Regulators come down hard on insolvent trading

Accountants play an important role in safeguarding integrity.

And that makes getting the correct advice ever more crucial.

Australian regulators come down hard on insolvent trading, and with directors personally liable for compensating creditors, getting correct advice is crucial.

The announcement in April by the Australian Securities and Investments Commission (ASIC) that it had banned two former directors of a group of failed high-end restaurants from managing corporations for two years, is a timely reminder of the role played by accountants in safeguarding the integrity of the limited liability company.

The banning orders were made in relation to the directors’ neglect of due care and diligence, which led to creditors being owed A$7 million. The core of the matter was that the businesses had continued trading when they were insolvent – and racking up even more debt than they could repay.

Insolvent trading refers to incurring further debt while insolvent or incurring debt which precipitates insolvency. The statutory rules are contained in “Division 3 – Director’s duty to prevent insolvent trading of Part 5.7B – Recovering property or compensation for the benefit of creditors of insolvent company” in the Corporations Act 2001.

But company directors can’t prevent insolvent trading unless they are getting sound financial advice and being kept well informed of the organisation’s financial position.

A director’s duty to prevent insolvent trading is part of a scheme to ensure that unsecured creditors receive adequate compensation if a business fails. If a company is wound up, its remaining assets are distributed according to the rules of creditor priority.

The insolvent trading provisions also place a personal liability on directors to pay compensation equal to the debt(s) incurred (refer to section 588M “Recovery of compensation for loss resulting from insolvent trading”).

Although these regulations are a strong deterrent to reckless business practices, they have attracted some criticism. Some people argue that it acts against valid commercial risk-taking and encourages company directors to choose liquidation when, feasibly, a business could have been rescued.

This tendency may be reinforced by provisions such as Div. 269 of Sch. 1 of the Taxation Administration Act 1953 which requires directors to promptly place their company into voluntary administration when there is an inability to meet taxation withholding and remittance obligations.

Insolvent trading’s main operative section, section 588G(1), applies where a director, at the time when the company incurs a debt, had “reasonable grounds” for suspecting the company was or would become insolvent.

This reasonable grounds criterion lessens the burden of proving knowledge of insolvency as a fact, particularly where accounting records have been lost, destroyed or are deficient. It also overcomes the defence that a particular transaction was entered into without the directors’ express approval or authority.

The cash-flow test

The other key element in Australia’s insolvent trading regulations is that they are heavily oriented towards a cash-flow rather than a balance-sheet assessment of solvency. This focus on liquidity and any possible detriment to creditors is evident across corporate law.

Derived from personal bankruptcy law, section 95A of the Corporations Act 2001 embodies in legislation the classic cash-flow test of insolvency:

Solvency and insolvency

(1) A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
(2) A person who is not solvent is insolvent.

A number of decisions by Australia’s High Court have set out the core principles of this definition. The most salient features relate to the future-oriented determination of insolvency and the factors to be taken into account – throughout, however, the test remains firmly entrenched as a cash-flow assessment.

In contrast, the balance-sheet test of solvency looks at whether the value of a company’s assets outweighs its liabilities, including the cost of liquidation. In jurisdictions where this test is used, such as the US, the process is one of assigning fair values with reference to the business as a going concern. Different approaches are brought to bear where the company is in financial crisis.

But the balance-sheet test has been rejected in Australia as a primary test of solvency as, according to various judges, it does not go to the heart of what is meant by insolvency.

The cash-flow test is regarded as a more practical measure. It involves “… look(ing) at what a company is actually doing and therefore, it may be more accurate in practice”, writes Andrew Keay, one of Australia’s leading insolvency law academics.

Focusing on the practical issue of whether the “company can pay its way in carrying on its business” makes it comparatively free from the uncertainties which might be encountered in accounting measurement.

Keay does, however, point out that the two tests are interrelated. “A company which is commercially solvent [an interchangeable expression for cash-flow solvency] has a much greater chance of satisfying the balance-sheet solvency [test], than one which is unable to pay its debts as they fall due,” he concludes.
A final caution must be made. The Corporations Act extends the definition of director to include “a person whom is not validly appointed as a director … [nonetheless] … acts in the position of a director”.

An accountant may become so involved in the critical decision-making of a company, particularly in times of financial stress, that they fall within this definition of de facto director, and find themselves personally exposed.

This article is from the September 2014 issue of INTHEBLACK magazine.

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