With companies continuing to report financial difficulty, it’s worth looking at a case that analysed the meaning of insolvency in great practical detail for some guidance for directors.

Although Hall & Ors v Poolman & Ors [2007] NSWSC 1330 is noteworthy because of the Judge’s criticism of the role of litigation funders in the case, the key issue was whether the directors permitted the company (a winery) to trade while insolvent (s.588G Corporations Act). There were various other cross claims and voidable preference proceedings.

One of the directors (Mr Irving) claimed defences under Section 588H, s.1317S and s.1318 Corporations Act. The judge analysed the difference between solvency and insolvency and posed the question that directors should ask themselves:

“How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?”

When is a company insolvent?

Irving argued that "the companies could have realised sufficient assets to pay all their debts in the Period as they fell due, but did not do so because they did not need to do so. The companies did not need to do so because their creditors were showing forbearance and were not issuing statutory demands."

In concluding there was insolvency, Judge Palmer responded:

"201    However, I have found as a fact that many of the creditors of both companies were insistent in demanding payment of their overdue debts during the Period. The fact that they did not immediately issue statutory demands or commence debt recovery proceedings did not operate to defer the companies’ present liability for those debts…

202    Therefore, it is not correct, nor is it to the point, to say that the companies did not need to realise assets to pay their overdue debts. The companies had a legal liability to pay those debts; they needed to realise assets to pay those debts, if they could, to avoid the Directors engaging in insolvent trading.

203    Solvency is a question of fact and in finding whether or not a company was solvent at a particular point of time in the past the Court does not proceed upon possibility or speculation as to what might have happened when it has clear evidence as to what did, in fact, happen…"

205   The companies’ own records show that when they went into administration some creditors’ debts had been outstanding since October 2002 and that debts had been aging for ninety days and more, to increasingly strident protest from creditors… Even allowing for the fact that a forced sale of assets in an insolvency administration usually results in realisations significantly less than what could have been achieved if the sale had been on a “going concern” basis, nevertheless there has been a massive deficiency in the assets of Wines and Vineyards available to pay the debts of both secured and unsecured creditors."

Defences for directors

"266    The law recognises that there is sometimes no clear dividing line between solvency and insolvency from the perspective of the directors of a trading company which is in difficulties. There is a difference between temporary illiquidity and “an endemic shortage of working capital whereby liquidity can only restored by a successful outcome of business ventures in which the existing working capital has been deployed”: Hymix Concrete Pty Ltd v Garritty (1977) 2 ACLR 559, at 566; Re Newark Pty Ltd (in liq); Taylor v Carroll (1991) 6 ACSR 255. The first is an embarrassment, the second is a disaster. It is easy enough to tell the difference in hindsight, when the company has either weathered the storm or foundered with all hands; sometimes it is not so easy when the company is still contending with the waves. Lack of liquidity is not conclusive of insolvency, neither is availability of assets conclusive of solvency: Expo International Pty Ltd (in liq) v Chant [1979] 2 NSWLR 820, at 837.

267    Where a company has assets which, if realised, will pay outstanding debts and will enable debts incurred during the period of realisation to be paid as they fall due, the critical question for solvency is: how soon will the proceeds of realisation be available… Bearing in mind the commercial reality that creditors will usually prefer to wait a reasonable time to have their debts paid in full rather than insist on putting the company into insolvency if it fails to pay strictly on time, I think it can be said, as a very broad general rule, that a director would be justified in “expecting solvency” if an asset could be realised to pay accrued and future creditors in full within about ninety days.

268    The position becomes murkier the less certain are the outcomes. The market value of the asset may not be ascertainable until the market is tested, so that it is not certain that the realisation will pay in full both existing debts and those to be accrued during the realisation period. The time at which the proceeds of realisation become available may depend upon the state of the market and the complexity of the transaction.

269    There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors: “How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?”

270    If the honest and reasonable answer is “certain” or “probable”, the director can have a reasonable expectation of solvency.

271    If the honest and reasonable answer is anywhere from “possible” to “no way of knowing”, the director can have no reasonable expectation of solvency.

272    If the honest and reasonable answer is “more likely than not”, the director runs the risk that a Court will hold to the contrary in an insolvent trading claim.

273    If the honest and reasonable answer is “no way of knowing yet, we need more information”, the director must then ask: “How long before we have the information so that we can give a final answer?”

274    If the honest and reasonable answer to that question is: “By a definite date which will not extend the realisation period (if there is to be one) beyond three months”, the director may reasonably say: “Let’s wait until then before deciding”.

275    If the honest and reasonable answer is “there is no way of knowing yet when we will have the information to make a decision”, the director must say: “Then there is no way that we can now have a reasonable expectation of solvency and there is no way we can reasonably justify continuing to trade without knowing when we will know whether the company is insolvent. Call the administrators”. By this series of questions and answers I do not mean to lay down some pro forma test of directors’ liability for insolvent trading. Each case depends on its particular facts. These questions and answers merely serve to illustrate that when a company is struggling to pay its debts, the directors must face up to the issue of insolvent trading directly and with brutal honesty: they must not shirk from asking themselves the hard questions and from acting resolutely in accordance with the honest answers to those questions.

In this case, the Judge concluded " I cannot hold that, at any time during the Period, Mr Irving had an expectation of solvency which was reasonably based. He did not hold more than a hope – a “bare hunch”, as he put it ­– that the dispute with the ATO would be resolved favourably and quickly enough to enable refinancing to occur before Wines and Vineyards ran out of cash completely. That is not sufficient to afford Mr Irving a defence under CA s.588H(2) and (3)."

However, the Judge concluded that, in failing to prevent Wines and Vineyards trading throughout the Period, Mr Irving acted honestly, for the purposes of a defence under CA s.1317S(2)(b)(i) and s.1318. I find that up to the conclusion of his meeting with Mr Evans on 5 February 2003, but only up to that time, Mr Irving acted as other reasonable, commercially experienced directors might have acted in waiting to see when a decision from the ATO could be expected with some certainty. I would, therefore, hold that, having regard to the conduct of Mr Irving and to the circumstances of the case at the time of his contravention of s.588G(2), Mr Irving should be wholly relieved, pursuant to CA s.1317S and s.1318, of liability for contravention of CA s.588G in respect of debts incurred by Wines and Vineyards from 1 October 2002 up to and including 5 February 2003, but no further."

Other issues

Could one company in a group rely on the assets and liabilities of another company in the group when considering solvency? Yes

Could a company regard a genuinely disputed tax assessment as a contingent liability rather than an actual liability (and therefore immediately payable)? No

Is the non-existence of Directors and Officers Insurance relevant? No