Sixty Seconds on Insolvent Trading

Written by on February 10, 2014 in Board Role and Duties, Governance with 0 Comments

Black and white photo of cottage windows and gardenHere’s a paraphrase of another sixty-second presentation (I’ve published a previous one on the 5.5 core board tasks).

I had sixty seconds to introduce my work to a breakfast discussion group, and I chose to focus on one topic: insolvent trading.  A big, hairy, scary topic, that some people fear even to mention in case the Solvency Police or the Insolvent Undead come knocking.

But rushing in where accountants fear to tread, I offered these 3.5 points on insolvent trading.

1. Context

Insolvent trading is a very serious matter, particularly in Australia.  You can be sued for the company’s debts, banned from being a director, and/or prosecuted for insolvent trading.  Penalties go all the way up to jail sentences.

Australia’s insolvent trading laws are severe, and some argue that they lead to needless destruction of value.  Directors may be discouraged from realistic programs to trade out of trouble, and encouraged to pull the emergency cord labelled “administration”, even when a company might well have a fighting chance of recovery.  That important discussion is in the public policy realm, for another day.

2. Definitions

A company is solvent if it can pay its debts as and when they fall due.  This is a cashflow not a balance sheet test – having assets you could liquidate to pay debts is not the same thing as having the cash to pay debts.  Insolvent trading is incurring a debt while the company is insolvent under this definition, or else incurring a debt that tips the company into insolvency.  This definition includes neglecting to take action to prevent such a debt being incurred.

This very stark definition is slightly softened in practice.  In some cases a realistic plan to correct strict insolvency by asset liquidation or refinancing has been accepted by a court.  But if you find yourself experimenting with the definitions of solvency, you are already in treacherous waters and you need legal and other advice now.

3. What to Do?

It should be clear that the best cure by far is prevention.  And the best prevention is board vigilance: insist on up-to-date creditor and cash position reporting and cashflow forecasting at every board meeting.  Pressure-test the board papers.  In case of any doubt, get independent advice, not just assurances from company officers.

And in the end, it’s better to go into voluntary administration than to try and trade out of it and fail.  But this is wild country – don’t go here without a lawyer.

3.5 A Word of Comfort

Most Australian directors don’t have a major worry here.  If the business model is sound, the company is well-managed, the board vigilant and the governance procedures thorough, you are very unlikely to face this problem.

Putting a company into administration is a big and expensive step, and usually nobody wins, particularly the shareholders whose interests directors are employed to safeguard. I can put you in touch with a law firm that specialises in rescuing all that can be rescued in such situations – and it’s often more than you think.  Of course, the earlier you talk to such an advisor, the better.

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