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Advice from Outside the Square

What Is Insolvency, Really?

What Is Insolvency, Really?

For any business, insolvency is a frightening and emotionally-charged concept. For an Indigenous organisation, it is complex, stressful, and may put many community-owned and hard-won assets at risk of being lost. For the Directors of Indigenous corporations, insolvency creeps up on them because few have received financial training or timely financial reports and advice.

Insolvency and potential administration is a time of denial, fear, and a time where they have to struggle with conflicting demands about saving the corporation to personal liability over some unknown twists of insolvent trading law.

In fact, once the corporation is put in administration, the Directors are effectively sidelined and have to live with guilt and being powerless.

The idea then is to be proactive before the corporation is put into administration. It is about Boards ensuring that they receive regular and accurate financial reports, not only about the recent past trading but also in forward-looking forecasts, budgets and scenarios. It is about getting the right advice early, whether this is advice on the finances, their legal position, or in any restructuring or mitigation.

Directors have a duty to be diligent in their work. This is not legally excused by relying on “experts” who should have reported the deteriorating situation but may be mitigated if the Directors can show themselves to have proactively sought information and advice sufficient to make their decisions, and then perhaps to have received incorrect information.

Directors also have a duty to not trade while insolvent. It is where this point takes place that is critical for the legal position of Directors, and what they decide to do once this position is reached.

Insolvency is a legal term defined as where a debtor is unable to pay all of their debts as they become due and payable. The phrase “as they become due and payable” may mean that, if the debtor is able to come to an arrangement to restructure their debts so that they are able to pay them when they become due and payable, they are not insolvent.

Under common law, there are two tests for insolvency, the cash-flow test and the balance sheet test. Under the cash-flow test, the debtor is assessed whether they can pay their debts (or sell assets fast enough to pay their debts) “as and when they become due.”

The balance-sheet test considers the solvency of the debtor in regard to their balance sheet so that they are technically insolvent if their total liabilities are more than their total assets.

The Court will use the cash-flow test as the principal test of a corporation’s insolvency.

This means that if a corporation has more liabilities than assets and is technically insolvent, the Court may still not find the corporation to be insolvent if the corporation is able to renegotiate due dates for debts and find sufficient cash by capital injections, sale of assets and so on, to pay them when they fall due.

The reason why this point is important is that the Directors have a legal duty not to trade while insolvent and from that point, they must cause the corporation to cease trading or they may find themselves personally liable for the debts and may even face criminal charges.

However, the fact that a corporation is technically insolvent (more liabilities than assets) even if the cash-flow test has not yet been reached, is a cause for concern and appropriate advice must be sought, and corrective action should be taken. At this time the corrective action may not necessarily be to appoint an administrator and may lie in taking action to refinance, restructure or to sell assets or seek more working capital.

In this time between realisation and actual insolvency, act early and get advice.

At this time, the Directors should make sure they are available and helping management more than in a stable environment. When the first reaction for Indigenous Directors is to attempt to move as far away from the day-to-day proceedings of the corporation as possible, it is important to do the opposite and work with management so that you are up to date with developments. You have to be calm, positive, hands-on, and level-headed at this time.

The Board should work with advisors to get a very clear picture of the most up to date financial position of the corporation, especially of its cash flow. This means that analyses of debts and timing of payments must be made, along with analysis of expected cash receipts and conversions of assets to cash, resulting in a rolling cash forecast.

As well, the Board must get appropriate legal advice so that the Directors comply with the law.

If the best efforts fail and it is decided to put the corporation into administration, the Directors effectively have to stand aside. They are not removed and they still stay on the register, but the Administrator takes on all the powers to operate the company. As Directors they still have statutory duties under this situation: –

  • they need to provide the corporation’s books and records to the Administrator;
  • they need to provide a written report within 5 business days; and
  • they need to meet with the Administrator and help them with their enquiries.

If the Directors do not co-operate the Administrator may refer the issue to the corporate regulator, whether ASIC or ORIC.

In fact, during the administration, Directors can play a positive role. This may even be beneficial to show good faith to employees and suppliers, and potentially to retain goodwill if the corporation were able to be restructured and removed from administration. Directors can be very helpful to the administrator by providing them with corporate knowledge to help the Administrator run the corporation as efficiently as possible and for the best result.

Ultimately, a corporation placed in administration will have its fate decided at a meeting of creditors. The creditors may decide on a limited continuing administration (more time to resolve what might happen), or most commonly either liquidation or a Deed of Company Arrangement (or “DOCA”). In fact the Directors can propose a DOCA to the creditors for their consideration.

A DOCA is a legally binding agreement where a corporation agrees to pay all or part of its debts, over an agreed time, and after that be free of all remaining debts. The creditors may accept this because the alternative is that they receive less in a liquidation.

A DOCA is legally binding on all parties, even those creditors who voted against it.

When proposing a DOCA, the Directors must again act early. Being proactive while creditors still have some sympathy for you may mean the difference between acceptance or not.

If the corporation goes into liquidation, then the Administrator hands over to a Liquidator (who may be the same firm or even same person) who basically converts all tangible and intangible assets to cash, pays off secured creditors first, then pay what they can to unsecured creditors, and only if anything is left do they pay members or shareholders in accordance with the corporation’s constitution.

In summary, insolvency may not be the end of the world, but in order to salvage something from a potential catastrophe, you need to act early and proactively.

Make sure that you have up to date financial information and recognise the danger of being a Director of a corporation that is trading while insolvent.

If a decision to appoint an administrator is required, look at all the facts and the forecasts and make the decision quickly, then make sure you co-operate with the Administrator while you get advice on if you can propose a DOCA to save whatever you can of the corporation.

If you have any questions about insolvency, contact us at teik@otsmanagement.com.au

 

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