Managing solvency amid the COVID-19 crisis


Posted By and on 24/03/20 at 3:01 PM

COVID-19’s impact on business has been, and will continue to be, significant and in some cases, catastrophic.  There are myriad issues that directors are juggling as a consequence of the current crisis. Critically, one of those issues is a company’s solvency.

In this article we highlight the warning signs of insolvency and the changes that were announced by the Commonwealth Government at the weekend and passed by Parliament today, aimed at giving directors and companies some breathing space in the context of insolvent trading.

What is insolvency?

The Corporations Act 2001 (Cth) (Act) provides that a company that is unable to pay its debt as and when they fall due is insolvent, and imposes a positive duty on directors to ensure that directors do not cause a company to incur a debt while insolvent, or cause a company to become insolvent by incurring that debt (s588G). There are various penalties and consequences for insolvent trading for directors, including civil penalties and criminal charges. In addition, compensation proceedings for amounts lost by creditors can be initiated by ASIC, a liquidator or a creditor against a director personally.

This may be modified by way of the foreshadowed changes below, but the risks will remain.

Now, more than ever, directors need to be aware of the early signs of insolvency so that appropriate advice can be obtained in a timely manner. Being proactive will be crucial in being able to establish the safe harbour defence to insolvent trading for directors.

What are some common signs of insolvency?

The issue of solvency is principally about cash flow and difficulties with cashflow. Non-collection of debtors, significant decreases in revenue, increasing overdraft facilities or spending on credit cards, and using personal money or cash reserved for liabilities (such as tax) should all sound alarm bells for directors that cash flow is a critical issue for the business.

More obvious signs of insolvency include:

  • negotiating formal payment plans in order to secure ongoing supply;
  • being unable to access finance;
  • being unable to pay superannuation or tax on time; and
  • legal demands for payment from creditors (including statutory demands).
KHQ Lawyers - solvency and COVID-19
What is the safe harbour defence?

The more traditional method of reducing personal liability for insolvent trading is to appoint an administrator or a liquidator. However, since 2017 there has been a safe harbour defence available, aimed at facilitating restructures outside a formal insolvency process, where directors act proactively and implement a course of action that is reasonably likely to lead to a better outcome for the company and its creditors, compared to the appointment of an administrator or a liquidator.

In working out whether a course of action is reasonably likely to lead to a better outcome for the company, regard may be had to whether the person is:

  • properly informing himself or herself of the company’s financial position;
  • taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts;
  • taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;
  • obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; or
  • developing or implementing a plan for restructuring the company to improve its financial position.

These factors are a guide only, and directors must continue to monitor the performance of the company, and the viability of the course of action adopted, with a view to ensuring that it is still reasonably likely to lead to a better outcome or, if that is not possible, place the company into voluntary administration.

Lastly, a director will only be eligible to rely on the safe harbour protection if they are able to demonstrate that the company has:

  • paid all employee entitlements by the time they fall due; and
  • complied with all tax reporting obligations (including lodging returns, notices, statements, applications or other documents), as required by taxation laws.
What does this all mean in the COVID-19 crisis?

It will be difficult to develop or implement a plan for restructuring a company to improve its financial position in the current financial climate as a result of the COVID-19 crisis as there are so many unknown factors that will impact the financial position of the company. Therefore, the availability of the safe harbour defence will be very hard to assess for directors and their advisers.

Positively, on 22 March, the Commonwealth Government announced some welcome temporary changes regarding insolvent trading, as follows:

  • there will be 6 months temporary relief for directors from any personal liability for trading while insolvent; and
  • the statutory demand[1] process will be altered as follows:
  • the creditor’s debt must be at least $20,000 (up from $2,000); and
  • the timeframe to respond to the demand is 6 months (up from 21 days).

It is hoped that this will give some breathing space to businesses to help them weather the COVID-19 crisis. These changes have now been passed by Parliament, and are expected to come into effect in the next day or two.

Of course, the flipside to these changes is a reallocation of some of the insolvency risk to creditors – as they will no longer be able to rely on the statutory demand regime to clarify the solvency of a debtor, or rely on the assumption that a prudent director would not expose their personal assets to an insolvent trading claim.  Directors should bear this in mind when dealing with debtors.

What next?

There will continue to be a disruption to businesses for a period of time to come and directors need to be prepared for this. If you have solvency concerns about your business or any of your customers, it is important to seek legal advice as early as possible to maximise the availability of defences for personal liability and/or minimise the risks to your business.

We are dedicated to helping businesses through this uncertain and stressful period. If you have any questions please reach out to your usual KHQ contact, or otherwise email us at contact@khq.com.au or call us on (03) 9663 9877.

 

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[1] A creditor’s statutory demand is a mechanism commonly used by a creditor who is owed a debt. As noted above, receipt of statutory demand is a sign of potential insolvency.  Once a statutory demand has been validly served on a company, the company must:

  • pay the amount claimed;
  • resolve the claim with the creditor; or
  • file and serve an application under section 459G of the Corporations Act 2001 (Cth) to set aside the statutory demand.

If a company fails to do one of the above things within the required timeframe, it is deemed to be insolvent and the creditor serving the statutory demand may proceed to apply to wind up the company.

Kate Landells Principal Solicitor

Kate is a principal solicitor in our Corporate & Commercial team.

Kate supports clients to build value, achieve key milestones and drive exit outcomes.  She has extensive experience across... Read More

Paul Welling Principal Solicitor

Paul Welling leads our litigation team.  Paul spent over a decade at a top tier national law firm and is a highly experienced litigator specialising in all areas of complex commercial litigation and... Read More