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01 Mar 2017

Deemed insolvency through inadequate financial records


3 min

You can’t rely on what you can’t see.

Directors exposed to liquidator insolvent trading claims can defend themselves on the basis that they had no grounds to suspect that the company was insolvent at the time the debt was incurred, or that the company became insolvent by incurring that debt. The liquidator’s task of proving insolvency and a director defending such an action is complex and costly. Significant financial analysis (usually working capital and cash-flow analysis) is required to prove insolvency, as well as to defend against it.

A much simpler way for a liquidator to prove insolvency in laying the groundwork for an insolvent trading claim, is to prove that the company failed to maintain proper books and records and to seek a court order that the company be deemed insolvent (at the time the insolvent trading allegations were made).

The Court, in Swan Services Pty Ltd (In Liquidation), recently considered what constitutes proper financial records.

In that case, the Court held that it must be proved either that no documents within the description of "financial records" were kept in that period or that the documents kept were "deficient as to content", because they did not correctly record and explain the company's transactions, financial position, and performance. For example, because the documents did not accurately record the matters purportedly recorded, or would not enable true and fair financial reports to be prepared and audited.

In Swan Services Pty Ltd, the liquidator identified that unrecorded tax liabilities due to non-lodgments had a material bearing on the company’s solvency. It was argued that the directors could not rely on the premise that without a lodgment the tax debt could not be expressly quantified, and therefore, the directors or a reasonable person would have had no reason to suspect the company was insolvent. Alternatively, that the company was deemed to be insolvent because the records’ content was deficient and failed to record and explain the company’s true financial position.

The liquidator accepted that the presumption under section 588E(4) of the Corporations Act 2001 does not arise merely because of a failure to keep or prepare income tax returns, business activity statements, balance sheets, or profit and loss accounts.

However, the liquidator argued that the company’s financial records were deficient to the point that they did not “correctly record and explain the company’s transactions and financial position and performance”.

The expert witness called by the liquidator expressed the view that the company’s financial records were poorly maintained and they had difficulty producing reliable, timely, and accurate financial data. Although the directors argued against that proposition, the Judge said that it seemed to him to be self-evidently correct where financial records maintained by the company did not properly record their taxation obligations, with business activity statements being incomplete and PAYG withholding liabilities being incorrectly reported.

The Court held that it necessarily followed, as the evidence amply demonstrated, that it was not possible to determine the company’s financial position from their financial records at any relevant time, including that financial statements for the company had not been finalised for many prior years.

The lesson for directors and advisors is to be aware that a company can be deemed insolvent even where business records exist, such as invoices, general ledgers etc.; however, the courts hold little sympathy when the records simply do not properly explain the financial position and company’s performance.

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