SUMMARY

Week 4: Defining and establishing ‘insolvency’

Key topics for this week

• ‘Debts’ v ‘claims’
• Who or what is a creditor?
• Statutory definition of ‘solvent’ and ‘insolvent’
• When a person or company may be deemed to be insolvent for a particular purpose
• When solvency assessments are typically made (including prospective and retrospective
assessments)
• The role of expert evidence in proving solvency and insolvency in court

Important legislation
(BA) Bankruptcy Act 1966 (Cth) ss 5(2), 5(3)
(CA) Corporations Act 2001 (Cth) ss 9, 95A, 459C, 459D, 588E,

Required (prescribed) reading (including this summary guide and Appendix A)

Assaf, Shields, Kincaid ‘Establishing Insolvency’ (Chapter 2) in Voidable Transactions in Company
Insolvency (2015) LexisNexis Butterworths (accessible on UTSOnline, recommended to read first)
Gronow and Maiden, McPherson’s Law of Company Liquidation (Westlaw AU), [3.310] – [3.350] and
[11.540] – 11.570]
McQuade and Gronow, Australian Bankruptcy Law and Practice (Westlaw AU) [5.10.05] (detailed
discussion of the legal definition of solvent and insolvent under s 5(2),(3) of the Bankruptcy Act)
Wengel, ‘How to recognise the 10 warning signs of insolvency’ (2012) 83 Charter 38 (accessible on
UTSOnline)
Pearce v Gulmohar [2017] FCA 660 at [144] – [164] (per Rangiah J).

Supplementary reading (optional)

Keay’s Insolvency: [1.45]-[1.85].

Practitioner services

Ford, Austin and Ramsay's Principles of Corporations Law (LexisNexis Aus) [20.100.3]- [20.110.9]
(these paragraphs are part of the discussion regarding director liability for insolvent trading b ut
provide a detailed discussion of the technical legal issues relating to the s 95A definition of solvency
and insolvency under the Corporations Act).
Duggan, ‘Australian Insolvency Management Practice Commentary’ (CCH intelliconnect) [16-030]
contains a detailed discussion of what a ‘debt’ is for the purposes of s 82 of the Bankruptcy Act.

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Articles
Harris, ‘The Role of Future Liabilities in Insolvency Law’ (2009) 9 Insolvency LB 129
Marshall, ‘Is 'Due and Payable' a Magic Phrase?’ (2007) 15 Insolv LJ 115
Powers, ‘The impact of unliquidated claims when assessing solvency: A director’s dilemma’ (2017) 32
AJCL 368
Purcell, ‘The Contrasting Approach of Law and Accounting to the Defining of Solvency and
Associated Directors' Declarations’ (2002) 10 Insolv LJ 192
Routledge and McNamara, ‘Assessing Solvency for Financially Distressed Companies’ (2005) 13
Insolv LJ 205
Sahathevan, ‘The Statement of Cash Flow as a Tool to Determine Solvency’ (2005) 16 JBFLP 93
Stucken, ‘A Blind Spot in the Test for Solvency? Reconsidering the Exclusion of Unliquidated
Damages Claims from s 95A’ (2018) 27 Insolv LJ 73.
Learning objectives
After completing this week’s work, you should be able to:
• Identify when solvency assessments may need to be undertaken
• Understand and apply the statutory definitions of solvency and insolvency to a range of fact
scenarios
• Apply the variety of presumptions of insolvency in specific situations
• Evaluate how different types of businesses can establish solvency
• Understand the role and limitations of expert evidence in solvency assessments.

SHORT TOPIC SUMMARY

[4.1] Introduction
Solvency and insolvency are foundational concepts that underpin much of the material covered in this
course. The focus of this week’s material is on the central concepts of debts and claims against a
debtor (whether individual or a company) and how to assess whether the debtor is solvent or
insolvent. As we will discuss, this includes some reference to amounts that are, or may be, payable in
the future.
The law requires that a solvency determination focus on an objective assessment of the commercial
realities of the debtor’s circumstances. This will often involve an application of legal definitions of
‘solvency’ and ‘insolvency’ to the debtor’s circumstances. In some cases, for limited purposes, there
may be a presumption of insolvency based on some event occurring or based on a particular set of
facts.
Solvency assessments are necessary for a broad range of legal requirements and also in a number of
commercial transactions (particularly in reviews of existing or future financing arrangements).
Therefore, the material studied in this week will provide some foundational knowledge that we will
draw upon in subsequent topics.
Your studies in this course will require you to develop a basic awareness of recovery proceedings by
liquidators under Pt 5.7B of the Corporations Act. This is an important issue in voluntary administration
because administrators must report on potential recovery proceedings and the outcomes of
administration will be judged against the likely return in liquidation (for example, when challenging a
DOCA). These reporting aspects will be covered in more detail in Week 8 (‘Voluntary Administration
Part 4’). Recovery proceedings open to liquidators are covered in-depth in the subsequent course
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‘Advanced Insolvency’.
[4.2] When is a solvency assessment important?
A solvency assessment can be important in a number of different contexts.
First, court proceedings (causes of action) may require that a debtor is insolvent. For example:
• a winding up application against a company on the grounds that is insolvent (CA ss 459A, 459P)
• an application by a liquidator in respect of certain voidable transactions under CA ss 588FE and
588FF on the grounds that the transactions involve unfair preferences or uncommercial
transactions (which must also be ‘insolvent transactions’ under CA s 588FC)
• an action against directors for insolvent trading (CA s 588G).

Second, directors who wish to appoint a voluntary administrator must be satisfied that the company is
insolvent or likely to become insolvent (CA s 436A).
Third, directors of most companies (public companies and large proprietary companies, and directors
of responsible entities in respect of registered managed investment schemes) must include a
declaration of solvency in the annual financial report (CA s 295(4)).
Fourth, concepts of creditor prejudice included as a benchmark for many Corporations Act provisions
(eg, authorised capital reductions and dividend payments) involve a solvency assessment. This is also
relevant for assessing directors’ duties to consider creditor interests.
Fifth, solvency events may be important for the application of certain contractual rights and
obligations (e.g. default clauses that are trigged on actual insolvency).

[4.3] Timing of the solvency assessment

The timing of the solvency assessment will be based on the purpose of the solvency assessment:
either before a transaction is entered into, before a power is exercised or before a liability is triggered.
These will be discussed throughout the course in the context in which they arise in subsequent
weeks.
One practical problem with solvency assessments is the difference between assessing the likely
solvency of a debtor in the future (prospective insolvency) compared with assessing whether a debtor
was solvent at some prior date (retrospective insolvency), which is discussed in Lewis v Doran [2004]
NSWSC 608. This is important where the courts are asked to determine whether liability arising from
insolvency should be imposed, for example in insolvent trading cases or in certain recovery
proceedings for voidable transactions. In such cases, the court must determine whether the debtor
was insolvent at a particular time, and not be overly influenced by the fact that subsequently the
debtor entered some formal insolvent administration (either bankruptcy, voluntary administration or
liquidation). It is permissible to take into account what happened after the relevant event, but that is
for the purposes of confirming or rebutting the alleged facts at the relevant date.

[4.4] Threshold concepts (listen to podcast)

The assessment of solvency and insolvency involves an analysis of the debtor’s financial position at a
particular point in time. The key concepts here are:
o Who is a debtor?
A debtor is a person who owes a debt. Under certain provisions of the Bankruptcy Act a debtor is
defined as a person who is insolvent (BA ss 122, 187).
o What is a debt?
A debt is a legal obligation to pay a sum of money to someone else.
o What is a claim and how is it different from a debt?
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A claim is not a debt but rather an alleged right to receive payment from someone else. The amount
payable is usually subject to some formal assessment (such as a court assessing damages for breach
of contract).
o Who is a creditor?
This is usually a person who is owed a debt, but insolvency legislation extends the concept of creditor
beyond mere ‘debts’ to include those holding claims (eg, BA s 82; CA s 553 set out the broad
category of debts and claims that are provable in a bankruptcy or a winding up).

[4.5] Proving the statutory definition

A solvency assessment can be made either on the basis of a presumption of insolvency as set out in the
legislation (e.g. in ss 459C or 588E), or by the application of the statutory definition of solvency and
insolvency to a particular debtor’s circumstances in s 95A.

[4.6] Presumptions of insolvency

The Corporations Act makes two provisions for allowing a court to presume that a company is
insolvent at a particular time:
• Presumptions for winding up applications (see CA s 459C, including the failure to satisfy a
statutory demand and the appointment of a receiver)
• Presumptions in CA s 588E (including inadequate books and records) for recovery proceedings
under Pt 5.7B (voidable transactions, void transactions and insolvent trading)
The Bankruptcy Act provides presumptions of insolvency for certain recovery proceedings:
• s 120(3A) (undervalued transactions)
• s 121(4A) (transactions to defeat creditors)
• ss 128B(5), 128C(7) (superannuation contributions to defeat creditors)
These presumptions in bankruptcy will be considered further in Advanced Insolvency in Semester 2.

[4.7] Defining solvency and insolvency

The Corporations Act defines solvency and insolvency in s 95A.
Solvency and insolvency
1) A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when
they become due and payable.
2) A person who is not solvent is insolvent.
Sections 5(2), (3) of the Bankruptcy Act contain identical wording to s 95A(1), (2).
Note: Acts Interpretation Act 1901 (Cth) s 2C states that references to persons in federal legislation
includes a body corporate as well as an individual (i.e. a natural person).
The key concepts of this definition are:
• Ability to pay
• All of the person’s debts
• As and when they become due and payable
These elements are discussed further in the podcasts for this week (and see below at [4.11]).

[4.8] Expert evidence

Accountants are often called to give their expert opinion on whether a debtor is or was insolvent at a
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particular time. This will usually arise in respect of court proceedings (such as insolvent trading or
voidable transaction proceedings).
Evidence of a person’s opinion is not typically permitted to establish that the opinion proves a fact
(see Evidence Act 1995 (Cth) s 76), however expert opinions are an exception to this rule under s 79
of the Evidence Act. The expert opinion must be derived from the person’s ‘specialised knowledge
based on the person's training, study or experience’. This may be an issue where an accountant’s
opinion is merely reproducing financial statements in which case the court can accept the records into
evidence and the expert opinion adds little or nothing. However, if the accountant is providing some
financial analysis based on data provided by business records (including financial statements) then
this will constitute an opinion based on specialist knowledge or expertise and will be admissible as
evidence.
See further Quick v Stoland Pty Ltd (1998) 87 FCR 371; Switz Pty Ltd v Glowbind Pty Ltd [1999]
NSWSC 1296 at [35]. The position is discussed in detail in Smith v Bone [2015] FCA 319.
The role of expert evidence is merely to help the court find facts that are relevant for the court’s
determination of whether the legal test for solvency or insolvency are satisfied. Expert evidence may
be of assistance but is not determinative: Sandell v Porter (1966) 115 CLR 666.
A liquidator will usually rely upon his/her report of an insolvency analysis which will state conclusions
as to when the company was insolvent. This expert opinion is usually regarded as admissible
evidence subject to what weight may be given to it if facts or assumptions underlying the report are
brought into question: Sheahan v Hertz Australia Pty Ltd (1994) 14 ACSR 209 at 213; Quick v Stoland
(1998) 87 FCR 317 and Re Tellsa Furniture Pty Ltd (1985) 81 FLR 185.
In recent cases, where the liquidator is the plaintiff in a recovery action, courts have expressed some
concern as to the possible effect that a lack of independence or impartiality may have on such
evidence: Hussain v CSR Building Projects Limited [2016] FCA 392 per Edelman J and Pearce v
Gulmohar at [155], [256] - [258] per Rangiah J.

[4.9] Indicia of insolvency

The courts have developed a number of factors that are useful when assessing whether a debtor is
solvent or not.
• 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
• 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
• problems obtaining finance
• change of bank, lender or increased monitoring/involvement by financier
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• 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
These are taken from ASIC Info Sheet 42 (updated 1 September 2017), Insolvency: A guide for
directors. Similar matters have been recognised by the courts: ASIC v Plymin [2003] VSC 123 at [386]
per Mandie J (the Water Wheel case, involving high profile director John Elliott); Lewis v Doran [2004]
NSWSC 608 at [75] per Palmer J.
The list of indicia is not meant to be a prescriptive ‘checklist’ that must be satisfied, nor does it
preclude reference to other factors that may be relevant for a particular company.

[4.10] Financial ratios (listen to the podcast)

Appendix A provides a concise discussion of the role of financial ratios in solvency assessments and
is complemented by a podcast/online presentation.

[4.11] Common issues (listen to the podcast)

When the court undertakes a solvency assessment a range of arguments are commonly raised to
help support a determination of solvency.
• Support from related parties
This is frequently offered in oral evidence, or by way of affidavit, suggesting that a shareholder, parent
company, company director, business partner, relative etc will provide financial support to ensure that
the debtor’s debts are paid. The court will discount this evidence unless it establishes:
A. Some form of binding obligation to provide the support (or a very strong likelihood of such
support)
B. The related party has the financial resources to actually provide sufficient financial support to
the debtor
• Delays in creditor enforcement or arrangements with creditors to vary payment terms
Although the courts make an assessment of solvency with a view to the commercial realities, the fact
that creditors delay enforcement or accept partial or late payment does not mean that the debts are
not due and payable. Arrangements with creditors to vary payment terms will only be relevant to a
solvency assessment where the variation is legally binding.
• Disputed amounts
If a debt is due and payable at law, the fact that the debtor may dispute the debt or may be seeking
court orders to have the debt set aside does not mean that the debt is no longer due and payable
(and hence included for a solvency assessment). However, disputes can arise as to the legal status or
balance (quantum) of an account or transaction between the company and an alleged creditor. See
Southern Cross Interiors for general principles and more recently Pearce v Gulmohar Pty Ltd [2017]
FCA 660. There is a good summary of the issues encountered in Pearce v Gulmohar – in proving the
quantum of a disputed debt – in an article by Andrew Lambros in the ARITA Journal in December 2017:
‘Recoveries against related entities’ (2017) 29(4) ARITA J 30 at 31.
The mere fact that a repayment arrangement has been entered into with the ATO does not, of itself,
establish that the due is not still due and payable (and so the debt should be included in a solvency
assessment): Clifton v Kerry J Investment Pty Ltd [2017] FCA 1379 at [157] – [170] (this is by dint of
the terms of relevant tax legislation).
• Use of borrowings
A debtor can rely upon borrowings to establish solvency as long as the borrowings are not replacing
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one short-term liability with another short-term liability.
• Future debts
As the definition of solvency includes debts ‘as and when they become due and payable’ this will
include debts that are not currently due but which are likely to become due and payable in the future.
How far one should look into the future will depend upon the nature of the debtor’s business or
financial affairs and on the nature of the debts incurred. In many cases this will be a period of weeks to
several months or perhaps a year, but some types of businesses may require longer assessments
(such as insurance companies or investment funds in ‘run off’ mode).
See also the recent decision in Treloar Constructions Pty Limited v McMillan [2017] NSWCA 72 at
[76]-[83] which discusses the indicia of insolvency and the potential for financial support from related
parties.

Other important cases (and summaries)

• Box Valley Pty Ltd v Kidd [2006] NSWSC 26

(insolvent trading claim involving status of claim relating to non-delivery of commodities (cottonseed)
under a futures contract. Held that a contingent claim (unliquidated damages claim in contract) was not a
‘debt’ and did not need to be included in s95A assessment. Basten JA: ‘However, whilst a breach
would have given rise to damages which were unliquidated, it could not be said that the Company had
thereby incurred a debt.’)

• Hall v Poolman [2007] NSWSC 1330

(Chair of public wine producer sued for insolvent trading. Company had large debts and little liquid
assets aside from bulk wine. Company sought to challenge large tax debt and retained advisers to
assist. Just because tax debt was challenged did not mean that the debt should be excluded from
solvency assessment. Intra-group debts needed to be realistically assessed in making solvency
assessment)
• Lewis v Doran [2004] NSWSC 608
(Balance sheet restructure within group of construction companies at a time when legal claims
pending against one company in the group. Court held purpose of restructure was not to avoid paying
debts. Application of the usual indicia of solvency. Consideration of prospective and retrospective
solvency assessments)
• Lewis v Doran [2005] NSWCA 243
(Appeal dismissed. Consideration of elements of s588FB and of the relevance of future liabilities)

• Southern Cross Interiors Pty Ltd v DCT [2001] NSWSC 621

(Claims for insolvent trading, and director liability for tax preferences against a spouse who was a
director of a company. Consideration of debts due and payable and relevance of delay in repaying
creditors)

• International Cat Manufacturing (in liq) & Anor v Rodrick & Ors (2013) 97 ACSR 200
(Example of a case where financial support likely to be provided by a company director ultimately
‘negatived’ any potential finding of insolvency.)

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 • Shot One Pty Ltd (in liq) & Anor v Day & Anor [2017] VSC 741
(Decision regarding the application of s 1305 of the Corporations Act. While books kept by a company
under the Act are prima facie evidence of the matters they record, that prima facie evidence may be
rebutted or outweighed by other evidence (which is what ultimately transpired in this case). See the
summary case report on the ARITA website.)

• In the matter of Bias Boating Pty Limited (recrs and mgrs apptd) (in liq) [2018] NSWSC 1977
(Judgment handed down by Black J of the NSW Supreme Court in December 2018 which determined
the separate question of whether a company in liquidation was ‘continuously insolvent’ during a
relevant period for the purposes of numerous unfair preference recovery claims brought by a liquidator
against multiple defendants. The judgment traverses and applies the key principles for the
determination of insolvency under s 95A including key financial (liquidity) ratios.)

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