Insolvency matters: Assessing a company's solvency

An insolvent trading claim was dismissed by the NSW Supreme Court when a creditor was unable to prove that a company was insolvent at the time it incurred its debts. The decision is a useful reminder of the essential elements of an insolvent trading claim, and where the onus of proof lies.

This update explores the case of WGE Pty Ltd v Morris, 13 April 2022, Williams, J, NSWSC, BC202202848.

Basic facts

The plaintiff, WGE Pty Limited (WGE), was a creditor of Coffey EMS Pty Ltd (in liq) (Company). The defendant, John Morris, was the sole director of the Company at all relevant times. WGE contended that the Company was indebted to it in the amount of $182,102.25 at the time the Company went into administration on 15 November 2018 and liquidation on 14 December 2018.

WGE obtained the consent of the liquidator of the Company to bring an insolvent trading claim against Mr Morris. WGE sought declarations that Mr Morris contravened section 588G of the Corporations Act 2001 (Cth) (Act) and that WGE had suffered loss and damage in the amount of $182,102.25 plus interest.

Mr Morris denied the alleged contravention of section 588G of the Act. Mr Morris denied that:

• the Company was insolvent at the time that it incurred the debts or that it became insolvent as a result of incurring the debts
• at the time the debts were incurred, there were reasonable grounds to suspect that the Company was insolvent or may become insolvent by incurring the debt; and
• he was aware of such grounds (if they existed, which was disputed) or that a reasonable person in his position would have been so aware

Elements in dispute

To succeed in its claim against Mr Morris, WGE had to establish that:

• Mr Morris was a director of the Company at the time it incurred the debts to WGE
• the company was insolvent at the time the debts were incurred, or became insolvent by incurring the debts
• at the time those debts were incurred there were reasonable grounds to suspect that the Company was insolvent or may become insolvent by incurring the debt
• Mr Morris was aware at the time that there were reasonable grounds to suspect insolvency, or a reasonable person in his position in the Company's circumstances, would have been so aware
• WGE suffered loss or damage in relation to the debts by reason of the Company's insolvency; and
• the debts were wholly or partly unsecured at the time that loss or damage was suffered

Only the second to fifth elements were in dispute. If the disputed elements were proved, Mr Morris relied on a defence under s 588H of the Act that, at the time the debt was incurred, he had reasonable grounds to expect, and did expect, that the Company would remain solvent despite all its debts incurred at that time.

Key issues

The key issue at hand was whether the company was insolvent when the debt was incurred, or whether it became insolvent by incurring the debt.

Her Honour adopted Black J's summary of the principles to be applied in determining whether or not the Company was solvent at the time that the debts were incurred, or became insolvent by reason of the debts being incurred (Re Custom Bus Australia Pty Ltd (in liq) [2021] NSWSC 1036).

A company's solvency is to be determined by reference to section 95A of the Act - a company is solvent if, and only if, it is able to pay all its debts, as and when they become due and payable. That definition adopts a "cash flow test" of insolvency, which turns upon the income sources available to the company and the expenditure obligations that it has to meet (Southern Cross Interiors Pty Ltd (in liq) v Deputy Cmr of Taxation (2001) 53 NSWLR 213).

Whether a company is able to pay its debts as and when they fall due and payable is a question of fact to be determined objectively and without hindsight in all the circumstances, including the nature of its assets and business, and the Court will have regard to commercial realities in that regard (Southern Cross Interiors (in liq) v Deputy Cmr of Taxation; White Constructions (ACT) Pty Ltd (in liq) v White (2004) 49 ACSR 220; Quick v Stoland Pty Ltd (1998) 87 FLR 371).

In this instance, the onus of proving the Company's insolvency at the time of, or as a result of, incurring the debts rested with WGE (Treloar Constructions Pty Ltd v McMillan (2017) 318 FLR 58).

WGE called expert evidence from a chartered accountant with experience in the insolvency industry, who occupied a senior management position within the liquidator’s firm and who had access to the books and records of the Company in the liquidator’s possession for the purpose of preparing his evidence. The liquidator had reported to creditors previously that the Company’s books and records were well maintained and included an accounting system that recorded substantial information about the historical trading position of the Company.

However, the Court found that WGE offered no evidence of:

• all of the Company’s debts as at the dates the relevant debts were incurred
• when those debts were due and payable; or
• the projected net cash flow from the Company’s business as at the dates the debts were incurred (forecast revenue less the cash expenses which would be incurred in generating that revenue).

WGE’s case relied heavily on the fact that the Company had failed to pay WGE's invoices when issued.

Judgment

WGE failed to prove the elements of the alleged contravention of section 588G of the Act, and as such, the question of loss and damage and the defence under section 588H did not arise for consideration. The proceedings were dismissed and WGE was required to pay Mr Morris' costs.

Assessing a company's solvency: Key takeaways

In order to determine whether a company was solvent at a given time, it would be relevant to consider the following matters:

• All of the company's debts at that time, to determine when those debts were due and payable
• All of the company's assets at that time, to determine the extent to which those assets were liquid or were realisable within a timeframe that would allow each of the debts to be paid as and when it became payable
• The company’s business at that time, to determine its expected net cash flow from the business by deducting from projected future sales the cash expenses necessary to generate those sales; and
• Arrangements between the company and prospective lenders, such as its bankers and shareholders, to determine whether any shortfall in liquid and realisable assets and cash flow could be made up by borrowings that would be repayable at a time later than the debts

Implication of the decision

The party that bears the onus of proving insolvency and reasonable grounds to suspect insolvency must cite sufficient evidence of such. Directors, accountants and liquidators called upon must be able to demonstrate and provide evidence of the amount of the company's debts at the relevant times. Whether a company is able to pay its debts when they fall due and payable is a question of fact to be determined objectively and without hindsight in all the circumstances. It is not enough to point to invoices that have not been paid. By themselves, they are not enough to demonstrate that a company was insolvent at that time.

For more information on insolvency matters and any of the topics raised above, please contact a member of our team.

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