regularly in order to determine whether the company can repay its debts as and when they fall due for payment.
  3. take positive steps to confirm the position of the company and realistically assess the available options if there is a question as to solvency.
  4. seek advice from a suitably qualified person if solvency is an issue
  5. act appropriately and in a timely manner to address any solvency issue

Are there defences to a claim for Insolvent Trading

A director being pursued for an insolvent trading may claim;

  1. There were reasonable grounds to expect the company was solvent at the time the debt was incurred
  2. The director relied on information produced by a competent and qualified person that lead to the view the company was solvent
  3. The director, was not involved in the management of the company for good reason, at the relevant time
  4. The director took all reasonable steps to stop the company from incurring the debt

Often these defences are difficult to access.

If you need help, call The Insolvency Experts on 1300 767 525

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