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Insolvency Law News, June 2010
The Federal Court has recently re-stated a fundamental principle of company law: the test for insolvency. It may also serve as a cautionary tale, underscoring the importance of maintaining complete and unambiguous accounts and financial records.
Turco & Co Pty Ltd v Pendella Holdings Pty Ltd; In the matter of Pendella Holdings Pty Ltd [2010] FCA 213
The Federal Court was asked here to consider whether or not the defendant company should be wound up in insolvency after failing to comply with a statutory demand. It fell to the defendant to rebut the statutory presumption of insolvency
Background
In February 2009, the plaintiff, Turco, served a creditor’s statutory demand for payment of debt for accountancy services to Pendella. Pendella did not pay the outstanding sum, and chose not to apply to have the demand set aside. Turco applied for a winding up order on the grounds of presumed insolvency, based on the defendant’s non-compliance with the statutory demand within the required 21 day period.
When the matter came on for hearing on 4 March 2010, the company did not dispute any of the above facts, but sought to argue that it was able to rebut the presumption of insolvency that arose out of ss459C(2)(a) pursuant to s459C(3) of the Act by reference to the actual situation and state of affairs of the company.
The evidence
The defendant relied upon the affidavit evidence of one of its directors, a Mr. Parish, and the evidence of a registered company auditor, a Mr. Jeffery. From December 2005, the company operated two flooring outlets in Perth.
Parish stated that, in mid-November 2007, he met with Turco, for the purpose of ‘discussing the company’s need for additional finance to keep its businesses trading’. Parish raised the question of obtaining an overdraft. At this time, the company had incurred a substantial debt with the ATO. The company appeared to have arranged an overdraft.
Meanwhile, the company had paid certain invoices issued by Turco.
Parish stated in his first affidavit that the company was and would continue to be able to meet its debts as and when they fell due, and contended that the company was likely to have made a pre-tax net profit of $100,000. He produced a draft profit and loss statement for the relevant period. Parish claimed that he had ‘limited access to financial documentation”. In the absence of that information, ‘he could not compare the performance of the company over previous years to its present performance’.
In subsequent affidavit evidence, Parish revised his estimate of the anticipated gross profit of the company for the 2008-2009 financial year which meant that the pre-tax net profit was anticipated to be roughly $95,000.00. Various draft profit and loss statements and balance sheets were tendered in evidence. With respect to the draft balance sheets, Parish stated that:
- The trade creditors of the company were ‘regular monthly accounts which relate to ordinary business operations’.
- Product purchased a particular creditor was generally paid for two months after invoicing. The account with this creditor was secured by a second mortgage taken out on the title of the property owned by Mr Parish himself.
- The liabilities to the ATO were subject to a negotiated repayment schedule.
- The securities provided by the company for the operation of its store were 2 term deposits a second mortgage granted to ANZ and a secured business loan
- Parish stated that he was ‘unable to cause an accountant or auditor or other independent person to confirm the financial information or to audit it’.
The court then considered in detail the costing methods and profit calculations used by Turco
Parish had engaged Jeffery as an independent auditor. Jeffrey noted that the financial statements of the company had not been properly maintained over the period 1 July 2008 to 30 June 2009. He noted incorrect entries in the financial statements, leading to a significant understatement of income. He noted that there was a contingent liability of around $38,000 which was disputed. Jeffery stated that:
‘In our opinion, because of the effect of the matters discussed in the qualification paragraph, the financial report, in accordance with applicable Accounting Standards and other mandatory professional reporting requirements does not present fairly the financial position of the Pendella Trust as at 30 June 2009 and its results from operations and cash flows from the year then ended.’
Jeffery stated that, as an external auditor, he was unable to ‘underwrite the credibility of the Financial Report’. Jeffery further stated that, in his professional role, he would not comment on the viability of a business unless he was ‘absolutely certain’ that the business was insolvent or about to become insolvent. Jeffery noted, however, that the company had apparently met its debts as and when they fell due (excluding the disputed liability of $38,000.00), and ventured that the company appeared to him not to be insolvent.
Held
The Court reiterated that:
‘[i]t is open to the company to call evidence going to its solvency to rebut the presumption of insolvency without the leave of the Court. Where a ground for resisting the winding up application could have been raised earlier, but was not, the leave of the Court is required under s 459S CA. However, an argument that the company is in fact solvent is not a ground the company can rely on in an application to set aside a statutory demand. Therefore, leave in this regard is not required under s 459S…’
The test for solvency in s95A of the Act establishes a ‘cash flow’ test rather than a ‘balance sheet test’. Solvency is a question of fact, which is to be ascertained from consideration of the company’s position as a whole, and with due regard being paid to commercial realities. The Court noted that it may be commercially realistic for a company to realise or borrow against non-cash assets in order to meet its debts. Such options were not, it was held, readily available to the company on the facts at hand.
The Court also considered another established proposition, namely that:
‘…in assessing whether a company’s position as a whole reveals a surmountable temporary liquidity or an insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality in that, in normal circumstances, creditors will not always insist on payment and that they will allow some latitude in time for payment of their debts, though that does not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency…’
Statements and assets of the company are relevant to any inquiry into its solvency, although other factors must also be considered. Relevant factors include access to unsecured borrowings.
The defendant admitted that, for a company to rebut the presumption that it is insolvent, a company ‘…needs to present the Court with the fullest and best evidence of [its] financial position…and that, ordinarily, unaudited accounts and unverified claims of ownership or valuation are not probative of solvency; nor are bald assertions of solvency arising from a general review of the accounts even if made by qualified accountants…’ Future events may be considered, but the solvency of the company in question must be assessed as at the date of the hearing.
A company in the defendant’s position must ‘make a decision’ as to whether or not the particular debt the subject of the statutory demand upon which the application for winding up relies is ‘material’ to establishing the company’s solvency.
The Court has a discretion to refuse an application for a winding up order where insolvency is merely presumed. This discretion may be exercised where, for instance, the company is found to be able and willing to pay the debt giving rise to the presumption of insolvency. This was not the case in this instance.
Ultimately, the Court determined the question of the company’s solvency by reference to the debt of $38,000.00 that was disputed by the defendant company at the time of trial. It was said that was ‘…difficult to see how the company could [have paid] this liability if it [was] required to do so.’ This conclusion was reached on all the available facts relating to the company’s financial position. At best, the balance sheet was said to reveal that the company’s situation was, at best, precarious. It was held that the company’s accounts were understated. A finding that the company had not clearly or convincingly demonstrated its solvency was arrived at. The statutory presumption of insolvency had not been rebutted. The Court did note that ‘…it is a drastic step to wind up a company in insolvency’, and that such order was not one to be made lightly. Nevertheless, the defendant had failed to rebut the presumption of insolvency and was ordered to be wound up.
This decision provides a neat restatement of the factors to be considered in determining the solvency of a company. It also provides a powerful warning of the dangers of maintaining incomplete or ambiguous financial records.