Insolvent Transactions and risks to Advisors

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1 Insolvent Transactions and risks to Advisors Mervyn Kitay Worrells Solvency & Forensic Who should Accountants you trust? Insolvent Transactions and Risks to Advisors Presented by: Mervyn Kitay, Partner Worrells

2 WHEN IS A COMPANY INSOLVENT? CASH FLOW TEST OR BALANCE SHEET TEST HOW DOES THE COPORATIONS ACT DEAL WITH THIS? Positive obligation not to trade whilst insolvent Directors exposed personally

3 DUTY NOT TO TRADE WHILE INSOLVENT Directors have a positive duty to prevent a company trading if it is insolvent. A company is insolvent if it is unable to pay all its debts when they are due. Before a new debt is incurred, Directors must consider whether they have reasonable grounds to suspect that the company is insolvent or will become insolvent because of incurring the debt. Whether a company can pay its debts when due and payable is a question of fact to be determined objectively and without hindsight. An understanding of the financial position of the company only when you sign off on the yearly financial statements is insufficient. CONSEQUENCES OF Civil penalties o civil penalties against directors, including pecuniary penalties of up to $200,000. Compensation proceedings o Can be initiated by ASIC, a liquidator or a creditor against a director personally. A compensation order can be made in addition to civil penalties. o Compensation payments are potentially unlimited and could lead to the personal bankruptcy of directors. o The personal bankruptcy of a director disqualifies that director from continuing as a director or managing a company.

4 CONSEQUENCES OF CONT. Criminal charges o If dishonesty is found to be a factor in insolvent trading, a director may also be subject to criminal charges (which can lead to a fine of up to $220,000 or imprisonment for up to 5 years, or both SIGNS OF INSOLVENCY ongoing losses poor cash flow absence of a business plan incomplete financial records or disorganised internal accounting procedures lack of cash-flow forecasts and other budgets increasing debt (liabilities greater than assets) problems selling stock or collecting debts unrecoverable loans to associated parties

5 SIGNS OF INSOLVENCY CONT. creditors unpaid outside usual terms solicitors letters, demands, summonses, judgements or warrants issued against your company suppliers placing your company on cash-on-delivery (COD) terms issuing post-dated cheques or dishonouring cheques special arrangements with selected creditors payments to creditors of rounded sums that are not reconcilable to specific invoices overdraft limit reached or defaults on loan or interest payments SIGNS OF INSOLVENCY CONT. problems obtaining finance change of bank, lender or increased monitoring/involvement by financier inability to raise funds from shareholders overdue taxes and superannuation liabilities board disputes and director resignations, or loss of management personnel increased level of complaints or queries raised with suppliers an expectation that the next big job/sale/contract will save the company

6 TEMPORARY WORKING CAPITAL DEFICIENCY OR ENDEMIC SHORTAGE OF WORKING CAPITAL Temporary working capital deficiency push on Endemic shortage of working capital close shop TEMPORARY WORKING CAPITAL DEFICIENCY OR ENDEMIC SHORTAGE OF WORKING CAPITAL How do you tell: Three-way forecast (P&L: balance sheet and cash flow) Pin-points when cash deficiency arises Uses the assumptions (reasonably tested) regarding trading performance; debtors days; creditor days; stock turn etc.

7 TEMPORARY WORKING CAPITAL DEFICIENCY OR ENDEMIC SHORTAGE OF WORKING CAPITAL Three month rule allows some flexibility Degree of certainty o Unlikely o Possible o Highly probable Defence to an insolvent trading claim DIRECTORS DEFENCES TO INSOLVENT TRADING They had reasonable grounds to expect that the company was solvent They did not participate in the management of the company due to illness or some other good reason They took all reasonable steps to prevent the company from incurring the debt

8 DUTY TO KEEP BOOKS AND RECORDS For the purposes of an insolvent trading action against a director, a company will generally be presumed to have been insolvent throughout a period where it can be shown to have failed to keep adequate financial records Arises where no records or where documents kept are deficient as to content in not recording the company s financial position and performance. TO SUMMARISE: DEALING WITH A DISTRESSED CLIENT Solvency = Ability to pay debts when due Courts look at Cash Flow Three-way Forecast is most reliable tool legally and commercially Advisers should capitalise on this

9 THE BIG BITE!! DIRECTOR PENALTY NOTICES (DPN S) Applies to withholding taxes and now includes Super Has the effect of Piecing the Corporate veil by making directors personally liable for company debts Relief from personal liability if: o Company pays the overdue debt o Directors appoints Liquidator or Administrator within 21 days of issue of DPN However new lock down provisions apply where the outstanding liability remains: o Unpaid and unreported 3 months after due date Personal liability cannot be avoided by placing company in Administration or Liquidation. Only payment of the debt will relieve personal liability PROTECTING YOUR HARD EARNED FEES - PREFERENCES Applies where o Payment made by a debtor to a creditor o At a time when the company was insolvent o Having the effect of preferring the creditor over others o By the creditor receiving more than they would have if the company was placed into Liquidation o All occurring within 6 months of commencement of the Liquidation or 4 years involving a related party or 10 years where fraudulent intent

10 PREFERENCES CONT. o Accountants / Advisers easily exposed to preferences o Strategy to side step receiving a preference o Receipt of funds before a debtor creditor relationship is established o Alternative to register a GSA and become secured PREFERENCES CONT. The ATO Director Indemnity (S588FGA) is a hidden trap Good discussion to have around asset protection!

11 QUESTIONS? For any future questions please contact: T Disclaimer: All material contained in this paper is written by way of general comment. No material should be accepted as authorative advice and any reader wishing to act upon material contained in this paper should first contact Worrells for properly considered professional advice, which take into account specific situations.