Looming insolvency – some traps for directors
Insolvency under Australian law?
Insolvency is defined in section 95A of the Corporations Act. It works in reverse. First, “solvency” is defined as when a person is able to pay all their debts as and when they become due and payable. A person (including a company) who is not “solvent”, is then deemed to be insolvent. This is a cash flow based test, not a balance sheet test. It sounds an easy test to apply, but in reality it can be difficult – especially when you need to determine the exact time of insolvency. A number of important legal consequences are tied to the date of insolvency – including the risk that directors of insolvent companies may be personally liable for the company’s debts.
However, while being precise as to the exact insolvency time/date is important for directors, what is more important is that they need to recognise a likely insolvency early enough to take steps to try to overcome it. If additional funding is not immediately available, those steps will include the appointment an administrator, or causing a voluntary liquidation.
There are some well recognised indicia of a company’s likely insolvency. These include:
- A poor aged creditors position, with pressing creditors;
- Breach of the bank’s lending terms;
- Overdue state or federal taxes and in particular BAS, PAYG or super;
- Ongoing losses.
ASIC Information Sheet 42 (see here) provides an extensive insolvency warning checklist. It follows that a potential insolvency should not be too hard to recognise.
Once a company experiences any or all of the above indicia, directors often seek external advice on the company’s financial position – what to do about it and how to manage their own personal risks. They may turn to their accountant, solicitor or an insolvency or turnaround expert. Traps exist for the director and the advisor however.
If the advisor advises the company when it may be insolvent, the advisors fees may be at risk if the company fails and they are unpaid. Even if the advisor is paid pre-liquidation, the fees may be an unfair preference payment and recoverable if the company goes into liquidation shortly thereafter. The advisor should consider taking some third party security or guarantee in this situation. The advisor’s advice is also readily obtainable by a liquidator if the company fails, as it will be an advice given to the company. The director(s) will not want advice about possible insolvent trading falling into the liquidator’s hands.
If a legal advisor advises a director as his client, then the advice will usually be subject to legal professional privilege and so not available to the liquidator. The advisor may have a better prospect of being paid for their advice as well.
Personal liability for ATO payments
If the company is likely to be insolvent and it owes the ATO substantial money, including PAYG, and it pays what is owed, then if the company then fails within 6 months a director can face personal liability for those payments.
If the company is placed into liquidation and the liquidator later seeks to recover those payments from the ATO as unfair preferences in a court action, then pursuant to a peculiar director’s personal indemnity provided to the ATO in the Corporations Act, the director(s) may have to pay whatever sum of money is recovered from the ATO. The ATO is a fairly common target for such unfair preference claims, particularly if a failed payment plan existed at the date the company was placed in to liquidation. The liquidator usually obtains the ATO files for the relevant time under a Freedom of Information request. These files might reveal the extent of the ATO’s suspicion of insolvency and so limit its potential to be able to defend the claim.
The Corporations Act permits the ATO to join directors as parties to such an unfair preference proceeding, and seek a personal indemnity from them for the claimed sum. The indemnity extends to an indemnity for costs. This statutory indemnity is unique to the ATO. These claims are usually unwieldy and costly. Three sets of lawyers will become involved, or more if there are other directors. There are some statutory defences available. The director may also have to take on the running of any available ATO defences to the unfair preference claim, if the ATO sits on the sidelines and takes no active role in that defence.
We successfully settled such an indemnity claim, acting for a director recently. It was a time consuming process which produced an acceptable negotiated settlement.
We have noted one legal author’s recent comments that the existence of this personal indemnity may cause directors to leave the ATO unpaid during an insolvency crisis. In that event the director may risk receiving a Director’s Penalty Notice, or add to the risk of insolvent trading.
For advice on these issues, contact James Hamilton