When is a Company Insolvent?

When is a company insolvent? A company is insolvent if it is unable to pay its debts as and when they become due and payable.

A company’s insolvency is calculated upon:

1. The cash flow test; and then
2. The balance sheet test.

There is a difference between company insolvency and temporary illiquidity.

In this article our experienced insolvency lawyers explain when a company is insolvent and the distinction between insolvency and the temporary lack of liquidity.

Contact us for advice and assistance with insolvency law.

When is a Company Insolvent?  This depends on a large number of factors.  It is vital that a director gets qualified legal advice before they cause the company to trade while insolvent!

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What is Insolvency?

Section 95A of the Corporations Act 2001 (CTH) (“Corporations Act“) says:

(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.

(2)  A person who is not solvent is insolvent.

Classically this is known as the “cash flow test”.  Does a company have enough cash on hand to pay debts as and when they become due and payable?

This raises some further questions, namely:

1. What does “debt” mean?
2. What does “due and payable” mean?

These will be discussed in more detail below.

When is a company insolvent?  As well as the cash flow test, the Courts have also adopted the “balance sheet test” which says that temporary lack of liquidity may not be indicative of insolvency.

A company is insolvent under the balance sheet test if the total liabilities are more than the total value of the assets of the company.

We will explain in more detail below.

When is a Company Insolvent?

It is very difficult in some circumstances to establish when a company is insolvent.

The Courts have stated that primarily pursuant to 95A of the Corporations Act, the cash flow test is the first and primary test in establishing insolvency.

However, the balance sheet test can be used as a secondary test to show the Court that the temporary lack of liquidity is indicative of that and does not prove insolvency.

This article will explain the above in more detail below.

The Cash Flow Test

When is a company insolvent? As mentioned above, section 95A of the Corporations Act says:

(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.

(2)  A person who is not solvent is insolvent.

This essentially says that a company that is unable to pay the company’s debts as and when they become due and payable is insolvent.

So, in order to understand this definition, a person must understand what a debt is, what the ability to pay means, and what due and payable means.

We will discuss these in more detail below.

What does “debt” mean?

In the absence of a definition of debt in the Corporations Act, we have to look at the common definition of the word, and the case law to determine how they have defined debt.

Debt is defined in the Oxford English Dictionary to mean:

A sum of money that is owed or due

Or

Something, especially money, that is owed to someone else, or the state of owing something

In Webb v. Stenton (1883) 11 Q.B.D. 518 the Court said:

The characteristic of a debt is that it is a sum of money which is immediately payable or which, by reason of a present obligation, will become payable in the future.

In Re WorkCover Queensland [1998] QSC 32, Muir J said:

A debt is a sum payable in respect of a liquidated money demand recoverable by action. Stroud’s Judicial Dictionary, 2nd ed., p.471 and see Geo Thompson (Australia) Pty Ltd v. Vittadello [1978] VicRp 20; (1978) 33 FLR 465 at 481.

In Hawkins v Bank of China (1992) 26 NSWLR 562, Gleeson C.J. said:

Dictionaries define debt as a liability or obligation to pay or render something.

In Rothwells Limited v. Nommack (No. 100) Pty Limited 2 Qd R 85 Mc Pherson J said:

That the word ‘indebted’ … was used in the context of a debt being a liquidated sum of money presently due owing and payable by a person called the debtor to another person called the creditor.

So, generally a debt is a sum of money, or an obligation to pay, owed by one person to another person.

By far the most common form of debt in insolvency law is the non-payment of invoices for goods provided or services rendered.  This is consistent with the definitions above.

However, it is worth knowing the definitions (as obvious as it appears) for the less common debts which may occur.  So, what does being able to pay the debts mean?

What does “due and payable” mean?

When is a company insolvent?  Once again, with lack of meaning in the Corporations Act, we can look at extrinsic materials and cases to understand what due means and payable means.

The Oxford English Dictionary defines due to mean:

(of a payment) required at a certain time, or an obligatory payment; a fee.

Or

owed as a debt or as a right; an amount that is due on a particular date

The Oxford English Dictionary defines payable to mean:

(of money) required to be paid; due

Or

that should be paid; used for saying how or when an amount of money should be paid

There is some difference between monies that are “due” and monies which are “payable”.  For example, monies owed under contract pursuant to an invoice with a date for payment in fourteen (14) days are payable, but not yet due.  The monies would not be due until the fourteenth day.

In Metropolitan Brick Company v Hayward and Anor [1938] SAStRp 57 Napier J said:

[t]here is a sense in which money can be “due” although not yet “payable”, but the converse cannot be true.

In Main Camp v Australian Rural [2002] NSWSC 219 Barrett J said:

A statement that a sum is “due and payable” thus connotes not only that it is “owed” (so that the debtor is “indebted”) but also that the time for payment has arrived and the obligation to pay is an unqualified and unfettered obligation requiring immediate performance.

However, in Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation (2001) 53 NSWLR 213, Palmer J discussed whether there is a difference between “due” and “payable”:

Unfortunately, the use of the two words “due” and “payable” when one would have sufficed has made room for the argument that if two separate words are used in the definition of insolvency then each word must have different work to do … the time at which a debt “becomes due” may be different from the time at which it “becomes payable”.

Palmer J dismissed this distinction between the words by colourfully stating:

The sooner this incipient heresy is scotched, the better … the test of insolvency prescribed by CA s.95A(1) is no different in substance from that prescribed by its predecessors … That test is simply whether the company is able to pay its debts as they become payable.

So, for a debt to be due and payable, it must be both due, but most importantly, that there must be an obligation to pay the debt, and it must be payable, that is any time stipulation (14 days) has to have come and gone.

In Sutherland & Anor as joint liquidators of Australian Coal Technology v Hanson Construction Materials Pty Ltd [2009] NSWSC 232 Barrett J said:

It has been authoritatively determined that s 95A calls attention principally to the cash flow test of insolvency with subsidiary relevance afforded to the balance sheet test.

We will now look at the balance sheet test for insolvency.

The Balance Sheet Test

The ability of the company to pay its debts has been given a lot of consideration by the Courts.

Most importantly, in Sandell v Porter (1966) 115 CLR 666 Barwick C.J. (with whom McTiernan and Windeyer JJ agreed said:

[t]he debtor’s own moneys are not limited to his cash resources immediately available. They extend to moneys which he can procure by realisation by sale or by mortgage or pledge of his assets within a relatively short time – relative to the nature and amount of the debts and to the circumstances, including the nature of the business, of the debtor.

The High Court then went on to say:

The conclusion of insolvency ought to be clear from a consideration of the debtor’s financial position in its entirety and generally speaking ought not to be drawn simply from evidence of a temporary lack of liquidity.

So, because the test is an objective test taking into consideration of the debtor’s financial position as a whole, being able to pay company debts is not limited to cash resources immediately available.

If the company is “able” to realise assets, or borrow cash in a relatively short time, then this might constitute being “able” to pay its debts when they become due and payable.

Temporary Lack of Liquidity

In order for a Court to make a determination of insolvency pursuant to section 95A of the Corporations Act, it will need to debtor’s financial position in its entirety and generally speaking ought not to be drawn simply from evidence of a temporary lack of liquidity.

After all, it is possible for a company to have a temporary lack of liquidity because of its own debtors, and once paid, will be able to pay its creditors.

In Sutherland & Anor as joint liquidators of Australian Coal Technology v Hanson Construction Materials Pty Ltd [2009] NSWSC 232 Barrett J said:

The emphasis must be upon the extent of cash and other liquid assets compared with the quantum of debts due and payable and to become due and payable in the immediate future. Insufficiency of cash or liquid resources to pay those debts is indicative of insolvency. The insufficiency becomes determinative if it is shown that it is more than a temporary lack of liquidity. In essence, there is a question whether the inability to pay is purely temporary.

If a company is experiencing a temporary lack of liquidity, then the Courts must determine objectively whether the value of its assets is more than its liabilities, remembering the commercial realities of the company.

In Southern Cross Interiors Pty Ltd and Anor v Deputy Commissioner of Taxation and Ors. [2001] NSWSC 621 Palmer J said:

Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable.

The commercial reality of valuation causes problems when trying to assess the value of a company’s assets.

When is a Company Insolvent?

So, as you can tell, only in the most cut-and-dry cases such as a $2 company with no assets and a number of debts, can insolvency be easily ascertained.

The Court will first make an assessment using the cash flow test and then make a subsidiary determination as to whether the company is experiencing temporary illiquidity or are in fact insolvent.

In Southern Cross Interiors Pty Ltd and Anor v Deputy Commissioner of Taxation and Ors. [2001] NSWSC 621 when deciding the solvency or insolvency of a company, Palmer J considered all of the authority cases on this point and said:

In my opinion, the following propositions may now be drawn from the authorities:

i)          whether or not a company is insolvent for the purposes of CA ss.95A, 459B, 588FC or 588G(1)(b) is a question of fact to be ascertained from a consideration of the company’s financial position taken as a whole;

ii)         in considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable;

iii)        in assessing whether a company’s position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality that, in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade but that does not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency;

iv)        the commercial reality that creditors will normally allow some latitude in time for payment of their debts does not, in itself, warrant a conclusion that the debts are not payable at the times contractually stipulated and have become debts payable only upon demand: Antico;

v)         in assessing solvency, the Court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the Court’s satisfaction, that:

•           there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; or

•           there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; or

•           there has been a well-established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors’ terms of trade or are payable only on demand:

vi)        it is for the party asserting that a company’s contract debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence.

There are a number of cases which have outlined what Courts have determined to be indicia or features of determining when a company is insolvent.

Common Features of Insolvency

When is a company insolvent?  There are a number of types of conduct which may suggest that the company is insolvent.

In Pearce v Gulmohar Pty Ltd [2017] FCA 660 Rangiah J said:

In ASIC v Plymin (No 1) [2003] VSC 123; (2003) 46 ACSR 126 at [386], the Court identified a number of common, albeit not essential, features in insolvency situations. That judgment has been referred to with approval in many subsequent decisions, including Bluestone Property Services Pty Ltd (in liq) v First Equilibrium Pty Ltd [2013] FCA 876 at [42]; Smith v Bone at [24] and McLellan v Carroll [2009] FCA 1415; (2009) 76 ACSR 67 at [106]. The features are:

1. Continuing losses.
2. Liquidity ratios below 1.
3. Overdue Commonwealth and State taxes.
4. Poor relationship with present Bank, including inability to borrow further funds.
5. No access to alternative finance.
6. Inability to raise further equity capital.
7. Suppliers placing [company] on COD, or otherwise demanding special payments before resuming supply.
8. Creditors unpaid outside trading terms.
9. Issuing of post-dated cheques.
10. Dishonoured cheques.
11. Special arrangements with selected creditors.
12. Solicitors’ letters, summons[es], judgments or warrants issued against the company.
13. Payments to creditors of rounded sums which are not reconcilable to specific invoices.
14. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.

Rangiah J then went on to say:

Importantly, this is a guide, not a checklist. It is merely a list of factors, the presence of one or more of which may indicate insolvency. Likewise, not all factors need be present.

In Lewis (as liquidator of Doran Constructions Pty Ltd (in liq) & v Doran & Ors [2005] NSWCA 243 Giles JA Hodgson JA McColl JA said quoting Palmer J:

As at 1 November 1994 there were present none of the usual indicia of insolvency;

1. A history of dishonouring cheques;
2. Suppliers delivering goods only on a COD basis;
3. The company issuing post-dated or ‘rounded sum’ cheques;
4. The company special arrangements with its creditors;
5. The company was unable to produce timely, audited accounts;
6. Unpaid group tax, payroll tax, workers compensation or superannuation;
7. The company had received demands from bankers to reduce overdraft limits and has a bad relationship with its bankers;
8. The company had received statutory demands, solicitors’ letters requiring payment of debts or legal proceedings for the payment of trade debts.

When is a company insolvent?  Further, in the ASIC guide – Insolvency: A guide for Directors they outline the warning signs of insolvency, namely:

1. Absence of a business plan;
2. An expectation that the ‘next’ big job/sale/contract will save the company;
3. Board disputes and director resignations, or loss of management personnel;
4. Change of bank, lender or increased monitoring/involvement by financier;
5. Creditors unpaid outside usual terms;
6. Inability to raise funds from shareholders;
7. Incomplete financial records or disorganised internal accounting procedures;
8. Increased level of complaints or queries raised with suppliers;
9. Increasing debt (liabilities greater than assets);
10. Issuing post-dated cheques or dishonouring cheques;
11. Lack of cash-flow forecasts and other budgets;
12. Ongoing losses;
13. Overdraft limit reached or defaults on loan or interest payments;
14. Overdue taxes and superannuation liabilities;
15. Payments to creditors of rounded sums that are not reconcilable to specific invoices;
16. Poor cash flow;
17. Problems obtaining finance;
18. Problems selling stock or collecting debts;
19. Solicitors’ letters, demands, summonses, judgements or warrants issued against your company;
20. Special arrangements with selected creditors;
21. Suppliers placing your company on cash-on-delivery (COD) terms; and
22. Unrecoverable loans to associated parties.

Is my Company Insolvent?

In determining if your company is insolvent, firstly you must look at the cash flow test and section 95A of the Corporations Act.  Can the company pay its debts as and when they become due and payable?

If not, looking at the indicia above, is it a temporary lack of liquidity or is it an insurmountable endemic illiquidity resulting in insolvency?

For advice and assistance on company insolvency contact an insolvency lawyer as soon as possible.

When is a Company Insolvent?  This depends on a large number of factors.  It is vital that a director gets qualified legal advice before they cause the company to trade while insolvent!

GET A FREE FEE ESTIMATE TODAY

OR CALL: 1300 545 133 AND SPEAK TO OUR LAWYERS

FAQ – Frequently Asked Questions – When is a company insolvent

Navigating the intricate landscape of company insolvency can be daunting. Whether you’re a company director, a creditor, or an employee, understanding the nuances of insolvency is crucial to making informed decisions.

This FAQ section is designed to shed light on the most common questions related to company insolvency. From basic definitions to detailed legal tests, our aim is to provide a concise and accessible overview for all readers.

While this serves as a starting point, always remember to consult a legal professional for any specific concerns or advice. Dive in to get acquainted with the essentials of insolvency!

What does it mean for a company to be insolvent?

A company is considered insolvent if it cannot pay its debts when they become due and payable.

When is a company insolvent – How is it calculated?

Insolvency is determined using two tests:

1. The cash flow test
2. The balance sheet test

Is there a difference between insolvency and temporary lack of liquidity?

Yes. Temporary lack of liquidity refers to a brief period where a company might not have enough cash, but insolvency is a broader, more lasting inability to meet debts.

How is insolvency defined in the Corporations Act 2001 (CTH)?

Section 95A of the Corporations Act 2001 (CTH) states that a person is solvent if they can pay all their debts when they’re due. If they’re not solvent, they’re considered insolvent.

What does the “cash flow test” involve?

This test checks if a company has sufficient cash on hand to pay its debts as they come due. It’s essentially a measure of a company’s liquidity.

When is a company insolvent – How is “debt” defined?

While the Corporations Act doesn’t offer a specific definition, debt generally refers to a sum of money or obligation to pay owed by one entity to another. In insolvency law, the most common form is the non-payment of invoices for goods or services.

What is the difference between “due” and “payable”?

While closely related, “due” refers to an obligatory payment required at a certain time, while “payable” refers to an amount that should be paid and may indicate how or when it should be paid.

When is a company insolvent – What is the balance sheet test?

This test compares a company’s total liabilities to its assets. A company is insolvent under this test if its total liabilities exceed the total value of its assets.

Can a company with temporary lack of liquidity be considered solvent?

Yes. The court considers a company’s financial position in its entirety. A company might have a brief period of cash shortage but can still be considered solvent if it has the ability to pay its debts in the near future.

How do courts determine when is a company insolvent?

The cash flow test is the primary assessment. If there’s ambiguity, the balance sheet test can be applied to verify if a temporary lack of liquidity indicates insolvency.

What should a company director do if they suspect insolvency?

It’s crucial for directors to seek qualified legal advice immediately to avoid trading while insolvent, which can lead to legal repercussions.

How do courts view debts that aren’t paid immediately but might be paid later?

Courts recognize that in normal business dealings, creditors might allow some flexibility in payment terms. However, for determining solvency, the court typically assumes a debt is payable at its stipulated time unless there’s evidence to the contrary.

When is a company insolvent – advice on insolvency law?

Interested parties can contact experienced insolvency lawyers or law firms for guidance and assistance on insolvency law.