When is a company unable to pay its debts Law Reporter

The insolvent trading provisions of the Corporations Act are clearly one of the most controversial, and important, areas of regulation that affect directors of many smaller companies.

When is a company unable to pay its debts?

A guiding hand from a new judge in the Supreme Court of New South Wales

The insolvent trading provisions of the Corporations Act are clearly one of the most controversial, and important, areas of regulation that affect directors of many smaller companies.

In general terms, if directors allow their company to trade while the relevant company is insolvent, or by entering into contracts lead the company into insolvency, those directors can be made personally liable for the debts of the relevant company. This may occur either as a result of an action taken by a liquidator appointed on behalf of the company, or alternatively if the liquidator authorises this then at the suit of a creditor acting on behalf of the company.

Personal liability in these situations is clearly most undesirable from a director's point of view with very significant consequences for the relevant director.

Recently appointed Supreme Court Justice McDougall of the New South Wales Supreme Court has had to consider how one assesses whether a company is insolvent for the purposes of evaluating whether directors are acting in the best interests of the company, are not in breach of their overall duties, are not engaging in negligent conduct or generally acting fraudulently.

The facts, as taken from the Butterworths report of White Constructions (ACT) Pty Ltd (in liq) v White & Ors ((2004) 49 ACSR 220), as summarised in the Butterworths Law Report, were briefly these.

On 30 June 1988 the plaintiff company White ACT was a wholly-owned subsidiary of another company known as White Constructions Ltd (Constructions). White ACT at the time had significant assets but also was subject to significant liabilities (around about $26 million in both cases). Most of the assets were represented by loans made to other companies within the relevant group of companies; most of the liabilities were also represented by loans received from those related companies.

In 1988 Constructions agreed to sell the whole of the issued capital in White ACT to another person, a Mr McAlary. On the application of the Australian Development Corporation (ADC), the Federal Court of Australia ordered White ACT to be wound up on the ground of insolvency.

At that time the only asset White ACT held in its "books" was $328 in cash. The main liability owed by White ACT was a judgment debt to the ADC of $33 million. Prior to that, in 1987, White ACT had entered into a contract with the ADC for the design and construction of a building known as the Quadrant project. That particular project was terminated by the ADC in mid-1988 for an alleged breach of contract on the part of White ACT.

A significant amount of litigation flowed out of the Quadrant project. It was carried on in a number of different jurisdictions. The ADC incurred significant costs in running this litigation but was unable to recoup any of this expenditure. Additionally, it had funded a series of liquidator's examinations.

The only apparent prospect that the ADC had of recovering the costs it had spent was the litigation against a number of the directors alleging they had acted outside their powers, without having proper regard to the interests of creditors, and that the directors knew or should have known that the company's financial position was so precarious as to warrant certain findings of negligence, breaches of statutory duties and other findings.

The action brought by the liquidator/-administrators of White ACT in this case basically alleged that both before and after the date the director defendants had planned and caused White ACT to enter into transactions, the effect of which was to utilise assets to repay intercompany debt and to divert the company's income in such a way as to make it virtually impossible for ADC to recover monies arguably owed to it.

In essence the pleadings alleged breaches of fiduciary duty as well as insinuating that they were acting beyond power and inferences that the directors were acting negligently and perhaps fraudulently.

Central to the claims brought by the plaintiff and at the heart of the judgment delivered by the court was whether the company was insolvent at any time that was relevant to the scenario being litigated. Such an issue is critical of course in the context of the insolvent trading provisions in general.

McDougall J in dismissing the action for damages considered that the company was not insolvent at any of the material times; he also ruled that the directors could not have known that it was insolvent at any of the relevant times.

In determining whether the directors were liable he had to distinguish between whether the directors knew what the relevant position was or what they believed the position was.

In holding that the company was not insolvent at the relevant time, he set out a number of criteria at paragraph 289 of the judgment which are worth repeating. In concluding that these were the relevant criteria he relied most heavily on a judgment of Palmer J in Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation ((2001) 39 ACSR 305) (Southern Cross). It is rather ironic that although the summary of the law by Palmer J in this case was supported by Justice Mandie in ASIC v Plymin (No 1) (([2003] VSC 123) (the Elliott case) and in other cases, his ruling in the Southern Cross case on the question of liability of the relevant director was overturned in the New South Wales Court of Appeal. However, his analysis of insolvency was not questioned by the Court of Appeal.

Six propositions had been put forward by Palmer J in the Southern Cross case which were endorsed by McDougall J in the current case. These propositions were:

"(i) whether or not a company is insolvent for the purposes of [relevant sections of the Corporations Act] is a question of fact to be ascertained from a consideration of the company's financial position taken as a whole ...

(ii) in considering the company's financial position as a while, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable ...

(iii) in assessing whether a company's position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality that , in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade but that does not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency ...

(iv) the commercial reality that creditors will normally allow some latitude in time for payment of their debts does not, in itself, warrant a conclusion that the debts are not payable at the times contractually stipulated and have become debts payable only upon demand ...

(v) in assessing solvency, the Court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the Court's satisfaction, that:

• there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; or
• there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; or
• there has been a well established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors' terms of trade or are payable only on demand ...

(vi) it is for the party asserting that a company's contract debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence ..." (para 289)

In later cases judges had questioned whether the fourth, fifth and sixth propositions set out by Palmer J were a correct summary of the relevant law. In doubting the correctness of these Davie J in the Queensland Supreme Court in Iso Lilodw' Aliphumeleli Pty Ltd (in liq) v Commissioner of Taxation ((2002) 42 ACSR 561) (the ILA case) suggested that those particular propositions "may imply a legality or inflexibility which is inconsistent with the point that the ultimate issue is a question of fact".

In answer to that view in the ILA case, McDougall J noted (at para 291) that he did not believe that Palmer J was seeking to "lay down exhaustively the circumstances in which indulgences that creditors may allow will be taken into account, or the manner in which such indulgences will be taken into account.

It is certainly possible to read the fifth proposition as being expressed in prescriptive terms; but even there, I think [Palmer J] was stating, in effect, the basis upon which the courts have generally assessed the significance of indulgences that were shown to have been granted [by creditors]."

McDougall J indicated that he did not believe Palmer J was trying to be dogmatic in relation to these propositions and therefore it was unnecessary for him to qualify the relevant summary.

After summarising the scenario that the White group of companies faced, McDougall J noted that it did not appear to him that the directors, or for that matter the management of the company, or of any of the companies, ever turned their minds specifically to the terms by which the inter-company debts were to be regulated. The mere fact that the debts were shown in the appropriate company accounts as being current liabilities, would mean, according to McDougall J, that they would be paid within 12 months.

There was, the judge found, a practice in place at all material times within the White Group that inter-company debts would not be called upon unless the debtor was in a position to pay them. In these circumstances it was necessary to examine whether they could be said to have been payable on demand at all. In his view, the debts could not be classified as being payable on demand.

These words of Justice McDougall are very useful to note:

"Where a debt is payable on demand, it is taken to be payable forthwith because the creditor has an uncontrolled discretion to make demand at any time. However, the effect of the arrangement that I have found [in this matter] proved was to fetter the discretion of the creditor to demand payment. The creditor could not demand repayment unless the debtor were able to meet the demand. In those circumstances, the better analysis is that the debt was due not on demand but upon a contingency: the contingency being, of course, the ability of the debtor to meet any demand." (see para 298)

In the circumstances the assertion that the company was insolvent had not been made out and therefore the subsequent contention that the directors had acted in breach of fiduciary duties, in excess of their powers, or even negligently (although that particular claim was not specifically pleaded) could not be substantiated.

Directors will be pleased at this kind of analysis especially if they have to face the intricate and difficult financial issues in managing the affairs of companies that are under similar financial strain.

It is important that the law is administered in a flexible and commercially sensitive way in this context.

Justice McDougall also made some interesting findings as to the state of mind of the directors on the question of insolvency. His comments on this matter, if not challenged on appeal, might provide some further guidance in evaluating questions of liability of directors in cases of this kind.

"Because I found that White ACT was not insolvent at any material time, it must follow that the director defendants could not have known that it was insolvent at any material time. That is because I think that to know something involves, at a minimum, that the thing that is said to be known exists in fact. One cannot know that which does not in fact exist. In this, I think, knowledge is distinct from belief (as in turn belief is distinct from suspicion), notwithstanding that it may be said, in general terms, that there is a spectrum of 'understanding' ranging from knowledge at one end to suspicion at the other, and that the dividing points between the component parts of that spectrum may not always be easy to identify." (at para 320)

The judgment then goes on to analyse the application of the relevant law to the particular facts of this rather unfortunate company group. In his view the evidence did not support allegations of fraud.

The decision will be one that will not please the Australian Securities and Investments Commission as it pursues cases of insolvent trading in more high profile matters.

It will certainly provide little comfort to liquidators and others who may wish to pursue individual directors in cases where it is alleged that the relevant trading engaged in by the directors breached the insolvent trading scenarios as set out in the Corporations Act.

It is unknown whether the case is being appealed. There are a number of propositions in the judgment that may warrant further consideration in a higher court.

The HIH litigation -

double jeopardy

How would the High Court deal with this issue?

As readers will know, the dramatic litigation that has followed from the collapse of the HIH companies has led to very significant civil penalties being awarded against Adler and other directors by Santow J. These penalties were largely upheld on appeal.

As readers will also know, the High Court of Australia has upheld the appeal by Messrs Rich and Silbermann against discovery applications made by the Australian Securities and Investments Commission in the One.Tel case because the civil penalty regime was held, by a majority of the High Court, as punitive and not protective (see Rich and Silbermann v ASIC (2004) HCA Trans 121). We are still awaiting reasons for judgment. Those particular reasons will be important in the context of the criminal prosecutions that are now proceeding against Adler (and no doubt others) arising out of the HIH collapse.

While Adler and the Adler Corporation were successful in having certain minor variations made in the appeals, they were generally dismissed (see Adler v ASIC (2003) 21 ACLC 1810). Special leave to the High Court was sought and dismissed by the High Court of Australia on 28 May 2004 (see Adler & Anor v ASIC [2004] HCA Trans 182).

At a later stage, Adler was served with five informations and summonses taken out by the Commonwealth Director of Public Prosecutions, each alleging that Adler had committed a separate offence under the Corporations Act. Adler has been committed to trial on all five charges. He has pleaded not guilty to all charges.

In the case of R v Adler ((2004) 22 ACLC 784) Adler argued that the criminal proceedings should be stayed as an abuse of process because they exposed him to double jeopardy. As noted above, he had already been punished as a result of the very significant penalty orders made by Santow J which were upheld on appeal and he argued that these covered substantially the same conduct as was being pursued in the criminal proceedings.

It may be interesting to see whether this question can be reargued in light of the successful arguments put by Rich and Silbermann in the One.Tel litigation referred to earlier (Law Reporter. April, 2004). Adler had in fact conceded that neither the declarations made in the civil proceedings the compensation order, nor the disqualification order were penal in nature.

In the context of the criminal proceedings, it was submitted by Adler that the compensation order was a very large sum and that it was very severely detrimental to him and should be taken into account in assessing the criminal charges.

While Adler accepted that in no case were the elements of the criminal offence brought against him the same as the elements of any civil causes of action, the Crown also conceded that there would be some overlap of evidence admitted in the civil proceedings which would also be admissible in the criminal proceedings. In these circumstances Adler argued that whatever the nature of the relevant proceedings, he had received sufficient punishment in the earlier proceedings and should not be exposed to further punishment, especially of the criminal kind.

His application was dismissed. Justice James in the New South Wales Supreme Court made some observations which are relevant in evaluating the interaction of criminal and civil proceedings. Subject to these views not being overturned on appeal they will remain a key feature in the development of other cases flowing from corporate collapses of which there are quite a number that are currently in the pipeline.

"Because the elements of the criminal offences are in all cases different from the elements and the causes of action in the civil proceedings, no plea in bar is available to Mr Adler ... However, even though no plea in bar is available, the court still has power to grant a stay of the criminal proceedings on the ground that they constitute an abuse of process. The power to grant a stay is a broad power and there is no closed list of categories of abuse of process." (para 111)

Having examined the relevant material before him James J accepted the submission of the Crown that the civil causes of action and the criminal offences had different purposes. "The purposes of the civil case was to enforce the obligations of a director and to provide remedies for wrongs done against the company or its shareholders. The purpose of the criminal offences was to protect the integrity of the market and shares in a company and to punish wrongs done to potential purchasers of shares in the company." (para 112)

Because of the important differences that he believed existed between the elements of the civil cases and the criminal offences alleged, and the different purposes served by the relevant litigation, the criminal proceedings did not constitute an abuse of process.

As the offences were different it was possible for the Crown to proceed with the criminal proceedings.

Justice James recognised that it was important, wherever possible, for the prosecutors to seek to ensure that all charges are pursued at one time, but nevertheless, this will not always happen. The High Court of Australia in Pearce v The Queen ((1998) 194 CLR 610) had ruled that, wherever possible, if there are criminal and civil proceedings which appeared to be quite similar, then the court had a very wide discretion to grant a stay of criminal proceedings in the appropriate circumstances.

It was submitted by counsel for Adler that whatever the nature of the two sets of proceedings Adler had been punished in the earlier civil proceedings and was now exposed to being punished again for the same conduct (see para 126).

Whether there is an opportunity for these matters to be revisited in light of the High Court decision in Rich and Silbermann v ASIC (once the reasons are published) should be a very important development in the context of further cases in this area of the law.

A varying attitude to quorums

Excusing failure to comply with corporate law requirements

Two interesting cases in different states in recent months have illustrated the flexibility of our courts in dealing with applications by companies for the exercise of a court's discretion in "forgiving" a failure to comply strictly with the rules set out in the company's constitution, or even in the statute, in certain cases.

This is particularly relevant in the context of the holding of meetings where a quorum may not be present, or some procedure has not been followed.

In the New South Wales Supreme Court case of the Chinese Culture Club Limited (2004) 22 ACLC 873 the "constitution" of the club (ie the memorandum and articles of association) provided for 11 directors with five directors being a quorum for a directors' meeting. Later new articles of association were adopted and the quorum was reduced to three.

In order to comply with the NSW Registered Clubs Act 1976 the Club inadvertently adopted a provision that the quorum of a company board had to be five.

The error was noted by the operations manager of the club who thought it was a printing error and arranged for the company's memorandum and articles of association to be reprinted which showed that the quorum was three. However, it was later discovered that the quorum was five; in the meantime a number of directors' meetings had been held in which the actual quorum had not been met.

The Director of Liquor and Gaming in New South Wales argued that the Club had breached the rules. This proceeding was brought in the Licensing Court. The club sought an order from the New South Wales Supreme Court under section 1322 of the Corporations Act asking the court to order that the meetings of the directors should not be held invalid because of the absence of a quorum. The club also asked that it be relieved of any liability that might have flowed as a result of any breach.

The New South Wales Supreme Court held that the absence of a quorum was a procedural irregularity. In Justice Campbell's view, as the matter was an irregularity under the Corporations Act, it was not possible for the Licensing Court to form the view that a substantial injustice had been caused to any relevant parties.

He ruled held that as the Licensing Court was not a court under the terms of the Corporations Act and therefore it could not deal with the matter. It was his view that the court should adopt a broad interpretation of whether the relevant meetings had been effectively held.

Justice Campbell felt that no-one had suffered as a result of the failure to have the relevant numbers present; the meetings had taken place a number of years ago, and no-one could be shown to have been at a disadvantage.

A different view was taken of similar failure of a company to meet quorum requirements by the Full Court of the Tasmanian Supreme Court in Whitehouse v Capital Radio Network Pty Ltd (2004) 22 ACLC 756.

The facts of this case are taken from the CCH report. Blyton had been the sole director of a company Capital Radio Network (the company). He had been involved in a dispute with his former spouse and in an apparent attempt to limit any order that might be made against his assets he resigned as a director of the company. He appointed Leitch and Garrott as directors with Garrott having a casting vote in any meeting of directors. He also rearranged the shareholding in the company.

Later, however, differences arose between Blyton and Garrott. Leitch sided with Blyton; Garrott attempted to gain control of the company. Leitch frustrated these attempts by deliberately absenting himself from board meetings at which it was proposed to pass resolutions which would give Garrott the ability to achieve that result. The quorum for a board of directors meeting was two.

Garrott, frustrated by the absence of Leitch, called a meeting of directors for the purpose of passing certain resolutions. He also asked the company to seek an order from the Supreme Court to validate the holding of the meetings under section 1322 of the Corporations Act notwithstanding the absence of the relevant quorum. Leitch and Blyton opposed this application and sought instead a declaration from the court that the meeting was in fact invalid.

The trial judge dismissed the application by Garrott and ruled that the meeting was invalid. Although the absence of a quorum was a procedural irregularity within the meaning of section 1322 of the Corporations Act, it appeared that the purpose of the meeting was to try to prevent the orders of the Family Court being put into full effect. Garrott appealed to the Full Supreme Court arguing that the court should exercise its discretion in his favour.

The appeal was dismissed. Recognising that the court has a very wide and important discretion in dealing with these matters, the court ruled that the appellant, seeking a declaration that the meeting was valid, had to satisfy the court that no injustice would arise from such an order. These words from Chief Justice Cox of the Tasmanian Supreme Court are interesting:

"The proceeding was essentially of a procedural nature [and the applicant must show] that no substantial injustice had been or was likely to be caused to any person. For [reasons enunciated earlier in my judgment Garrott] had succeeded in establishing that the proceeding sought to be validated was essentially of a procedural nature. He bore the onus of proving that no substantial injustice had been or was likely to be caused to any person, and that there was a nexus between the procedural irregularity which occurred and the matters of prejudice relied upon as constituting injustice ..." (para 16)

Having analysed some earlier cases, Cox CJ found that there was an injustice caused by the holding of the relevant meeting and that what Garrott was seeking, would have been "an infringement not only of the orders of the Family Court ... but an infringement of the status quo which Mr Blyton had sought to preserve [by the relevant mechanism]." (at para 20)

Cox CJ found that the nexus between the irregularity and the prejudice to Blyton's interests were clearly established and that the judge was correct in refusing to validate the relevant meeting.

The other judge sitting in this case agreed with the reasons of Cox CJ.

These cases show that where there is a valid interest that will be prejudiced as a result of the irregularity the court will generally not exercise its discretion to exercise the breach; on the other hand, as in the Chinese Culture Club case, where the irregularity of such a minor and non-consequential matter, the irregularity will generally be excused.

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