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The Difference Between Insolvency and Bankruptcy (And How To Avoid Both)

Commercial Law

Many people are under the impression that the terms “insolvency” and “bankruptcy” are interchangeable. How often have you read headlines about companies going bankrupt or trading insolvent? In fact, the two are very different. Read on as Sheena Vinden, Senior Partner explains the key differences between insolvency and bankruptcy.

Many people will often use the terms “insolvency” and “bankruptcy” interchangeably. However, it’s important to recognise that the two are actually very different. In this article, we explore the difference between the two.

What is insolvency?

Insolvency refers to the inability to pay your debts when they are due, and applies to both individuals and businesses.

What is bankruptcy?

Despite what many people believe, it is actually impossible for an Australian company to declare bankruptcy. Under Australian law, bankruptcy is a legal process that only applies to individuals who are unable to pay their debts on time.

What are the main differences between insolvency and bankruptcy?

In Australia, we have separate pieces of legislation that apply to different insolvency situations. The Corporations Act 2001 covers insolvency for companies and the Bankruptcy Act 1966 covers insolvency for individuals.

How does a company become insolvent?

As with individuals, companies become insolvent when they incur a debt that they are unable to manage. This may be due to a number of factors including unforeseen disasters, market turns, poor management and corruption.

There are many actions which suggest a company is insolvent, however many refer to the checklist presented by J Rangiah in Pearce v Gulmohar Pty Ltd [2017] FCA 660 which includes, but is not limited to:

  1. Continuing losses
  2. Liquidity ratios below 1
  3. Overdue Commonwealth and State taxes
  4. No access to alternative finance
  5. Inability to raise further equity capital
  6. Suppliers placing [company] on COD, or otherwise demanding special payments before resuming supply
  7. Issuing of post-dated cheques
  8. Dishonoured cheques
  9. Solicitors’ letters, summons[es], judgments or warrants issued against the company
  10. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts

What happens when companies go insolvent?

In Australia, the Australian Securities and Investments Commission (ASIC) administers the Corporations Act 2001. Under the Act, there are a number of insolvency provisions for businesses. They include:

Voluntary Administration

In this instance, the company’s directors or a secured creditor with a charge over most of the company’s assets will appoint an external administrator, called a voluntary administrator”.

The voluntary administrator will investigate the company’s affairs, and recommend that the company either go into liquidation, enter a deed of company arrangement, or continue to operate under the current directors.

Receivership

When a company goes into receivership, a process that is usually initiated by a secured creditor of the business, a receiver is appointed to sell all or some of the company’s secured assets to pay the debt owing to said creditor. Should the directors have provided any personal guarantees on debts, they can also be pursued by creditors.

Deed of Company Arrangement (DOCA)

This is a formal and binding agreement between the company’s directors and its creditors. The agreement outlines how the company’s affairs will be managed to best maximise the chance for the company to continue trading, or provide a better return to creditors as opposed to liquidation.

Liquidation

Liquidating a company involves the formal sale of all available company assets, the proceeds of which will go towards paying any outstanding company debts, with any surplus going towards company shareholders. If there are no funds left, the company is wound up and any outstanding debts will remain unpaid. There are two types of liquidation:

  1. Court liquidation: This is the result of a court order after an application is made to the Court (usually by a creditor of the business)
  2. Creditors’ voluntary liquidation: This is liquidation initiated by the company itself.

In some instances, as with a receivership, the director may have given a personal guarantee for the company’s debts. This is when pursuing bankruptcy (against the director) becomes an option.

What happens if a Company Director declares bankruptcy?

If a Company Director decides to declare bankruptcy, the bankruptcy is registered with the Australian Financial Security Authority (AFSA). They will no longer be able to manage corporations, and cease to be a Director, Alternate Director, or Secretary unless given leave by the Court to do so.

If they continue to do so and are found and convicted, this will result in a fine up to $8,500.00, one-year imprisonment, or both.

When dealing with corporate insolvency, it is crucial to get the advice of individuals who are experienced in the industry. Contact the team at AV Lawyers today to arrange a free consultation.

When dealing with corporate insolvency, it is crucial to get the advice of individuals who are experienced in the industry. Contact the team at AV Lawyers today to arrange a free consultation.