What is insolvent trading?
Insolvent trading is considered to occur when a company is trading and accumulating debts that it cannot foreseeable repay. According to ASIC, key indicators of insolvency include (but are not limited to) the following:
- poor cash flow, or no cash flow forecasts
- disorganised internal accounting procedures
- incomplete financial records
- absence of budgets and corporate plans
- continued loss-making activity
- accumulating debt and excess liabilities over assets
- default on loan or interest payments
- increased monitoring and/or involvement of financier
- outstanding creditors of more than 90 days
- instalment arrangements entered into to repay trade creditors
- judgement debts
- significant unpaid tax and superannuation liabilities
- difficulties in obtaining finance
- difficulties in realising current assets (eg stock, debtors)
- loss of key management personnel
The question of solvent trading vs insolvent trading can be answered by applying two tests of insolvency which are referred to as the Industry and Economic tests.
The Industry Test
The Industry Test looks at the accepted norms and practices of the given industry in which the enterprise operates. If it is accepted practise in the industry in question that accounts are not settled for 120 days, and other companies within the same industry follow the same practices, then one cannot draw the inference of insolvent trading simply because the business has unpaid invoices that are older than 90 days.
In Manpac Industries Pty Ltd v Ceccattini, Justice Young was of the opinion that, in an industry where terms of payment of invoices are not indicative of how players in the industry operate in practice, and especially in times of a recession, a company should not be viewed insolvent simply because it wasn’t paying its debts when they fell due.
The Economy Test
In ASIC v Plymin, Elliott & Harrison Justice Mandie was of the opinion that the test for insolvency was the ‘cash flow test’, that is, whether a business can pay its debts as and when they fall due, rather than looking at its assets and liabilities.
Similarly, in Olifent v Emwest Products Pty Ltd Justice Anderson took the view that when a business cannot pay its bills it is insolvent, regardless of common industry practices of delaying payment of invoices.
Unfair Preferences
Section 588FA(1) of the Corporations Act 2001 defines unfair preferences as follows:
A transaction is an unfair preference given by a company to a creditor of the company if, and only if:
- the company and the creditor are parties to the transaction (even if
someone else is also a party); and
- the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company;
even if the transaction is entered into, is given effect to, or is required to be given effect to, because of an order of an Australian court or a direction by an agency.
Rules of Unfair Preference
- Relation-back Period: payments received by a company within six months of the commencement of liquidation, can be considered preference. It should be noted that the ‘commencement’ of liquidation is not always the same date that a company ‘enters’ liquidation.
- Liquidation: A company must be in liquidation before a payment can be considered a preference. Payments received by companies in receivership or Voluntary Administration
- Insolvency: A payment cannot be considered preference unless the company is insolvent. Section 95A of the Corporations Act 2001 defines solvency as follows:
(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.
The insolvent company may not have been insolvent during the entire 6-month period during which the payment was made; the onus is upon the Liquidator to prove insolvency. Thus, where a preference claim is being defended, it might be worthwhile seeking a second opinion about the company’s solvency at the time that the payment was made.
- Interest and Cost: If the matter goes to court and the liquidator is successful, cost and interest can be claimed. Interest on a preference claim is accumulated from the date of the Liquidators letter of demand for payment. An unsuccessful preference claim on the other hand, can result in the defending company claiming a portion of its legal cost from the Liquidator.
Defences against Preference Claims
- Section 588FA(3) of the Corporations Act outlines the ‘running account defence’ as follows:
(a) a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company (including such a relationship to which other persons are parties); and
(b) in the course of the relationship, the level of the company's net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;
then:
(c) subsection (1) applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction; and
(d) the transaction referred to in paragraph (a) may only be taken to be an unfair preference given by the company to the creditor if, because of subsection (1) as applying because of paragraph (c) of this subsection, the single transaction referred to in the last‑mentioned paragraph is taken to be such an unfair preference.
- Good Faith payments is another defence against preference claims. As most payments will be considered to have been made in good faith, a good faith payment claim may be refuted where the payment was made after serious threat prompted the payment made.
- Where there were no reasonable grounds to suspect insolvency; and
- A reasonable person in the circumstances would not have had any grounds to suspect insolvency, are also defences against preference payment claims.
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