Since 2003, corporate lawyers and insolvency accountants have benefited from a helpful ‘cheat sheet’ which answers the question, ‘how to tell if your business is insolvent‘. It comes in the form of a list that outlines 14 key indicators of insolvency. This list was established by the Courts as a general yardstick to identify if a business is in financial trouble and whether or not it can deemed insolvent.
Indicators of insolvency
- Continuing losses
- Liquidity ratios below 1
- Overdue Commonwealth and State taxes
- Poor relationship with present Bank, including inability to borrow further funds
- No access to alternative finance
- Inability to raise further equity capital
- Suppliers demanding cash-on-delivery, or otherwise demanding special payments before resuming supply
- Creditors unpaid outside trading terms
- Issuing of post-dated cheques
- Dishonoured cheques
- Special arrangements with selected creditors
- Solicitors’ letters, summons[es], judgments or warrants issued against the company
- Payments to creditors of rounded sums which are not reconcilable to specific invoices
- Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts
Where did these indicators of insolvency come from?
The indicators of insolvency, which we use to help determine if your business is insolvent, originated from the case of ASIC v Plymin, Elliott & Harrison [2003] VSC 123, which involved two companies, Water Wheel Mills Pty Ltd and Water Wheel Holdings Limited, which were found guilty of trading while insolvent.
ASIC commenced civil proceedings against the companies’ leadership team including the managing director, chairman of the Board the non-executive director. The Courts eventually found the companies traded insolvent from at least September 14, 1999 up until a voluntary administrator was appointed in February 2000.
ASIC succeeded but in order to do so it had to establish that the companies were insolvent at the time debts were incurred, and during the period where the companies were not paying their bills, there were reasonable grounds for suspecting that the companies were, or would, become insolvent. ASIC also had to prove that the company directors were, or a person in a like position would have been, aware that there were reasonable grounds for suspecting insolvency.
You can imagine that prior to the insolvency indicators that are so readily available for reference today, this would have been a complicated process of proving the companies’ cash flows and liquidity. Ultimately, the Courts found that there were a number of red flags surrounding the companies, including “continuing losses over a prolonged period of time, overdue Commonwealth and State taxes, inability to obtain further or other bank finance, inability to raise equity capital, placement of orders by suppliers on COD terms, issue of post-dated cheques some of which were dishonoured, legal proceedings and payments of rounded sums to creditors”.
These indicators ultimately led to the inescapable conclusion that the companies were insolvent, and to this day the indicators of insolvency may be used not only to demonstrate insolvency after the fact, but also can assist as guides for companies to take early action.
Is my company insolvent, or am I just going through a temporary rough patch?
If a company struggles to pay its debts, it may be up to ‘judicial interpretation’ as to whether or not it may be ‘insolvent’ or may be merely suffering from a temporary lack of liquidity.
Sometimes a bill falls due before an invoice is paid, or perhaps a new loan is needed to take care of an unexpected upgrade or malfunction. Sometimes, a company just falls a little behind before new money flows through.
The insolvency indicators created after ASIC v Plymin are certainly flags you want to avoid, but experiencing one or two on occasion does not automatically point to insolvency.
Unfortunately there is no set formula to the problem, ‘how to tell if your business is insolvent’. There are, however, some important flag posts that all business owners should be aware of.
One or two indicators
One or two indicators do not immediately point to insolvency. However, there may be cause for concern if the same indicators continue to persist.
Two or more indicators
If more than two indicators become a common occurrence, your business may be insolvent. It is important to see immediate advice about voluntary administration or company liquidation.
Why are the indicators of insolvency so important?
The short answer is that knowing how to tell if your company is insolvent can avoid insolvent trading, and responding to the indicators of insolvency can help company directors avoid criminal penalties.
‘Insolvent Trading’ or ‘Trading While Insolvent’ occurs when a company continues to trade and incur new liabilities, even though it is unable to pay its debts as and when they fall due. Insolvent trading is illegal and it is a company director’s duty to prevent it as per the Corporations Act 2001 (Cth).
Penalties can incur for insolvent trading, especially if:
- The director was aware or at least suspected their company was insolvent, but continued trading;
- A reasonable person in the same position in the company’s circumstances would have been aware of insolvency; or
- There were reasonable grounds for suspecting that the company was insolvent, or on the verge of insolvency.
Civil penalties
Insolvent trading can result in civil penalties against directors, including pecuniary penalties of up to $200,000.
Compensation
Directors may have to compensate ASIC, a liquidator or a creditor personally. Compensation can be potentially unlimited and could lead to personal bankruptcy.
Criminal charges
Company directors may be subject to criminal charges which could include fines up to 2,000, imprisonment for up to five years, or even both. If a director was found to be dishonest about trading while insolvent, they could be found guilty of the criminal offence and receive a director’s disqualification.
It’s important to remember…
When it comes to insolvent trading, the ultimate responsibility does not fall exclusively on however sits on the top of the organisational chart. Other members of the leadership team can be penalised for dishonest dealings. For example, in the case of ASIC v Plymin, Elliott & Harrison [2003] VSC 123, the courts found a non executive director involved with the Water Wheel companies equally responsible, stating:
“A non-executive director is expected to take steps to put himself in a position to monitor the company and to exercise and form an independent judgment and to take a diligent and intelligent interest in the information either available to him or which he might with fairness demand from the executives or other employees and agents of the company.
“This basically means that turning a blind eye is not a defence even if you are non-executive director and the company isn’t very forthright with giving you up-to-date financial information.”
It is recommended that a company should use the indicators of insolvency to monitor its performance and to determine whether or not urgent action must be taken to avoid insolvency. If insolvency is suspected, expert advice should be sought urgently on the options available in order to deal with the company’s financial issues and to safeguard against the consequences of a forced winding up.
Taking action after identifying indicators of insolvency
If your business has been struggling financially and, after reviewing the indicators of insolvency, you’ve realised that you have experienced several, it is vital to take immediate action. By leaning back and avoiding appropriate action as per the duties of a company director, you could face the legal ramifications of insolvent trading.
Insolvency Guardian can help. With one simple phone call we will work with you to determine the best company dissolution service to suit your company’s financial circumstances. Insolvency Guardian offers liquidation packages that are extremely affordable, meaning you won’t have to worry about another heavy expense during an already difficult time.
More importantly, Insolvency Guardian provides an Australian-first Zero Contact Liquidation service during COVID-19 restrictions, allowing you to work with us and handle the situation in your own comfort.
To find out more about your options, contact the experts at Insolvency Guardian.
