insolvent definition

-1- What is Insolvent? The latest legal position on what makes a person or company insolvent. Index Page A. B. The tests for Insolvency Corporate Insolvency i) ii) iii) iv) Statutory Presumptions Statutory Demands Statutory Definition of Insolvency What are “debts due and payable”? • The Newark • The Southern Cross Division When does a debt become payable? • Calzaturificio • Pioneer Concrete • 3M Australia Pty Ltd What can be taken into account in determining whether a debtor is solvent? Contingent or prospective liabilities 2 2 2 2 4 6 v) 7 vi) 11 12 vii) C. Personal Insolvency 12 -2- A. THE TESTS FOR INSOLVENCY There are two Primary tests or determining insolvency:1 2 The cash flow test; and The balance sheet test Cash Flow test An individual or company is regarded as insolvent if they are unable to pay debts when they fall due. Balance Sheet Test Individual or company insolvent if total liabilities outweigh the value of assets. It is accepted in Australia that the appropriate test is the cash flow test. B. (i) CORPORATE INSOLVENCY Section 459C Presumptions of Insolvency Section 459C of the Corporations Act 2001 lists 6 statutory presumptions as to the solvency or otherwise of a company. The section states that a court must presume that the company is insolvent if, during or after the three months ending on the day that the application was made:a) the company failed (as defined by section 459F) to comply with a statutory demand; or b) execution or other process issued on a judgement, decree or order of an Australian court in favour of a creditor of the company was returned wholly or partly unsatisfied; or c) a receiver, or receiver and manager, of property of the company was appointed under a power contained in an instrument relating to a floating charge on such property; or d) an order was made for the appointment of such receiver, or receiver and manager, for the purpose of enforcing such a charge; or e) a person entered into possession or assumed control, of such property for such purpose; or -3- f) a person was appointed so to enter into possession or assume control (whether as agent for the chargee or the company). (ii) Statutory Demands If a company does not comply with the requirements of a statutory demand, then the court, on an application under section 459P, must presume the company is insolvent This presumption operates except so far as the contrary is proved – section 459C(3) On an application to wind up a company on the basis of a failure to comply with a statutory demand, the company may lead evidence as to actual solvency. In Ace Contractors & Staff Pty Ltd v Westgarth Development Pty Ltd [1999] FCA 728, Weinberg J stated the following regarding the operation of statutory demands:“The authorities which govern the operation of s459G of the Corporations Law seem to me to establish the following propositions:a) The respondent is presumed to be insolvent and as such bears the onus of proving its solvency: s459C(2) and (3); Elite Motor Campers Australia v Leisureport Pty Ltd (1996) 22 ACSR 235per Spender J; Commissioner of Taxation v Simionato Holdings Pty Ltd. (1997) 15 ACLC 477 per Mansfield J; b) In order to discharge that onus the Court should ordinarily be presented with the “fullest and best” evidence of the financial position of the respondent: Commonwealth Bank of Australia v Begonia (1993) 11 ACLC 1075 at 1081 per Hayne J; c) Unaudited accounts and unverified claims of ownership or valuation are not ordinarily probative of solvency. Nor are bald assertions of solvency arising from a general review of the accounts, even if made by qualified accountants who have detailed knowledge of how those accounts were prepared: Simionato Holdings Pty Ltd (supra); Re Citic Commodity Trading Pty Ltd v JBL Enterprises (WA) Pty Ltd [1998] FCA 232 per Heerey J; Leslie v Howship Holdings Pty Ltd (1997) 15 ACLC 459 at 463 per Sackville J; d) There is a distinction between solvency and a surplus of assets. A company may be at the same time insolvent and wealthy. The nature of a company's assets, and its ability to convert those assets into cash within a relatively short time, at least to the extent of meeting all its debts as and when they fall due, must be considered in determining solvency: Rees v Bank of New South Wales (1964) 111 CLR 210; Re Tweeds Garages Ltd [1962] Ch 406 at 410 per Plowman J; Simionato Holdings Pty Ltd (supra); Melbase Corporation Pty Ltd v Segenhoe Ltd (1995) 13 ACLC 823 at 832 per Lindgren J; Leslie v Howship Holdings Pty Ltd (supra) at 465-466; e) The adoption of a cash flow test for solvency does not mean that the extent of the company's assets is irrelevant to the inquiry. The credit resources available to the company must also be taken into account: -4- Sandell v Porter (1966) 115 CLR 666 at 671 per Barwick CJ (with whom McTiernan and Windeyer JJ agreed); Leslie v Howship Holdings Pty Ltd (supra) at 466; Taylor v ANZ Banking Group Ltd (1988) 6 ACLC 808 at 812 per McGarvie J; f) The question of solvency must be assessed at the date of the hearing. However, this does not mean that future events are to be ignored: Leslie v Howship Holdings Pty Ltd (supra) at 466-467; g) It is no abuse of process for an applicant to seek to wind up a company presumed to be insolvent by reason of its failure to comply with a statutory demand merely because that company contends that it is solvent, or because there may be alternative means available to the applicant to vindicate its rights: Elite Motor Campers Australia v Leisureport Pty Ltd (supra). (iii) Statutory Definition of Insolvency The statutory definition of insolvency in relation to corporations is contained in s 95A Corporations Act 2001 This defines solvency as:“A person is solvent if, and only if, the person is able to pay all the persons debts, as and when they become due and payable” Section 95A(2) continues:“A person who is not solvent is insolvent.” This approach has in effect adopted the cash flow test – Melbase Corporation Pty Ltd v Segenhoe Ltd (1995) 17 ACSR 198. This case concerned an application by Melbase, a contributory of Segenhoe holding approximately 5.5% of Segenhoe’s issued capital, seeking an order that Segenhoe be wound up under s 459P of the former Corporations Law. Lindgren J stated ( at page 198):“Section 95A of the Law states a “cash flow test” rather than a “balance sheet test” of insolvency: cf R M Goode, Principles of Corporate Insolvency Law (1990) at 25-7. But this is no reason to construe the word “debts” in the section as referring only to those debts which are treated for accounting purposes as having been incurred on revenue account as distinct from capital account.” The wording used in section 95A has created some confusion amongst practitioners. These concerns relate to 2 matters:- -5- 1. What “unable to pay debts as and when they become due and payable” means; and 2. What can be taken into account in determining whether a debtor is solvent? The court’s task in determining insolvency is to decide whether a company is suffering from a temporary lack of liquidity, in which case the company is not insolvent (Sandell v Porter (1966) 115 CLR 666), or whether it is suffering an endemic shortage of working capital (Hymix Concrete v Garritty (1977) 13 ALR 321). In Hymix, creditors of a company relied upon a financial report which showed that the company’s “Present condition is considered to be good with the trend up”. The creditor relied on this report, and allowed payments owed to it to remain unpaid, and lent to the company a further $40,000. Two months later the company went into liquidation. Taylor J (at page 328) stated “But the words “unable to pay its debts as they become due from its own money” should not be applied in either of these ways. There is an intermediate application of them which has long been established. I shall not set out once again the passages in the judgments of the court in Bank of Australasia v Hall (1907) 4 CLR 1514 per Griffith CJ at 1528 and per Isaacs J at 1543. They are set out in the judgment of Taylor J in Rees v Bank of New South Wales (1964) 111 CLR 210 at 229–30; [1965] ALR 139 at 149–50 I shall set out some passages from the judgment of Barwick CJ (111 CLR at 218–9; [1965] ALR at 141–2) which I think are particularly apposite to the present case:“It is quite true that a trader, to remain solvent, does not need to have ready cash by him to cover his commitments as they fall for payment, and that in determining whether he can pay his debts as they become due regard must be had to his realizable assets. The extent to which their existence will prevent a conclusion of insolvency will depend on a number of surrounding circumstances, one of which must be the nature of the assets and in the case of a trader, the nature of his business. Here the company’s business was the sale of foodstuffs through a number of retail outlets. The asset whose value was said to negative a conclusion of insolvency, or at any rate to obviate the suspicion of it, was its trading stock of foodstuffs. In the ordinary course of the company’s business this asset was not available to be realized except by means of retail sales through its various shops. The stock-in-trade was clearly not an asset which was available to be realized to meet current debts except in the ordinary course of the company’s business, a course which had proved itself inadequate.” • Taylor J concluded:- -6- “A temporary lack of liquidity must be distinguished from an endemic shortage of working capital whereby liquidity can only be restored by a successful outcome of business ventures in which the existing working capital has been deployed”. (iv) When are Debts Due and Payable? This phrase is not defined in the Corporations Act, so reference must be had to case law to determine its precise meaning. Re Newark In the case of Re Newark Pty Ltd ( in liquidation) [1993] 1 QdR 409, the Full Court of the Queensland Supreme Court was asked to consider whether a company was insolvent, according to the previous section 122(1) of the Bankruptcy Act, at the time certain payments were made to two individuals. Thomas J stated that he considered that the words of section 122(1) requiring that a company be “unable to pay (its) debts as they become due from (its) own money” as being a:“…a question of fact to be decided as a matter of commercial reality in the light of all the circumstances , and not merely by looking at the accounts and making a mechanical comparison of assets and liabilities” • Recent consideration of this phrase was provided by Palmer J in Southern Cross Interiors Pty Ltd ( in liq) and Another v Deputy Commissioner of Taxation and Others (2001) 39 ACSR 305 The Southern Cross Decision In this case, the founder of Southern Cross, who was also one of the directors, asked his wife in 1995 to become a director when other directors resigned. She agreed, but was not involved in the day to day running of the company In mid 1997, the company had substantial trade debts. The company’s normal terms were payment within 30 days, however many debts were older than this. Even though the debts were older than 30 days, the company did not press for payment. An external administrator was appointed in September 1997, and the company wound up in October 1997. The liquidator’s of the company sought to recover $208,737 paid to the ATO on the basis that the monies paid was an unfair preference, and the company was insolvent at the time of payment. The ATO argued that although the debts owed to the company may have been due under the company’s terms of trade, the debts were not payable at that time, and would only become payable if statutory demands were issued to the debtors. -7- Palmer J described this proposition advanced by Counsel for the ATO as a “surprising one”. He provided this commentary regarding the phrase “due and payable” (at page 312):“Doubtless, it was in the hope of reducing the scope for argument as to the of a company’s insolvency and in order to emphasise that the test was concerned only with a company’s ability to pay its debts when they became payable that the drafter of section 95A indulged in what might be described as a surfeit of pleonasms. The words “as and when” place emphasis upon the time at which the character of the debts is to be ascertained, although “as” and “when” are synonymous in this context. Likewise, the words “become due and payable” place emphasis on the character of the debts which is to be ascertained, although, again, the words “due” and “payable” are clearly synonymous in this context. Unfortunately, the use of the two words “due” and “payable” when one would have sufficed has made room for the argument that if two separate words are used in the definition of insolvency then each word must have different work to do. Thus, (counsel for the ATO) has had a respectable, if tenuous, toehold for his submission that, on the true construction of section 95A(1), the time at which a debt “becomes due” may be different from the time at which it “becomes payable”. This submission has some encouragement from at least one academic writer… Palmer J commented on this suggested approach to the interpretation of section 95A, and stated:“The sooner this incipient heresy is scotched, the better.” In Palmer J’s view, the test is simply whether the company can pay its debts as they become payable. (v) When does a debt become payable? There have been differences in judicial opinion as to when a debt becomes payable. The three most commonly cited cases as to the origins of the differences in judicial opinion as to when a debt is regarded as payable are:1. Calzaturificio Zenith Pty Ltd (in liq) v NSW Leather and Trading Co Pty Ltd [1970] VR 605 2. Pioneer Concrete Pty Ltd v Ellston (1985) 10 ACLR 289 3. 3M Australia Pty Ltd v Kemish (1986) 10 ACLR 371 -8- Calzaturificio This case was concerned with a claim for the recovery of a preference under the NSW Companies Act. The operative provision in the NSW Act incorporated section 95(1) of the Bankruptcy Act. Menhennitt J, said that to determine whether a company was unable to pay its debts as they became due required an examination of all the company’s resources, including terms of credit available to a debtor. A significant number of the company’s creditors were extending up to 90 days credit to the company, but pursuant to a factoring arrangement, the company was receiving payment of debts due to it within 1 week. As a result of these facts, Menhennitt J stated ( at609) that:“…merely to take a balance sheet which puts opposite each other book debts and creditors liabilities as if they were to be equated is, in my view, erroneous. It would be necessary to make an appropriate calculation to decide when the creditors had to be paid and when the debts were likely to be received in order to decide whether at any particular moment of time the company was or was not able to pay its debts as they fell due.” Pioneer Concrete This case concerned a claim by a creditor against a director of a company in liquidation under the insolvent trading provisions of the NSW Companies Code. The question in that case was whether the plaintiff had established that “…immediately before the time when the plaintiffs debt was incurred, there were reasonable grounds to expect that the company would not be able to pay all its debts as and when they became due.” Carruthers J stated (at 301):“…the question whether a debt has or has not become due is to be determined by reference to the legal agreement between the parties. Hesitation on the part of a creditor (probably for commercial reasons) to take immediate steps to enforce its rights against a customer can have no bearing upon this question.” 3M Australia Pty Ltd In 3M Australia, the court was again concerned with an insolvent trading claim against a director under the NSW Companies Code. Foster J said (at 378):- -9- “I am satisfied that a debt does not necessarily become “due” within the meaning of the section upon the date originally stipulated for its payment. I consider that it is proper to take into account arrangements made by the company with the creditor for extended time for payment , even where such arrangement would not be contractually binding upon the creditor. Even where there is no express arrangement for the extension of credit beyond the time originally stipulated, I think it appropriate to take into account in determining whether the section has been satisfied, whether a course of dealing between the company and a particular creditor would reasonably lead to an expectation on the part of the defendant that some reasonable extension of a period of credit would be allowed by the creditor as a matter of grace. Clearly, nice questions of fact must be involved in such considerations and the question of whether the “due” date for payment of a company’s debt has been extended, will depend on the precise circumstances relating to the individual debt, and the particular creditor.” In Queensland, the approach in Calzaturificio has been followed in Neville Smith Timber Industries Pty Ltd v Lennan [1996]2 QdR 177 In Southern Cross Interiors Pty Ltd (in liq) and Another v Deputy Commissioner of Taxation and Others (2001) 39 ACSR 305, Palmer J considered the various approaches espoused as to when a debt becomes payable. He stated (at 316):“I cannot find any support in the authorities for the proposition that the court ought to take cognisance of what is said to be a common business practice of debtors delaying payment to creditors for as long as possible and of creditors accepting that practice as a fact of commercial life, with the result that no contract debt can be regarded as payable for the purposes of ascertaining a company’s solvency unless there is evidence that the creditor has actively pursued payment to the point of a statutory demand. If such a proposition were accepted by the law, the consequences in the commercial community would be chaotic. Debtors would know that contractually stipulated times for payment of their debts are virtually meaningless and that they have the luxury of delaying payment until the creditor commences legal proceedings against them.” Palmer J then stated the following as propositions that may be drawn from the authorities (point 5 being most relevant for a consideration of the meaning of “due and payable”):1. Whether or not a company is insolvent for the purposes of section 95A…, is a question of fact to be ascertained from a consideration of the company’s financial position taken as a whole; 2. In considering the company’s financial position as a whole, the court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, - 10 - whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable; 3. In assessing whether a company’s position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality that, in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade but that does not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency; 4. The commercial reality that creditors will normally allow some latitude in time for payment of their debts does not, of itself, warrant a conclusion that the debts are not payable at the times contractually stipulated and have become debts payable only on demand; 5. In assessing solvency, the court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the court’s satisfaction, that:a) there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; b) there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; c) there has been a well established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors’ terms of trade or are payable only on demand; 6. It is for the party asserting that a company’s contract debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence. (vi) What can be taken into account in determining whether a debtor is solvent? According to Isaacs J in Bank of Australasia v Hall (1907) 4 CLR 1514:“If… the debtors position is such that he has property either in the form of assets in possession or of debts, which if realised would produce sufficient money to pay all his indebtedness, and if that property is in such a position as to title and otherwise that it could be realised in time to meet the indebtedness as the claims mature, with money thus belonging to the - 11 - debtor, he cannot be said to be unable to pay his debts as they become due from his own moneys.” In Metropolitan Fire Systems Pty Ltd v Miller and Others (1997) 23 ACSR 699, the court had to consider which assets of the company could be examined in order to determine the company’s solvency. Einfeld J considered it necessary to “…consider the whole of the company’s resources, including its credit resources.” In Sandell v Porter (1966) 115 CLR 666, the High Court considered and commented on this question. Barwick CJ indicated that the debtor was not limited to their own cash resources, but could have recourse to funds available through the sale or mortgaging of assets. He continued by stating that a time limit is placed on taking this action and the funds must be available within a relatively short period of time. Although Barwick CJ did not define what a relatively short period of time was, he did state that this would be determined by the court in each case, and outlined criteria by which the time period should be calculated:a) The nature and amounts of the debts; b) The prevailing circumstances; and c) The nature of the debtor’s business. There are also assets that may not be taken into account when determining a company’s solvency. Assets which re excluded will depend on the same factors as outlined by Barwick CJ in Sandell, above. Examples of assets that may not be taken into account:i) Stock in trade – except in the ordinary course of business: Rees v Bank of New South Wales (1964) 111 CLR 210; ii) Realisation of assets that would involve a cessation or breaking up of business: Re Timbatec Pty Ltd (1974) 24 FLR 30; iii) Funds obtainable by unsecured borrowing: Re Norfolk Plumbing Supplies Pty Ltd (1992) 6 ACSR 601; iv) Courts have also suggested that credit provided to the company by the company’s directors may also be rejected: Re RHD Power Services Pty Ltd (in liq) (1990) 3 ACSR 261. (vii) Contingent or prospective liabilities - 12 - Section 459D provides that in determining whether or not the company is solvent, the court may take into account a contingent or prospective liability of the company. A contingent liability means a liability which will only become due in an event which may or may not occur, whilst a prospective liability is a liability which will certainly become due in the future, either on some date which has already been determined or on some date determinable by reference to future events: Stonegate Securities Ltd v Gregory [1980] 1 Ch 576 As to how far into the future to look for contingent or prospective liabilities, Griffith CJ in Bank of Australasia v Hall (1907) 4 CLR 1514, stated that consideration should be given to the immediate future. C. PERSONAL INSOLVENCY Section 5(2) of the Bankruptcy Act defines solvency in similar terms to those found in the Corporations Act. Section 5(3) states that:- “A person who is not solvent is insolvent”. The concepts and legal position regarding the definition of solvency and insolvency in a personal, rather than corporate environment virtually mirror those discussed above. Regarding personal insolvency, one of the leading cases on the area is Bank of Australasia v Hall (1907) 4 CLR 1133, which established the following points:a) That the word “debts” includes any liabilities that would have been provable in bankruptcy if the debtor had become bankrupt at the time in question; That the “debts” referred to also refer to future debts; Only the “immediate future” should be looked to in terms of payable debts. b) c) A recent case which examined the definition of insolvency in a personal as opposed to corporate context is International Alpaca Management Pty Ltd v Ensor [1999] FCA 72. This case concerned the making of a sequestration order against the estate of the debtor. The debtor contended that the sequestration order should be dismissed according to section 52(2) on the grounds that the debtor was able to pay his debts as they became due and payable. Katz J, stated the following regarding the definition of insolvency in a personal context:- - 13 - a) “Unable to pay debts as they become due”, includes debts that may arise in the immediate future; A debtor’s cash resources extend to amounts that he can procure by sale or mortgage or pledge of his assets within a relatively short time; The conclusion of insolvency ought to be clear from a consideration of the debtor’s financial position in its entirety and generally speaking ought not to be drawn simply from evidence of a temporary lack of liquidity; It is the debtor’s inability, utilizing such cash resources as he has or can command through the use of his assets, to meet his debts as and when they fall due which indicates insolvency. Although the words “from the debtor’s own money” are no longer included in the definition of insolvency, or in section 52(2), Katz J proceeded, using a construction requiring the debtor to prove that he could “pay his debts as they became due, from his own money”. b) c) d) e) In this case, Katz J concluded that the debtor was unable to pay his debts as and when they fell due, out of his own money. What is Insolvent? Paper presented by David Tucker Worrells Solvency & Fraud Conference 2 November 2002 TUCKER & COWEN Solicitors Level 15 15 Adelaide Street Brisbane Qld 4000 Tel: 07 300 300 00 Fax: 07 300 300 33 Email: dtucker@tuckercowen.com.au