Turkalert solvent or insolvent that is the question

Pieter Oomens and Alison Malek | September 2013 | Commercial Disputes and Transactions

Determining whether a company is solvent at a particular date hinges on a primary question: whether the company is able to meet its debts as and when they fall due.

The recent case of In the matter of Ashington Bayswater Pty Limited (in liquidation) [2013] NSWSC 1008 confirms the authority for determining the answer to this question: first, to apply the cashflow test see for example, Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation [2001] NSWSC 62; and then to consider the indicia of insolvency such as those set out in Australian Securities and Investments Commission v Plymin (No 1) [2003] VSC 123.

The cashflow test turns on the cash available to a company and the expenditure obligations that it has to meet, rather than a simple balance sheet test which refers to a company’s assets and liabilities as reflected in its books. The test must involve a consideration of a company’s financial position in its entirety

and has regard to external funding that might be available to it. As part of this assessment process, a Court routinely considers whether there are any indicia of insolvency.

Indicia include continuing losses, liquidity ratios below 1, overdue Commonwealth and State taxes, a poor relationship with lenders including an inability to borrow further funds, no access to alternative finance, an inability to raise further equity capital and involvement in legal proceedings.

The decision also examined the presumption of insolvency under s s286 and s588E of the Corporations Act 2001 (Cth) (‘the Act’), unfair preferences for the purposes of s588FA(1) of the Act and uncommercial transactions pursuant to s588FB of the Act.

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Solvent or insolvent? That is the question

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In the matter of Ashington Bayswater Pty Limited (in liquidation) [2013] NSWSC 1008 30 July 2013 A recent decision of the Supreme Court of New South Wales illustrates the options available to a liquidator under part 5.7B of the Corporations Act 2001 (Cth) (‘the Act’) in respect of clawing back funds from secured creditors. The Court considers circumstances in which transactions are liable to be set aside as insolvent transactions which were unfair preferences and uncommercial transactions. The case also provides a useful summary of the factors that need to be considered when determining the solvency of a company at a particular date.

Background Ashington Bayswater Pty Limited (‘the Company’) operated as a commercial property developer in Sydney from 2004 onwards. To allow it to undertake a substantial property development in Potts Point in 2006, the Company borrowed funds from third party financiers and also from the defendant, Bayswater Capital Pty Limited (‘Bayswater’). A facility agreement (‘the Agreement’) was entered into between the Company and Bayswater. Under the Agreement, Bayswater was to provide ongoing advances to the Company over a five year period. By way of security, a fixed and floating charge (‘the Charge’) was granted to Bayswater by the Company on 9 September 2010 over all of the Company’s present and future assets. The Company and Bayswater had a common director.

Between 2006 and 2012, the Company also entered into two further transactions with Bayswater, which, along with the Charge, were the subject of these proceedings. The second transaction was a Deed of Assignment of the Company’s legal rights in respect of a negligence action against former solicitors who acted for the Company in earlier unrelated proceedings (‘the Assignment Deed’). The third transaction was a series of eight repayments made by the Company to Bayswater (‘the Payments’).

A liquidator was appointed to the Company on 9 February 2012 as the result of a creditor’s winding up application (‘the Liquidator’).

The Liquidator brought an action against Bayswater in relation to the three transactions it had entered into with the Company.

In respect of these three transactions, the Liquidator sought the following orders pursuant to s588FF of the Act: 1. An order discharging the Charge, or alternatively an order that the Charge is void or unenforceable; 2. An order directing Bayswater to assign the Company certain property, rights and interests which were assigned to it by the Company under the Assignment Deed, or alternatively an order that the Assignment Deed is void; and 3. An order directing Bayswater to pay an amount to the Company equal to the amount of the Payments.

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First step: cashflow test Before considering the nature of the transactions, the Court firstly addressed the issue of the Company’s insolvency as at 9 September 2010, being the date of the Charge. The Liquidator’s position was that the Company was insolvent when the Charge was granted and at all relevant times thereafter. The Liquidator relied on the ‘cashflow test’ outlined in Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation [2001] NSWSC 621 and the several indicia of insolvency named in Australian Securities and Investments Commission v Plymin (No 1) [2003] VSC 123 (‘Plymin’), a significant number of which the Liquidator argued had been met.

The cashflow test of insolvency turns on the income sources available to the Company and the expenditure obligations that it has to meet, rather than a simple balance sheet test which narrows the focus to the Company’s assets and liabilities reflected in its books.

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The cashflow test is used to objectively determine whether the Company is able to pay its debts as and when they fall due and payable (without the application or influence of hindsight). It must involve a consideration of the Company’s financial position in its entirety, including matters such as expected profits and other sources of income and funding – matters which balance sheets do not take into consideration.

To support its claim, the Liquidator relied on a letter sent to the ATO (“the ATO letter”) by the Company on 16 July 2010. The ATO letter was a response to a statutory demand served on it by the Deputy Commissioner of Taxation for the amount of $299,369.66. The ATO letter also enclosed a repayment proposal with a supporting balance sheet and cashflow forecast for the Company.

The judgment of Mandie J in Plymin identifies several ‘indicia of insolvency’ (however later judgments have added the disclaimer that the absence of one or more indicia does not necessarily establish insolvency). These factors include: continuing losses, liquidity ratios below 1, overdue Commonwealth and State taxes, a poor relationship with the lenders including an inability to borrow further funds, no access to alternative finance, inability to raise further equity capital, suppliers placing a company on cash delivery arrangements or demanding special payments before resuming supply, creditors unpaid outside trading terms, the issue of post-dated cheques, dishonoured cheques, special arrangements with selected creditors, solicitors’ letters of demand, summonses, judgments or warrants issued against a company, payments to creditors of rounded sums not reconcilable to specific invoices and an inability to produce timely and accurate financial information to display a company’s trading performance and financial position to make reliable forecasts.

The Liquidator relied on the ATO letter as containing an admission of the Company’s insolvency as at that date. The ATO letter also indicated that the Company had outstanding debts to a number of other creditors, including $4,257,500 to Banksia Mortgages Limited, $336, 753 to Grey & Perkins Mortgage Corporation Limited, $122,022 to Clayton Utz, $31,915 to Henry Davis York, payroll tax liability in excess of $300,000 (excluding interest) to the OSR, $3,542,020 outstanding on a St George facility and $41,905 to about 15 other trade creditors.

Regardless, the Company submitted to the ATO that it had a surplus of current assets to current liabilities of $3,211,356 that it predicted property sales (which did not come to fruition) and did not disclose certain other liabilities including upcoming payments of $225,000 to Ashington Management Pty Limited.

Bayswater’s position was that the Liquidator was placing too much emphasis on the above indicia, and in doing so was detracting from the primary question: whether the Company was able to meet its debts as and when they fell due. Bayswater argued that the Company had sufficient cashflow at the relevant times and that at 9 September 2010 it was meeting all of its obligations when they arose. In support of this argument, Bayswater relied on the affidavit and cross examination evidence of its secretary and director, Mr Burkett and Mr Anderson, respectively.

The Court agreed with Bayswater that consideration of the indicia of insolvency is secondary to determining whether insolvency existed on a cashflow basis. Notwithstanding, the Court found on balance that the Company was indeed insolvent at all material times.

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Even though the ATO approved an instalment arrangement with the Company in respect of its debt in response to the ATO letter, the Court was not satisfied with Bayswater’s argument that an inference could be drawn that the ATO had therefore satisfied itself of the Company’s solvency. This was because the documentation provided to the ATO omitted important information and was ‘unduly optimistic’ as to property sales. The fact that the Company later defaulted under the payment arrangement with the ATO (and also defaulted under its payment arrangement with Clayton Utz), did, however, support an inference that the Company was unable to pay its debts as and when they fell due and payable. Further, Mr Burkett conceded in cross-examination that the Company could not have paid its debts to the ATO, Clayton Utz or HDY, despite its own optimistic forecast (contrary to his affidavit evidence).

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The Court found that the Company was insolvent as at 9 September 2010. The size of its debts to the ATO, Clayton Utz, HDY and other trade creditors, the fact that payment arrangements were not complied with and other debts were overdue, the Company’s liabilities to the OSR, the fact that the Company’s only source of funds to meet these debts was insufficient revenue generated from the sale of properties (mostly sales to related parties as there was insufficient interest from third party buyers in the depressed post GFC climate) demonstrated that the Company was unable to meet its debts as and when they fell due. The Court did not accept the Liquidator’s alternative argument that the Company was presumed insolvent as at 9 September 2010 as a result of a failure to maintain proper books and records in accordance with s286 of the Act. This finding was made on the basis that the Company maintained MYOB records among other financial records (regardless of the fact that the records contained some inconsistencies.)

The first transaction: the Charge Once it was determined that the Company was insolvent as at 9 September 2010, the date of the Charge, the Court then turned to whether the Charge was itself an unfair preference pursuant to s588FA of the Act, or alternatively whether it was an uncommercial transaction for the purpose of s588FB of the Act. A transaction is an unfair preference if a creditor of the company is involved in a transaction which allows the creditor to receive more from the company in respect of an unsecured debt than it would have received from the company in respect of that debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company. A transaction is uncommercial where there is a bargain of such magnitude that it could not be explained by normal commercial practice.

quality because the Company did not receive any real benefit from the transaction as it was not granted to encourage Bayswater to make further advances to the Company under the loan.

The facility agreement did not provide for such advances and the Charge did not secure such advances. The transaction, therefore, was of no real benefit to the Company.

The Charge was set aside as it was held to be an unfair preference and an uncommercial transaction; it was an insolvent transaction and a voidable transaction.

The second transaction: The Assignment Deed On 3 June 2011 the Company assigned to Bayswater its rights to a claim against its previous lawyers in earlier unrelated proceedings. Clause 3 of the Assignment Deed provided for Bayswater Capital to pay the amount of $325,000 to the Company in consideration of that assignment, by offset against the existing loan account between the parties under the Agreement. As Bayswater received a benefit by way of the assignment (the alleged claim was said to be worth in excess of $1 million) that it would otherwise not have been entitled to had it proved as an unsecured creditor in insolvency, the assignment was held to have given rise to an unfair preference. The assignment was also found to be an insolvent and voidable transaction.

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The third transaction: The Payments Finally, the Liquidator argued that eight payments made by the Company to Bayswater between 15 August 2011 and 9 November 2011 were unfair preferences and ought to be repaid to the Company. The Court agreed as the Payments occurred when the Company was insolvent. The Payments were found to be unfair preferences as well as insolvent and voidable transactions under the Act.

The Court accepted the Liquidator’s arguments that the grant of Charge converted an unsecured debt into a secured debt and thereby conferred an additional benefit on Bayswater to that which it would have received had it submitted a proof of debt as an unsecured creditor. The Court also accepted that the Charge lacked commercial

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Implications There are a number of lessons that can be taken from the case. They include: • The Court takes a number of factors into consideration when determining whether a company is solvent at a particular date – the critical test is the cashflow test. Consideration of indicia of insolvency is an important exercise but is secondary to the application of the cashflow test (at 4-6).

• A presumption of insolvency is not proved under s286 of the Act just because a company does not maintain completely accurate financial records (at 44).

• Get your story straight. Cross examination evidence often carries a lot more weight than affidavit evidence, particularly when the deponent makes concessions or statements that are contrary to his or her affidavit evidence (at 9).

Even though the Liquidator was successful, Black J made a point of noting that “the Liquidator was unable to address the detail of several issues raised with him in cross-examination, referring to his need to review his work papers in order to do so” (at 7).

• Secured creditors need to ensure that their security, and the underlying transaction, confers an actual benefit on all parties. If no real benefit is conferred, the Court may deem the transaction uncommercial, essentially relegating the creditor to the rank of an unsecured one. In other words, just because a transaction appears to do something does not necessarily mean that it does so. Transactions which cannot be explained by normal commercial practice, as they amount to a bargain of extreme magnitude for one party and have no substantive benefit to the other, are likely to uncommercial (at 51-55).

For more information, please contact:

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Pieter Oomens & Alison Malek | September 2013

Pieter Oomens Partner T: 02 8257 5709 M: 0417 268 334 pieter.oomens@turkslegal.com.au

Alison Malek Lawyer T: 02 8257 5775 M: 0411 482 219 alison.malek@turkslegal.com.au

www.turkslegal.com.au Syd | Lvl 44, 2 Park St, NSW 2000 T: 02 8257 5700 | F: 02 9264 5600 Melb | Lvl 10 North Tower, 459 Collins St, VIC 3000 T: 03 8600 5000 | F: 03 8600 5099