When we start out in business, we have a vision which for most of us, resolves around a profitable growing business. However, sometimes things do not work out as expected and our businesses may get into financial distress. In this article, I wanted to outline the different types of insolvency and what they mean.
Insolvency is defined in Section 95A of the Corporations Law as "a person who is not solvent." A solvent person or entity is one that is able to pay its debts as and when they become due and payable. What this means is that if you are an individual or a company who is unable to pay its debts as and when they fall due you are in the eyes of the law insolvent.
Directors Duty to Prevent Insolvency
The Corporations Law imposes a number of obligations on directors of companies. These obligations apply whether your entity only employs you and turnover $1 or employs 1,000 of people and is listed on the Stock Exchange turning over many $millions. Under Division 3 of the Corporations Act, it is a director's duty to prevent insolvent trading. Accordingly, if a director has knowledge or assumes the company is insolvent and it incurs a debt, then the director can be personally liable for the debts incurred by the company.
If a director suspects their company is trading whilst insolvent, then they have a legal obligation to deal with the situation in one of two ways:
1. Do not incur any new debt i.e. If you wish to continue to trade your way out of insolvency, then you need to not incur any fresh debt which means paying COD for any supplies; or
2. You need to place the company into a form of insolvency
If you do not do one of the above and continue to trade the company and incur new debt, you could be held personally liable for the debts incurred.
Types of Insolvency
In broad terms there are three different types of insolvency as follows:
- Voluntary Administration
A summary of each of these is outlined below:
Voluntary administration is an external administration where the directors of a financially troubled company or a secured creditor with a charge over most of the company’s assets appoint an external administrator called a ‘voluntary administrator’.
The role of the voluntary administrator is to investigate the company’s affairs, to report to creditors and to recommend to creditors whether the company should enter into a deed of company arrangement, go into liquidation or be returned to the directors.
A voluntary administrator is usually appointed by a company’s directors, after they decide that the company is insolvent or likely to become insolvent. Less commonly, a voluntary administrator may be appointed by a liquidator, provisional liquidator, or a secured creditor.
The Voluntary Administration provisions are most often used where there is an urgent need to freeze the company situation and provide breathing space to work out a way to restructure the company.
Liquidation is the orderly winding up of a company’s affairs. It involves realising the company’s assets, cessation or sale of its operations, distributing the proceeds of realisation among its creditors and distributing any surplus among its shareholders. The three types of liquidation are:
- creditors’ voluntary, and
- members’ voluntary.
A creditors' voluntary liquidation is a liquidation initiated by the company. A court liquidation starts as a result of a court order, made after an application to the court, usually by a creditor of the company.
Liquidation is most appropriate where there is little hope of salvaging the business and the best cause is the orderly realisation of assets and dissolution of the company.
A company most commonly goes into receivership when a receiver is appointed by a secured creditor who holds security over some or all of the company’s assets. The receiver’s primary role is to collect and sell sufficient of the company’s charged assets to repay the debt owed to the secured creditor.
A receivership is most common where a financier to the company such as a bank has not been paid and has lost patients with the company. It will then enforce its security and appoint a receiver to sell the assets of the company and repay its debt.
Although insolvency is not pleasant and no business owner wishes to end up in this position, sometimes circumstances mean the company is insolvent. When this is the case, it is best to seek external advice from your accountant, lawyer or an insolvency practitioner as to what is the best option having regard to your circumstances. In my experience, it is best that the directors/companies acknowledge their position and act early to get expert advice as they they are in the best position to salvage something out of the predicament they find themselves.