During difficult economic conditions it is important that all directors revisit their duties as directors and are aware of how the board should deal with a situation where the company is in financial difficulty or may be insolvent.
What is insolvency?
A company is deemed to be insolvent when it cannot pay its debts as and when they fall due.
The test sounds simple however its application involves a range of accounting and legal issues. When determining a company’s solvency, the Court will consider the overall financial circumstances as a matter of commercial reality. Particular emphasis will be placed on a cash flow test, however, there are also a range of balance sheet factors including the ability to realise the value of assets and raise further funds, be it equity or debt.
Directors Duties in general
Directors in Australia face onerous duties if their company faces financial difficulties.
It is a director’s duty to prevent a company from trading whilst insolvent. Importantly, directors must prevent their company from incurring debts where the company is insolvent, or becomes insolvent by incurring the debts if there are reasonable grounds for suspecting the company is insolvent, or would become insolvent.
The test requires that whatever is “suspected” must be based on reasonable grounds and imports an objective test for suspicion.
Failing to guard against insolvent trading may result in the director being personally liable for payment of compensation, a pecuniary penalty and/or disqualification from managing a corporation.
What should a director do?
Directors should apply the following five recommendations:
- Directors must avoid a “head in the sand” mentality as the problem is unlikely to go away without action. The board should be proactive, act early and quickly.
- Directors should increase their monitoring of the financial position of the company if it is facing financial difficulty. In particular, directors should be more vigorous in monitoring the company’s bank facilities, its cash flow, current assets and current liabilities. They should also be alert to danger signs such as continuous losses, poor liquidity ratios, overdue taxes or trade creditors and an inability to produce timely and accurate financial information.
- The board should seek legal and financial advice and develop a “Plan B”. Directors of companies often rely upon the injection of fresh funds from an asset sale or a capital raising to emerge from financial difficulties. Is there a Plan B? What if that transaction was to fail or be delayed? Can debts be paid in the meantime? Boards should seek legal advice on their duties and restructuring advice from a restructuring and turnaround professional.
- Engage with your bank and other financiers sooner rather than later. Banks are more likely to support a borrower that is proactive and engages with its bankers/financiers. If the bank has confidence in you and your advisers, you can usually expect that they will constructively engage with you and do their best to assist you through a restructure and turnaround, regardless of the size of your business.
- Consider all of the options as early as possible. Restructures and turnarounds can be very complex and can take time to prepare and implement. Some may require a formal scheme of arrangement that will take several months to implement.
Practical considerations indicating insolvency
There are some practical factors that may indicate insolvent trading, including:
- Continuing losses.
- Liquidity ratios.
- Overdue taxes.
- Unpaid staff superannuation entitlements.
- Poor relationship with the bank resulting in inability to borrow further.
- No access to alternative finance.
- No ability to raise more capital.
- Suppliers only providing goods COD.
- Creditors paid outside trading terms.
- Issuing post-dated cheques.
- Dishonoured cheques.
- Special arrangements for selected creditors.
- Judgments or solicitors’ letters issued against the company.
- Payments to creditors of rounded amounts not payments of specific invoices.
- Inability to produce timely and accurate financial statements.
Penalties for insolvent trading include disqualification from managing a corporation or a pecuniary penalty of up to $200,000.
A director may also be liable to criminal proceedings by ASIC through the Commonwealth Director of Public Prosecutions if they contravene a civil penalty provision.
A director may be convicted of an offence where it is proven that they knowingly, intentionally or recklessly:
- Dishonestly intended to gain, whether directly or indirectly, an advantage for that or any other person; or
- Intended to deceive or defraud someone.
It is essential that directors are aware of their duties and of the consequences including civil and criminal penalties that can be imposed if trading whilst insolvent.
If you feel you might need to explore your company’s legal position and your duties it’s always prudent to do so sooner rather than later, particularly as it takes time to turn a company around or to arrange a restructure.