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1. What is insolvency?

Insolvency means an individual or business can't meet its financial obligations towards its lenders (and/or tax obligations towards the ATO) when the debts fall due for payment. For both businesses and individuals, insolvency can lead to legal action. In the case of a business, the risk of insolvency could lead to the business entering informal arrangements with its creditors. Businesses at this stage might look into restructuring and/or turnaround plans.

Beyond that, businesses in financial strife could enter insolvency procedures such as voluntary administration, liquidation and receivership. These could help creditors achieve a better outcome and support the business in returning to profitable trading or, alternatively, in shutting down.

Drivers of business insolvency could include new competition, changing market conditions, poor cash flow management, poor sales and revenue performance, and an increase in costs. Note insolvency is different to bankruptcy, which is a specific legal state for individuals who are insolvent.

2. What are other commonly used terms for insolvency?

The following are some terms commonly used for or associated with insolvency.

Bankruptcy – This is a personal insolvency procedure for individuals, not companies or businesses. If you're insolvent, you can enter bankruptcy (a legal status) by agreement or court order, and it protects you from creditor actions.

Liquidation – Liquidation is an insolvency process and refers to the orderly shutting down of a business. Assets are sold and the proceeds are used to repay creditors before shareholders. Liquidation is different to insolvency as not all company insolvencies result in liquidation.

Receivership – This insolvency procedure involves a secured creditor appointing an insolvency practitioner as the receiver to the company. The receiver then takes control of the secured assets to repay the creditor's debt. So receivership is quite different from insolvency as it's about creditors taking action in response to insolvency.

Voluntary administration – Voluntary administration is another type of insolvency procedure. It involves an external administrator taking charge of the company, investigating its affairs, and making recommendations to creditors about the company’s next steps.

Restructuring – Restructuring can be associated with insolvency but it's not focused just on the ability of a business to repay debt. It involves reorganisation of ownership, finance, operations, and/or other elements of a company to improve profitability.

Turnaround – Turnaround in a business sense usually means a formal plan, typically with turnaround experts, to revive a struggling business. As such, it's not the same as insolvency as it's a specific action plan to address insolvency or the risk of insolvency.

Arrears – If you're in arrears, you have left at least one invoice unpaid or not yet made on a debt amount that has become overdue. While being in arrears is similar to insolvency, you can be in arrears without being insolvent. For example, your business can afford to repay a debt but your employee forgot to make payment on time. Alternatively, your financial institution had a technical issue, so you're in arrears but not insolvent.

3. What are the different kinds of insolvency?

When it comes to corporate insolvency, there are three common types to be aware of.

Liquidation – Liquidation involves your company being permanently shut down, with asset sales and distribution of proceeds to creditors. The three different types of liquidation are court, creditors' voluntary, and members' voluntary (solvent liquidation). Note winding up is often used interchangeably with liquidation.

Voluntary administration – This insolvency process has an external administrator appointed (by directors or secured creditor) to take charge of the company's affairs. Once the administrator has investigated the business, the creditors vote for the business to enter a deed of company arrangement, go into liquidation, or be returned to the management of the directors.

Receivership – Usually a company goes into receivership when a secured creditor who holds security or a charge over some or all of the company’s assets appoints a receiver. The receiver then sells enough of the company’s charged assets to repay the debt owed to the secured creditor.

These terms are not the same as insolvency as they're a specific procedure initiated in the event of an insolvent company or likelihood of insolvency. You can be insolvent without any of these procedures taken effect, for example trading whilst insolvent.

4. What are the main reasons for a business to file for insolvency?

Common reasons businesses end up filing for insolvency include cash flow management, trading and downturns, and lack of expertise and experience. The business might have inadequate revenue or spend too much while trying to build up the business.

Clients failing to pay, competition, inadequate financial management, overleveraging, and insufficient strategic management may also contribute to insolvency. An unviable business model, disruptive technologies and innovation, and shifting market conditions can be contributing factors that lead to businesses struggling and eventually ending up insolvent.

5. What is the difference between insolvency and bankruptcy?

Insolvency is when an individual or business can't fulfil their debt obligations when a debt falls due.

In contrast, bankruptcy is a legal status and process for insolvent individuals, and it's a process that could eventually help resolve personal insolvency. You can be insolvent without being declared bankrupt. Companies can't be bankrupt as bankruptcy applies only to individual people.

As an insolvency procedure, the bankruptcy process starts when the individual applies for it or a court order is made. Once you're declared bankrupt, you're released from your debts (exceptions apply) and you can make a fresh start with your finances. However, your bankruptcy stays on your credit file for a number of years and remains permanently on the National Personal Insolvency Index.

6. What are the directors' responsibilities if a company is insolvent?

In Australia, company directors have a duty to prevent insolvent trading. Insolvent trading happens when a business continues to trade and incur debts even though it's unable to pay them as they fall due. Generally, unless the company can quickly restructure, refinance or obtain equity funding to recapitalise, the directors should explore options like voluntary administration or liquidation. Above all, getting timely advice from insolvency experts is essential. A breach of the insolvent trading duty can lead to personal liability for company debt, civil penalties, compensation proceedings, and even criminal charges.

Note the directors' responsibilities will change if the company enters an insolvency procedure such as voluntary administration, receivership, and liquidation. The directors usually need to step aside, cede control, and support the external administrator, receiver, or liquidator with his or her responsibilities.

7. Can you still trade while insolvent?

Trading while insolvent brings with the risk of personal liability for new debt incurred after the company became insolvent, civil penalties, compensation proceedings, and even criminal penalties for directors. Company directors are required to prevent the company from incurring new debt when insolvent.

So what are the options when there's a risk of insolvency or if the company's already insolvent? Directors need to ensure the company doesn't incur new debt. Getting professional advice from insolvency experts is also essential so you can determine the best course of action, whether that's voluntary administration or some other insolvency procedure.

8. What are the rights of stakeholders when a company is insolvent?

Creditors, especially secured creditors, may eventually be able to recover some or all of their debt from an insolvent company, but what about the other stakeholders and their rights? These rights can vary depending on the type of insolvency process the company enters into.

Shareholders

Shareholders usually have priority behind creditors when there's a liquidation. In terms of updates, they're usually only able to get limited information from any external administrators. In the event of liquidation or administration, the shareholders will need permission from the external administrator or a court before they can transfer shares in the company. For tax purposes, the shareholder might be able to realise a capital loss in certain situations.

Employees

Employees are a special class of creditors and during a liquidation your entitlements will rank for payment ahead of unsecured creditor's claims. If you're an employee of an insolvent company with serious concerns, consider contacting the ATO about any unpaid super and making a complaint to ASIC. If you have unpaid entitlements, check if you're eligible for government assistance through the Fair Entitlements Guarantee.

Investors

Investors with shares or those in managed investment schemes and unlisted investments like debentures should get financial advice on how non-payment of things like interest and distribution will affect their tax and other personal circumstances. Similarly, get advice if there's a withdrawal or redemption freeze and always contact the investment company for more information.

If you're a debenture holder in an insolvent company, you'll likely be a creditor of the company. In this case, administrator or liquidation will usually result in a freeze of payments to you, but you'll likely have the rights of a creditor when it comes to order of priority of proceeds.

9. What is a Director Penalty Notice?

A Director Penalty Notice (DPN) is the first step for the ATO to recover a company's unpaid ‘pay as you go’ withholding, or superannuation guarantee charge. A DPN correspondence will outline the unpaid amounts and remission options.

If the ATO has served you with a DPN, you're personally liable for these unpaid amounts, even if you're a former director or a new director (after 15 days in the role) and the amounts became outstanding before you became a director. A traditional DPN gives you 21 days to act.

10. What is an unsecured creditor?

An unsecured creditor is someone who is owed money to a business without securing certain assets as collateral and a registered security interest on the PPSR. A secured creditor, on the other hand, has specific assets identified as collateral. Typically unsecured creditors rank lower than secured creditors and employees in the order of priorities in the event a business becomes insolvent and is liquidated.

A lender who has loaned money to the company without collateral is an unsecured creditor. Other examples of unsecured creditors to a company include customers who've paid for goods or services in advance, someone who's paid a deposit, a holder of a credit note, or a supplier who has provided goods and services to the company.

11. What is a statutory demand?

Statutory demands are a type of legal document (under corporations legislation) sent by creditors to a company owing them money. The demand requests the debt to be paid within 21 days. If the company doesn't make payment, come to an alternative agreement, or make an application to the court to set aside the demand, the company is presumed to be insolvent. The creditor can then apply to the court to wind up the company. If you've received a statutory demand from a creditor, seek legal advice as soon as possible.

12. What is a receivership?

If a company has breached its agreement with its secured creditor, is insolvent or in financial strife, a court or a secured creditor could put the company into receivership. Receivership enables an independent expert - the receiver - to take control of all of the company's assets or some of its assets, usually what's known as charged assets or assets used as collateral.

The receiver then collects and sells enough of these assets to repay the debt owed to the secured creditor. His or her primary duty is to the secured creditor who appointed them, but they'll also report to ASIC if they come across any offences or irregular matters.

Once they've repaid the secured creditor and completed other duties, they can resign or be discharged by the secured creditor. The company and any remaining assets then return to the control of the directors.

13. How do you declare insolvency?

If you're an insolvent company and want to appoint an insolvency practitioner, there are some alternatives. You could opt for liquidation, which means having a registered liquidator wind up your business in an orderly fashion. The outcome is permanent closure of your business.

Alternatively, you could choose voluntary administration, which might not result in the shutting down of your company. Voluntary administration enforces a monitor on creditor action by having an external administrator take over the business and review its accounts and operations before making recommendations to creditors as to its future. The creditors then vote on the recommendation, whether it's a deed of company arrangement, liquidation, or return to trade under the control of the directors.

If your business is insolvent and you're thinking about insolvency processes, get expert advice about your options as soon as possible with TPH Advisory.

If you're an individual, you declare bankruptcy rather than insolvency. To be declared bankrupt, you'll need to apply to the Australian Financial Security Authority (AFSA) (or ordered by a court). You'll need to be eligible to declare bankruptcy, and the AFSA could turn you down if you don't meet the criteria.

14. What is insolvent trading?

An insolvent business is one that can't pay debts when they fall due, and insolvent trading is an insolvent business that keeps trading and operating when it can't meet its obligations. Company directors have a duty to prevent insolvent trading, and if they breach this duty, they could be personally liable for the debt incurred from insolvent trading as well as face civil and criminal penalties.