Stress or Distress—try explaining to the Judge
Recently, the insolvent trading legislation has attracted publicity due to the Turnbull Government’s Innovation Agenda, which proposes enacting ‘safe harbour’ provisions to give directors some protection. Unless and until such legislative reform is enacted, directors must deal with the current regime, which is inevitably the subject of detailed consideration by directors of companies in difficult financial circumstances. Unfortunately, limited authorities provide practical guidance as to how directors should approach the issue.
Section 588G of the Corporations Act 2001 provides that a person has engaged in insolvent trading if, in general terms:
- The person is a director when a company incurs a debt.
- The company was insolvent or became insolvent when the debt was incurred.
- The director had reasonable grounds to suspect the company's insolvency.
- A reasonable person would be aware of the company’s insolvency.
If a company is placed into liquidation and the liquidator or a creditor initiates an insolvent trading action, directors can defend claims under the Corporations Act defence provisions.
One defence is that the director had reasonable grounds to expect and did expect that the company was solvent and would remain solvent even if it incurred that debt and other debts (incurred at the same time).
In this case, a director must establish they had a measure of confidence or a positive expectation that the company was solvent, and not a mere hope.
At the junction when a company experiences any degree of financial stress, directors and their advisors must pause to reflect and ask themselves:
Is the company experiencing a temporary liquidity problem (i.e. a state of stress) or, is the company experiencing an endemic shortage of working capital (a state of distress)?
An objective assessment (to the required standard of a reasonableness) to answer this question is key to a director properly defending themselves against an insolvent trading claim.
Notably, when a liquidator considers making an insolvent trading claim, it is with the benefit of hindsight, and often in circumstances where the directors have sought, and failed in securing various funding solutions (as otherwise the company would not be in liquidation).
Frequently, the director will have a three-way forecast (prepared with their accountant) that brings together the Profit and Loss (P&L), Balance Sheet, and cash flow statement for the review period (usually 12 months). The benefit of the three-way forecast is that it forms the foundation for the insolvency assessment—can the company can pay all its debts as and when they fall due. A three-way forecast integrates opening balance sheet items (notably, debtors, creditors, stock, cash) to reveal the weekly/monthly cash position, while considering the underlying assumptions of the P&L, debtor days, creditor payments etc.
Two key areas need careful attention in preparing a three-way forecast:
- Creditor payments
Unless arrangements are in writing, the three-way forecast should reflect the creditor's current repayment terms. Extended creditor payment terms cannot be included in the cash-flow forecast unless such extended terms are in writing. - Sale of an asset
Often companies have surplus assets in the form of plant and equipment, land and buildings etc. The sale of such assets can recapitalise a business and restore solvency. However, merely indentifying and intending to sell surplus assets is insufficient to include the anticipated cash proceeds in the cash forecast.
In this regard, the guidelines for assessing temporary liquidity vs endemic shortage of working capital in Hall v Poolman [2007] NSWSC 1330 are helpful. In that case, the Judge found that a director would be justified in "expecting solvency” if an asset could be realised to pay creditors in full within three months.
When considering whether a director could rely upon such an asset sale in the ‘reasonable expectation of solvency’ defence, the Court contemplated three levels of expectation that a director may have to an asset being realised:
- Certain or Probable
- More likely than not
- Possible or no way of knowing
The Court determined in Hall v Poolman that only where the facts supported an asset realisation as “Certain or Probable” could the directors successfully defend an insolvent trading claim.
Therefore, merely recognising surplus assets that could be realised to overcome a liquidity crisis, is insufficient to qualify as an insolvent trading defence; nor is it sufficient, for example, to list a company premises for sale, and rely on that action itself as a defence that funds will become available to the company. Rather, for directors to have a viable defence they must be satisfied (i.e. on reasonable grounds—most likely third party advice) that sale proceeds are “certain”. This means that there is a reasonable expectation of the asset being sold (but subject to settlement) within 90 days.
Directors risk their personal assets if they trade when their company cannot pay its debts "as and when they fall due". Therefore, directors of companies in difficult financial circumstances should examine its cash-flow forecasts to support continued trading (and solvency). Critically, directors should understand:
- the creditor terms assumed in the forecast, and in particular whether extended creditor payments terms are unilaterally assumed or have been agreed to in writing by the creditor; and/or
- whether forecast assets realisations are based on a high degree of certainty or probability (and in particular, would those assumptions withstand a ‘hindsight’ analysis).
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