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Insolvencies - The Basics

September 28, 2015 by Andrew Schwarz


With the latest statistics on corporate insolvency in Australia revealing an increase in companies entering external administration, it’s a sad reminder of what can happen in your business without strategic economic management.

According to the June 2015 quarterly insolvency statistics published by the Australian Securities and Investment Commission (ASIC) for the 2014-2015 financial year, the number of companies entering external administration increased by 38.7%, with appointments totaling 2734 – a sharp climb from the 1971 figure in the previous quarter. The numbers show a quarterly total 18.5% higher than the June 2014 quarter (2, 308).

The three most common types of corporate insolvency are voluntary administration, liquidation and receivership.

Voluntary Administration

The Voluntary Administration process was introduced into the Corporations Act (‘the Act’) in 2003 with the objective of providing a mechanism for the affairs of an insolvent company to be administered in a way that maximizes the chances of the company continuing. A Voluntary Administration can be commenced by the directors of the company or the secured creditor.

An advantage of the Voluntary Administration process is the speed at which an appointment can be made and the immediate effect of freezing creditor claims against the company and the protection afforded to directors from litigation such as insolvent trading.

For the voluntary administrator, the task is to explore the affairs of the troubled company, to submit detailed reports to any creditors, and to recommend to those same creditors which option the company should take. The choices include entering into a deed of company arrangement, going into liquidation or being returned to the directors. The Administrator has significant powers to trade the business, close the business down, realise assets, seek equity injection or do just about whatever is required in order to maximize the return to creditors.

The Voluntary Administration process is best used when a company is insolvent or likely to become insolvent as a result of something which can be corrected, such as past decisions of management, a one off event which has negatively impacted the company or as a result of economic conditions outside the control of the directors. In this situation although the company is currently in financial difficulty the underlying business maybe strong and once restructured has the opportunity to be a viable profitable business.

The benefits of restructuring the entity is that employees may continue to have a job going forward, creditors get some return on the past and the opportunity to have a continuing ongoing customer and the owners of the business get a second chance.

Liquidation

Liquidation involves the winding up of a company and its affairs. The process is initiated either by the directors and members or by a creditor who is owed money by the company. The process is usually initiated because the company has no realistic chance of resolving its financial difficulties. Although a solvent company can also be liquidated via a members voluntary liquidation when the members no longer wish for the company to exist.

There are three types of liquidation:

  • Court – liquidation instigated following a court order, made after an application to the court, often by a creditor of the company
  • Creditors’ voluntary – liquidation initiated by the company
  • Members’ voluntary - when directors/shareholders close a company with large accumulated reserves, creditors are paid in full and any remaining funds can be distributed to the company’s shareholders/directors

The process involves the appointment of a Liquidator who is an independent person charged with selling all available assets belonging to the company and then distributing any available proceeds between the creditors, with any surplus distributed to shareholders. The Liquidator is required to investigate the affairs of the company, including the reason for the company’s failure and any breaches of directors’ duties or offences committed by them. The Liquidator will submit a report to ASIC pursuant to Section 533 of the Act on his findings in this regard.

A liquidation is best considered where the company is hopelessly insolvent or members have decided there is no longer any use for the company. Following the liquidation process the company is dissolved and deregistered with ASIC.

Receivership

Receivership is a form of administration, which can apply to corporations, partnerships and individuals. Corporate receiverships are most common and usually occur where the company has defaulted under a loan contract.

As a result of the default, a receiver is appointed by the party holding security over the company (The Secured Creditor). The chief role of the receiver is to take control of the secured assets and realise them for the benefit of the Secured Creditor.

The receiver’s primary duty is to the secured party and not ordinary unsecured creditors. The secured creditor can appoint a receiver or a receiver and manager. The receiver will generally only have the power to control and realise the secured asset where as a Receiver and Manager will usually have control over all assets of the company and the power to trade and sell the company as a whole.

Checklist – Is Your Company Under Financial Stress?

The ASIC website is a handy reference tool for a wealth of information about insolvency. Some warnings signs about the financial pressure on your company include:

  • Continued, consistent losses
  • Poor cash flow
  • No business plan
  • Incomplete financial records
  • Poor accounting procedures
  • Growing debt
  • No forecasting or budget
  • Failure to meet creditors’ payment terms
  • Legal letters and demands
  • Defaults on loans
  • ATO debt

The definition of an insolvent company is one that fails to meet its financial obligations when debts are due. If you allow your company to continue trading while technically insolvent, there are severe penalties that can be applied.

AFFIRMATIVE ACTION

Facing the issue of insolvency can be a stressful and upsetting time but taking responsibility and talking to professionals about potential for debt resolution must be actioned professionally and promptly to avoid the issue escalating - and potentially costing you even more stress through legal action and other formal processes.

Directors in Australia face important duties if their company faces severe financial difficulties and, the most important thing to consider is the duty to stop a company from trading while it is insolvent. Directors also need to prevent their company from incurring even more debt.

By failing to avoid trading while insolvent, company directors can be held personally liable for compensation payments – as well as having penalty orders lodged against them and disqualification from future corporation management.

To avoid the risk, there are some critical rules:

  • Take prompt action. The problems will not go away. Your board needs to be proactive and act swiftly before things get worse.
  • Increase monitoring of financials. With the right systems in place – and an accurate an honest appraisal of the company’s real financial position, problems can be avoided.
  • Rather than rely on an injection of funds that may never really come, it is important to implement a secondary plan – with solid legal and financial advice guiding your decision-making.
  • Communication is key. Don’t avoid the phone calls from your bank or the ATO. By offering potential solutions, problems can be tackled professionally – before they grow even more out of control.

It is important to realise that finding the solutions may take time – and may take input from various people. Insolvency is an unfortunate reality for many Australian companies but it can be avoided with careful management.

If your company or your clients company is experiencing financial difficulty, it is best to take action to minimize the potential fall out and control the situation.

If you would like more specific advice about your situation please feel free to contact us directly.



Tags: Financial Distress Financial Distress

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