Lack of commercial viability does not necessarily mean insolvency

By Karen O'Flynn and Kristy Zander.

Key Points:
In determining whether a company is insolvent, a court will only have regard to present or contingent liquidated debts, even when it's likely that unliquidated contingent liabilities will adversely affect the commercial viability of a company's trading in the short term.

The insolvency of a company, within the definition in section 95A of the Corporations Act 2001 (Cth), is often a major evidentiary hurdle for a creditor or liquidator seeking to prove that directors of a company are liable for insolvent trading. The applicant must prove, usually by way of expert evidence, that at the time certain debts were incurred, the company was unable to pay its debts as and when they fell due.

In this issue, we look at a decision of the New South Wales Court of Appeal in the case of Box Valley Pty Limited v Kidd [2006] NSWCA 26, handed down in February 2006. The Court held that likely future breaches of a contract to sell and deliver goods, giving rise to a potential claim for unliquidated damages, did not constitute "debts" for the purpose of determining a company's solvency or insolvency under section 95A of the Corporations Act.

The effect of the decision is that, in order to determine whether a company is insolvent, the court will only have regard to present or contingent liquidated debts, regardless of the likelihood that unliquidated contingent liabilities will adversely affect the commercial viability of a company's trading in the short term. It will therefore be more difficult for a creditor or liquidator to prove that a company was insolvent at the relevant time.

Facts

The Claimant, Box Valley Pty Limited, was a creditor of David Kidd Grain Trading Pty Limited (the Company). Box Valley and the Company had entered into an agreement in early June 2001 for the supply of sorghum. Box Valley supplied sorghum to the Company in the first half of June 2001. The cost was approximately $100,000. Box Valley was not paid. The Company subsequently went into voluntary administration and then liquidation.

Box Valley sought orders against two of the directors of the Company pursuant to section 588M(3) of the Corporations Act. It alleged that the directors had engaged in insolvent trading by incurring liabilities to Box Valley at a time when the Company was insolvent.

Box Valley had sought to prove that the Company was insolvent at the relevant time by way of an expert accountant's report. The expert's evidence turned on the significance, for the solvency of the Company, of large obligations which the Company had incurred by entering into forward sale contracts for primary products, particularly white cottonseed.

At the time the directors of the Company appointed a voluntary administrator, it was the managing director's assessment that the Company was about to be "completely overwhelmed" by its liabilities. It was highly likely that, when the time for performance of the Company's forward sale contracts came, the Company would be unlikely to be able to meet its obligations unless the market price of white cottonseed fell dramatically.

Unliquidated contingent liabilities

On appeal, the Court held that it was incorrect for the expert accountant to have regard to the unrealised profits and losses on the forward sale contracts when calculating a deficiency of working capital as a means of assessing solvency for the purpose of section 95A of the Corporations Act. The Court found that a "debt", for the purposes of assessing solvency, can include a contingent debt only if the amount is liquidated (for a specific sum) and not if the obligation comes into existence only upon the exercise of an election or is unliquidated: see Shephard & Ors v ANZ Banking Corporation Limited & Anor (1997) 15 ACLC 1802; Hawkins v Bank of China (1992) 26 NSWLR 562.

The critical factor in the Court's decision was that, if the Company defaulted on the forward sale contracts, it would not be then exposed to a liquidated debt, but instead to a potential claim for unliquidated damages for breach of contract. Such an unliquidated claim is not a "debt" for the purposes of the definitions of solvency and insolvency in section 95A of the Corporations Act. As Justice Basten noted, while the position of the Company may have become commercially untenable, it was not insolvent.

Factors relevant to assessment of solvency

Justice Bryson noted that the "usual" indicators of insolvency were missing in relation to the Company for the relevant period. In particular, there was:

• no evidence of defaults in meeting obligations to pay trading or other debts in accordance with usual payment terms;
• no record of any dishonoured cheque;
• no other indication of a cash flow difficulty;
• no instances of failure or late payment of taxation obligations;
• no notices of demand or statutory demands;
• no late payment of wages;
• no judgments, summonses for debt or attempted levies of execution;
• no indications of any difficulties in the Company maintaining its relationship and dealings on overdraft with its Bank; and
• no evidence of the signs that usually accompany persistent late payment of suppliers.

Conclusion

Even if a company is doomed to failure unless something drastically changes, however unlikely that change may be (such as a significant and unexpected rise in the market price of white cottonseed), the court may not take that factor into account in assessing solvency under section 95A of the Corporations Act. To be considered in the assessment of solvency at a particular point in time, the present or contingent debts must be for a liquidated amount and not dependent upon the exercise of an election.

For further information, please contact Karen O'Flynn and Kristy Zander .