Corporate insolvency

Directors must be aware of “insolvent trading” laws that can have substantial penalties or implications.

If your business is insolvent, it is best to touch base with Worrells to discuss what can be done legally to save your business and to understand what your rights and obligations are.

Employee entitlements (including wages, superannuation, leave, and termination amounts, etc.) are treated as a priority dividend—as a priority creditor in all insolvency appointments

Outside of the priority dividends outlined under the Corporations Act 2001 and Bankruptcy Act 1966 ahead of other types of creditor claims, the government provides financial assistance to cover certain unpaid employment entitlements to eligible employees who lose their job due to the liquidation or bankruptcy of their employer. This scheme is known as the Fair Entitlements Guarantee scheme (FEG). This scheme’s funding assists to satisfy and pay outstanding wages, leave entitlements, and termination amounts (subject to some limits) that employees are owed when the business cannot afford to pay these debts. Call us to find out more.

Given the sole trader structure is relatively easy and inexpensive to set up, it's a popular choice for many Australians. A sole trader is legally responsible for all aspects of the business including any debts and losses.

Liquidation and voluntary administration are for businesses trading through a company structure (incorporated companies and trust structures). If you are trading as a sole trader and have financial issues in the business, then your debts can be dealt with through bankruptcy or other debt solutions mechanism. Go to our bankruptcy page to learn more.

Secured creditors have more options to recover what's owed.

A secured creditor can take action to protect, collect and sell some or all the company’s assets. This is done for the company to repay debts owed to the secured creditor.

Unsecured and secured creditors are treated differently in insolvency appointments.

A secured creditor holds a security interest, such as a mortgage, in some or all the company’s assets, to secure a debt they are owed by a company. For example, lenders might require a security interest in company assets when they provide a loan.

Unsecured and secured creditors are treated differently in insolvency appointments.

An unsecured creditor does not hold a security interest in relation to a debt they’re owed by a company.

Secured creditors usually rely on their securities to satisfy their outstanding debts. But sometimes they may also wish to lodge a proof of debt in an insolvent estate to maximise their return.

Introduction

Secured creditors usually rely on their securities to satisfy their outstanding debts. But sometimes they may also wish to lodge a proof of debt in an insolvent estate to maximise their return. This applies when they know they will suffer a shortfall from the sale of the secured item (i.e. the value of the secured asset is less than the amount of the secured debt) and when there will be a dividend paid to unsecured creditors.

A secured creditor may also wish to vote on certain resolutions in the estate. They may have an interest in the conduct of the estate in their role as an unsecured creditor for the amount of that shortfall (i.e. that part of the debt not covered by the secured asset).

Both the Corporations Act 2001 and the Bankruptcy Act 1966 allow secured creditors to lodge proofs of debt and vote at meetings for their shortfall amounts. But only in voluntary administrations can they vote using the full secured debt. In all other administrations, secured creditors must be careful to complete their proof of debt correctly and only vote on the appropriate dollar amount, or they risk compromising their security. This Guide looks at the position in a bankruptcy scenario.

A secured creditor can voluntarily surrender their secured asset and prove for the whole debt as an unsecured creditor. Secured creditors would only surrender their security if they believe the security is worthless, or when a substantial dividend is being paid to the unsecured creditors.

Proving for a shortfall

Secured creditors can prove for the shortfall amount they have suffered—or will suffer. The shortfall is quantified once the secured asset is sold and then a secured creditor can lodge a proof of debt for any shortfall. Effectively, they become an unsecured creditor because the secured asset no longer exists.

However, a secured creditor can lodge a proof of debt for an anticipated shortfall before the secured asset is sold. This can happen when the asset cannot be readily—or reasonably—sold before a dividend is paid into the estate. If a secured creditor believes that they will suffer a shortfall from the sale, the shortfall is calculated by estimating the secured asset’s value and deducting that amount from the outstanding debt. The proof of debt can then be lodged for the balance of the debt, i.e. the estimated shortfall.

The proof of debt form lodged by the secured creditor must have all of the relevant detail, and creditors should attach any documents to support their debt and the estimated security value.

A secured creditor should have a reasonable basis for the estimated security value, as amending their valuation affects certain rights and obligations between the bankruptcy trustee and the secured creditor. These rights and obligations may cause the secured creditor to lose all, or part, of their rights under the benefit of their security.

A secured creditor can issue a notice to a bankruptcy trustee to determine whether they will redeem or force a sale of the secured asset. Once the notice is received, a bankruptcy trustee must redeem or force a sale within three months, or they will lose their rights over the asset.

Amendment of valuation

Occasionally the original value estimate placed on a security is no longer appropriate. This happens when the asset’s value naturally changes with market conditions, or when the value of the asset changes after the proof of debt was lodged. Alternatively, the original estimate may have been incorrect and the correct value is now known, or capable of being estimated.

In these cases, the estimate must be corrected, whether that correction is an increase or a decrease. Both Acts allow the estimate to be amended under certain conditions.

An amendment is not an automatic process. A secured creditor must apply to the insolvency practitioner, or the court, for an amendment in their claim and must show that the original estimate was reasonable at the time (i.e. under the circumstances), or that the value has changed since the estimate was made. If the amendment occurs after a dividend is paid, this may create complications. If the secured asset is sold after the proof of debt was lodged, the estimated security value must be amended to the sales amount.

Adjustment of a paid dividend

If the estimate of the secured asset’s value is amended after a dividend is paid, the secured creditor may have to either refund any excess dividend received (i.e. if the estimate increases and the shortfall decreases), or they will be entitled to a catch up dividend (i.e. if the estimate decreases and the shortfall increases).

The payment of a catch up dividend is subject to money being available in the estate and cannot disrupt any past dividend paid. That is, if the amendment occurs after a final dividend, the secured creditor is unlikely to be paid a catch up dividend.

Conversely, monies received by the insolvency practitioner from a dividend refund will be paid into the estate.

Subsequent realisation of security

Once a secured asset is sold, the shortfall amount owed to the secured creditor can be quantified. The Bankruptcy Act automatically amends value estimates made prior to asset realisation, and substitute the net amount received by the secured creditor. This automatically adjusts the shortfall and activates the repayment of an excess dividend and the catch up dividend provisions adjust any previous dividends received by the secured creditor.

Voting at meetings

A secured creditor’s actions may result in surrendering their security. In this regard the Acts vary slightly. Both Acts allow secured creditors to vote at creditors’ meetings for their shortfall amounts, if they have estimated the value of their secured asset (i.e. their shortfall amount). Their voting rights will be unaffected if they have already sold their secured asset as they are now, in effect, an unsecured creditor for the shortfall.

The Bankruptcy Act allows a secured creditor to vote for the shortfall—called the ‘excess of debt’—over the estimate declared on their proof of debt form. That is, they are only allowed to vote for their shortfall amount; they cannot vote for their secured debt amount (which is secured by the secured asset’s value).

The Corporations Act has the same provisions but also states that a security is deemed surrendered if a creditor votes for their full debt as an unsecured creditor. In essence, the secured creditor places a nil value on their security and is automatically redeemed.

However, the voluntary administration provisions allow a secured creditor to vote for the full amount of their secured debt without any risk of losing their rights.

Creditors must be aware of these implications before voting on resolutions as an unsecured creditor.

Last Updated: 3.11.2017

Insolvent trading is when directors allow their company to incur debts when the company was insolvent. The liquidator can make a compensation claim against a director if those debts are unpaid when the liquidation commences.

A director may be held personally liable to compensate creditors for the amount of the unpaid debts incurred from the time the company became insolvent to the start of the liquidation.

Why do liquidators make these claims?

Liquidators are obliged under the provisions of the Corporations Act 2001 to investigate the existence of any insolvent trading claim, and if so, take appropriate action. Further, directors have a duty to stop a company from incurring debts it is unable to pay. Under the Corporations Act, failing to stop a company from incurring debts it is unable to pay is a breach of the directors’ duty. Directors may have to pay compensation to the company for losses creditors have incurred under that breach of duty.

Who makes insolvent trading claims?

Liquidators have the first opportunity to make insolvent trading claims. If they decide not to make a claim, creditors may start their own actions, but creditors’ claims are limited to the amount of their individual debt.

Can creditors take insolvent trading action?

Yes. If a liquidator does not pursue an insolvent trading claim, the creditors of the company (individually or in a group) can make a claim. Creditors may start an action either with a liquidators consent or if the liquidator fails to provide their consent, the creditors can seek leave of the court in certain circumstances.

Creditors can only take action against directors for their own debts. Whereas a liquidator can pursue an insolvent trading claim on behalf of all creditors’ unpaid claims.

A creditor cannot commence action when a liquidator has already begun proceedings or has intervened in an application for a civil penalty order. That is, claims are restricted when the liquidator has started their own action.

What are the factors in an insolvent trading claim?

Aside from the company being in liquidation, the factors in an insolvent trading claim are:

1. The company must have been insolvent when the debts were incurred.

2. The debts must remain unpaid at the time of the liquidation.

3. The claims must be made against people who were company directors at the time debts were incurred.

4. There were reasonable grounds for the director to suspect the company was insolvent.

Who are directors?

The status of ‘director’ of a company is not exclusive to those who are appointed as directors, recorded in the company register, or those notified to the Australian Securities and Investments Commission (ASIC). People who act as a director, even if not formally appointed, may be defined as a director. Shadow or de facto directors, or other parties that controlled the company at the time the company became insolvent can be exposed to an insolvent trading claim.

The Corporations Act defines a ‘director’ as:

‘(a) a person who:

(i) is appointed to the position of a director; or

(ii) is appointed to the position of an alternate director and is acting in that capacity; regardless of the title of their position; and

(b) unless the contrary intention appears, a person who is not validly appointed as a director if:

(i) they act in the position of a director; or

(ii) the directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes.’

The definition excludes people who give advice as part of their normal professional role. For example, accountants, solicitors and other paid consultants.

When is a company insolvent?

A company is insolvent when it cannot pay its debts as and when they become due and payable. The Corporations Act defines solvency and insolvency as:

Section 95A — 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 person is defined to include a corporation.

What about accrued debts?

For an insolvent trading claim, the debt must be incurred, not just accrued, when the company is insolvent. Incurring a debt is the legal creation of a debt that did not previously exist. Accrued debts usually relate to ongoing contractual agreements.

Contractual agreements are incurred at the time of the original agreement and only become payable (or accrue) at a later date. If the original agreement was made while the company was solvent, and the later amounts only accrue because of that original contract, those debts will not form part of an insolvent trading claim. For example, reoccurring lease payments are under a contract that was entered into prior to the company’s insolvency.

How do directors become liable for insolvent trading claims?

Section 588G of the Corporations Act sets out the director’s duty to prevent insolvent trading and sets the parameters by which a liquidator can initiate the process for making a claim against a director. Directors contravene this section by allowing the company to incur a debt when they are aware of grounds to suspect the company was insolvent.

When directors breach their duty, the provisions of section 588M of the Corporations Act allow compensation to be recovered from that director. A claim is possible where the creditors suffered loss or damage because of the company’s insolvency and the debt was wholly or partly unsecured.

What defences are available to directors?

The Corporations Act provides statutory defences for directors. The burden of proving these defences is on directors. The statutory defences can be summarised as:

1. the director had reasonable grounds to expect (not just suspect) the company was solvent

2. a reasonable, competent person produced information that would reasonably lead to a belief that the company was solvent

3. the director had a good reason for not taking part in the company management at the relevant time

4. the director took all reasonable steps to stop the company incurring the debt, including attempting to appoint a voluntary administrator to the company.

The courts have made it clear that the position of director carries certain responsibilities, which cannot be avoided, including the duty to keep informed about the company’s solvency.

Is insolvent trading an offence?

Yes. Insolvent trading is an offence and can be referred to ASIC for further investigation and possible criminal prosecution. Directors should seek legal advice. Section 588G (Director’s duty to prevent insolvent trading by company) stipulates:

(3) A person commits an offence if:

(a) the person is a director of the company when it incurs a debt; and

(b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and

(c) the person suspected at the time when the company incurred the debt that the company was insolvent or would become insolvent as a result of incurring that debt or other debts (as in paragraph (1)(b); and

(d) the person’s failure to prevent the company incurring the debt was dishonest.

How long do liquidators have to take action for insolvent trading?

Liquidators have six years from the beginning of the liquidation to commence an action for insolvent trading. Proceedings must be commenced by way of the filing of an application with the court within that six-year period. It is not sufficient to just issue a letter of demand.

What should directors do if a liquidator makes an insolvent trading claim?

A liquidator should be asked to demonstrate:

1. that the company was insolvent during the appropriate period

2. that the debts were incurred after that time

3. proof of director status at that time, whether formally appointed or not.

In settling claims with the liquidator, the settlement must be sanctioned by the court, usually by way of a consent order. This consent order protects directors from any future claims made by creditors of the company.

Last Updated: 3.11.2017

Aside from the company being in liquidation, the factors in an insolvent trading claim are:

1. The company must have been insolvent when the debts were incurred.

2. The debts must remain unpaid at the time of the liquidation.

3. The claims must be made against people who were company directors at the time debts were incurred.

4. There were reasonable grounds for the director to suspect the company was insolvent.

A company is insolvent when it cannot pay its debts as and when they become due and payable. The Corporations Act defines solvency and insolvency as:

Section 95A — 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 person is defined to include a corporation.

For an insolvent trading claim, the debt must be incurred, not just accrued, when the company is insolvent. Incurring a debt is the legal creation of a debt that did not previously exist. Accrued debts usually relate to ongoing contractual agreements.

Contractual agreements are incurred at the time of the original agreement and only become payable (or accrue) at a later date. If the original agreement was made while the company was solvent, and the later amounts only accrue because of that original contract, those debts will not form part of an insolvent trading claim. For example, reoccurring lease payments are under a contract that was entered into prior to the company’s insolvency.

Insolvent trading is an offence. ASIC can investigate and may prosecute offending directors.

Insolvent trading is when directors allow their company to incur debts when the company was insolvent. The liquidator can make a compensation claim against a director if those debts are unpaid when the liquidation commences. A director may be held personally liable to compensate creditors for the amount of the unpaid debts incurred from the time the company became insolvent to the start of the liquidation.

Liquidators are obliged under the provisions of the Corporations Act 2001 to investigate the existence of any insolvent trading claim, and if so, take appropriate action. Further, directors have a duty to stop a company from incurring debts it is unable to pay. Under the Corporations Act, failing to stop a company from incurring debts it is unable to pay is a breach of the directors’ duty. Directors may have to pay compensation to the company for losses creditors have incurred under that breach of duty.

Liquidators have the first opportunity to make insolvent trading claims. If they decide not to make a claim, creditors may start their own actions, but creditors’ claims are limited to the amount of their individual debt.

If a liquidator does not pursue an insolvent trading claim, the company’s creditors (individually or in a group) can make a claim. Creditors may start an action either with a liquidator’s consent or if the liquidator fails to provide their consent, the creditors can seek leave of the court in certain circumstances.

Creditors can only take action against directors for their own debts. Whereas a liquidator can pursue an insolvent trading claim on behalf of all creditors’ unpaid claims.

A creditor cannot commence action when a liquidator has already begun proceedings or has intervened in an application for a civil penalty order. That is, claims are restricted when the liquidator has started their own action.

What factors into an insolvent trading claim?

Aside from the company being in liquidation, the factors in an insolvent trading claim are:

1. The company must have been insolvent when the debts were incurred.

2. The debts must remain unpaid at the time of the liquidation.

3. The claims must be made against people who were company directors at the time debts were incurred.

4. There were reasonable grounds for the director to suspect the company was insolvent.

A company is insolvent when it cannot pay its debts as and when they become due and payable. The Corporations Act defines solvency and insolvency as:

Section 95A — 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 person is defined to include a corporation.

For an insolvent trading claim, the debt must be incurred, not just accrued, when the company is insolvent. Incurring a debt is the legal creation of a debt that did not previously exist. Accrued debts usually relate to ongoing contractual agreements.

Contractual agreements are incurred at the time of the original agreement and only become payable (or accrue) at a later date. If the original agreement was made while the company was solvent, and the later amounts only accrue because of that original contract, those debts will not form part of an insolvent trading claim. For example, reoccurring lease payments are under a contract that was entered into prior to the company’s insolvency.