Debt Recovery, Bankruptcy & Insolvency

Determining Solvency Of A Company - Cash Flow Assessment Confirmed As The Most Appropriate Method


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Determining Solvency Of A Company - Cash Flow Assessment Confirmed As The Most Appropriate Method

The recent case of Emanouel v Cube Footwear Pty Ltd in the Supreme Court of Queensland, concerned the application for winding up of a company which on the surface appeared solvent but whose liabilities far exceeded its total assets. The question for determination by the court was whether the company was insolvent and could consequently be wound up on the insolvency ground.

The Background Law – Corporations Act

Under the Corporations Act 2001 (Cth) a company can be wound up on the grounds of insolvency under s 459A. A company can also be wound up on just and equitable grounds under s 461. Under s 459P a creditor can apply to have a company wound up in insolvency. Under s 95A a person is considered solvent “if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable”. In these circumstances where an application is made, under s459C, the court must presume that the company  is insolvent and that presumption operates unless the company can prove otherwise.

The main factual question in this case was whether the company had proved that they were solvent at the time of the hearing.

The facts

Under the Corporations Act, Emanouel sought to wind up Cube Footwear on the grounds of insolvency and just and equitable grounds. Cube Footwear was trading profitably but had greater liabilities than assets and was only managing to stay afloat due to two creditors who had agreed to defer payment of their debts. Because of this, Emanouel was forced to concede at the hearing that at the present time, Cube Footwear was solvent. However they argued that this did not meet the definition of solvency in s 95A of the Corporations Act.

This was because the dispute as to solvency was fought over two future debts, due to be paid in August and mid-September 2013 and totalling in excess of $8 million. It was argued that as the definition of solvency in s 95A involved the ability to pay debts when they become due, the assessment of solvency should  be made looking into the future. Therefore Emanouel’s argument was that Cube Footwear was not solvent when taking into consideration the fact that it would not be able to pay the debts due in August and mid-September. The question for the court was how far into the future it is necessary to look when determining a company’s ability to pay its debts.

Cube Footwear’s Argument

It was held by the court in this case, in support of earlier leading decisions, that debts placed on deferred payment terms could be considered as a source of credit available to the company and that such agreements are important when looking at the company’s overall ability to pay its debts. It was therefore relevant that the managing director of one of the companies who had deferred payment of their debt, was also a shareholder and director of Cube Footwear and that he was related to the other shareholders and directors.  Further, it was also relevant that one of the other shareholders in Cube Footwear, was a shareholder in the second company that had deferred payment of Cube’s debt. The crux of Cube Footwear’s argument was that it could not be held to be insolvent based on its potential inability to repay those debts, because it required looking too far into the future to inform the answer of solvency and that given the family relationship between the directors of the companies, it was highly likely that they would defer payment as needed in the future.

Cash Flow Assessment/Commercial Solvency vs Balance Sheet/Financial Insolvency

Cash Flow Assessment/Commercial Solvency

In determining whether Cube Footwear was solvent as defined under the Corporations Act , the court looked at the relevance of the cash flow test, also known as the commercial solvency of the company. This involved an assessment of the ratio of current assets to current liabilities, with only a secondary focus on whether the company has an overall net surplus. In looking at the “current” assets and liabilities, the cash flow assessment involves an overall examination of the company’s “current” prospects by looking at the available assets and the liabilities which will be payable within a certain amount of time from the date of assessment.  The Judge in this case commented that the “certain amount of time” had not been clearly defined by previous case law, however the court should avoid speculation, which would be less likely to occur by looking ahead to a period of months, rather than years.

In this particular case, the Judge was willing to look forward to the period when payment of the two deferred debts would be due (from the date of judgment this was approximately 9 months into the future). There was little evidence that Cube Footwear would be able to pay these debts at the time they fell due (a fact in and of itself meeting the definition of insolvency under the Corporations Act). However of relevance to this case was the fact there was strong evidence, of which the Judge was satisfied, that the familial relationship between the directors of the three companies involved in those debts along with evidence given by both creditors, strongly suggested that the debts would be further deferred/dismissed until payment was possible.

In answer to this test is was held that “measured as a matter of cash flow or commercial reality, Cube Footwear has shown that it is solvent”.

Balance Sheet/Financial Insolvency

The court also examined the balance sheet insolvency (also known as the financial insolvency) of the company. The determination of balance sheet insolvency was based on the comparison of the net assets of the company to the amount owing to the creditors and the likelihood that it would not be possible to pay these debts when due. The court noted that the definition of insolvency in the Corporations Act makes no reference to balance sheet insolvency, in contrast to other jurisdictions which include it as a separate ground for winding up. It also held that to determine that Cube Footwear was insolvent on the basis of balance sheet insolvency would require mere speculation that future debts would not be paid.

Consequently the cash flow assessment method was confirmed as more appropriate.

Decision of the Court

The court concluded that Emanouel’s contention that Cube Footwear should be wound up on the ground of insolvency, failed. It was also held that the company should not be wound up on the ground that it would be just and equitable to do so. Consequently the application to have the company wound up was dismissed and Emanouel was ordered to pay the costs of Cube Footwear.

The main reasons given by the Judge for the dismissal were that balance sheet insolvency is not contained within the Corporations Act, there was no just and equitable ground on which the company should be wound up, the fact that the future debts are likely to be deferred until able to be paid would maintain Cube Footwear’s solvency and finally that under the cash flow assessment, Cube Footwear should be considered solvent.

This case confirms that the preferred method for determining solvency of a company is the cash flow assessment test and that the timeframe appropriate to the assessment is a matter to be determined based on the facts of each case.

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