The Twelve Warning Signs of Insolvency – Podcast Episode 44

In this podcast, Nicholes Family Lawyers Managing Partner Sally Nicholes and Senior Partner Keturah Sageman are joined by Jirsch Sutherland Insolvency Solutions Partner Malcolm Howell and Business Director Paul Pattison to discuss ‘the twelve signs of insolvency’. With many businesses having experienced financial pressure throughout the COVID-19 pandemic, it is timely for business owners, directors and their advisors to conduct a business ‘health check’ to identify any financial red flags.

 

Keturah:

Good afternoon, my name is Keturah Sageman and I am Senior Partner at Nicholes Family Lawyers.  Welcome to the Nicholes Family Lawyers podcast series. Today I am joined by Sally Nicholes, Managing Partner, with whom I work alongside at Nicholes. We are also joined by Malcolm Howell, Partner, and Paul Pattison, Business Director from Jirsch Sutherland Insolvency Solutions.  Jirsch Sutherland provides specialist insolvency and business recovery management services across a wide variety of sectors.

With offices located throughout Australia, Jirsch Sutherland is committed to local businesses and works closely with small and mid-size accounting, finance and legal firms and their clients to provide extensive insolvency expertise and advice. Perhaps what makes this a standout among others is that it handles matters spanning a wide range of sectors by simplifying industry jargon to provide common-sense solutions.

Malcolm has more than two decades of experience in the public and private sectors and advises on both personal and corporate insolvency matters. Malcolm worked as a corporate regulator and investigator before moving to the private sector.

Paul has over 37 years’ experience, primarily advising in the area of insolvency administration and its allied services.  Paul is also recognised for his social entrepreneurship having spent his professional career in acting on committees of not-for-profit organisations on a voluntary basis.

On today’s podcast, Paul and Malcolm will provide their insights on the 12 Warning Signs of Insolvency. With many businesses having experienced financial pressure throughout the COVID-19 pandemic, we are interested to hear from both about how business owners, directors and their advisors can do a business health check to identify any red flags.  Thank you very much, Malcolm and Paul, for joining us today and for sharing your expertise regarding insolvency and business recovery.  We might kick off with a question about insolvency and in fact ask: what exactly is insolvency? And in answering that, could you tell us about what liquidation is, and potentially give us some examples.

Malcolm:

Thank you Keturah. Yes, Paul and I have been dealing with insolvency matters for a large number of years now, and we think we have seen it all but there’s always a new example coming to us, and we always see different things happen in different matters. So this is an interesting topic to bring up and it actually has a lot of depth  which we won’t get far into today, but there is a strict definition about insolvency and that is that a person is solvent if and only if the person is able to pay all their debts as and when they become due and payable.  Following on from that, a person who is not solvent is insolvent.

Convoluted but basically what this means is that if a person or an organisation does not have enough money to pay all their debts as and when they are due, they may well be considered to be insolvent.

Liquidation is the result of insolvency and it is basically the winding-up of a company or an entity.  A lot of people get confused with that and think that individuals are in liquidation or that companies are in bankruptcy.  In fact, liquidation relates to the company aspect of it and it involves the appointment of a registered liquidator and that liquidator is charged with the responsibility of collecting all the assets and then converting them into cash and hopefully making a distribution to the creditors of the insolvent entity.

They are also charged with the responsibility of undertaking significant investigations with regard to the conduct of the directors and the management of the organisation and reporting to ASIC on various aspects of their conduct and how the business got itself into a situation when it could not pay its debts. Liquidation typically occurs when a company has reached a point where for one reason or another, it has been decided that the business cannot continue.  In this case, directors or creditors of those companies may consider liquidating the company, and turning the assets into cash and making a distribution.  We have many examples, Paul, of liquidations over our time and obviously some are big liquidations.

Paul:

Just on the liquidations: there are two forms of insolvency liquidation, there is Creditor’s Voluntary Liquidation or Court Liquidations. In court liquidations, the court makes the order and appoints a liquidator to go in and take control of the assets of the company to sell them for the benefits of the creditors. Or there is a voluntary process which is initiated by the directors which is what we call a creditors voluntary liquidation. In addition to liquidation for insolvent companies, you can also have voluntary administration where the directors resolve to put the company into voluntary administration and put together a form of deed to enable the company to pay a guaranteed dividend to creditors in due course.  There is a new regime in place which has now been simplified where – very similar to a Chapter 11 in America – where the director remains in control of the company, enters into the deed but gets the company back and continues to operate the company under the guidance of a restructuring practitioner.

If you are an individual and cannot pay your debts, there are two forms available to you: that’s either Bankruptcy or Part 10 or there is a third form which is very rarely used, and that is a Debt Agreement or what they call Part 9 of the Bankruptcy Act.  So there are various forms available to individuals or companies who are unable to pay their debts as and when they fall due and as Malcolm said, we have seen a huge range of insolvencies in all sorts of industries, construction, retail, hospitality and in varying sizes ranging from small mum-and-dad operators to multi-nationals or companies that turn over hundreds of millions of dollars.  At some point when they are insolvent they all end up in one of those forms of administration.

Malcolm:

And a lot of these entities go into administration because of external factors. We see them often when they are involved in litigation, they might be sued because of a particular event that has occurred or sued under a contract and they lose that action, or there is going to be an adverse judgment or a cost order against the company or the individual and that is when they then seek the advice of someone like Paul or myself, and make a determination as to whether or not they should continue to trade the company at that point in time, or whether there is an alternate direction that they should take.  Liquidation is not always a bad thing; neither is bankruptcy.  Quite often we have situations where people come to us early enough that we can actually help them to re-structure the company and perhaps even sell parts of it off and the creditors get a significant return, sometimes I’ve paid out 100 cents in the dollar to creditors in both bankruptcy and liquidation scenarios.

Sally:

That would be good news for creditors, Malcolm.

Malcolm:

It is very effective in that and it is good news for creditors.  It’s not always that this occurs but we are certainly always looking for the opportunity to do that.

Sally:

Speaking of different business types, is there a certain type of business or organisation which is generally at most risk of insolvency?

Paul:

I think with the impact of COVID, we are going to see a number of hospitality businesses never return so once the JobKeeper stops on 31 March, we anticipate that there is going to be a huge number of companies go into some form of insolvency or administration or individuals go bankrupt or Part 10 but you have also got the retailers who are marketing online, those who are trying to retail through the old method of opening the front door to see what comes in, they are going to find themselves struggling. We only need to walk around the Melbourne CBD, it is almost like a ghost town and the number of tenancies who have either been re-located or are up for lease, that clearly shows that there are going to be a lot of collapses. The interesting forecast about collapses for this year are estimated at between 250,000 and 500,000, so they are expecting a huge increase in the number of insolvencies to occur this year, just due to COVID alone.

Malcolm:

I think it is very difficult, Sally, to pinpoint a particular industry at this point in time, particularly given that COVID has been round now for about 12 months and during that time there was a moratorium on creditors being able to wind up companies or bankrupt individuals, and that has meant that the statistics, if there are any regarding industry types, would be flawed, I think, and we haven’t seen any of those statistics come out at this point in time.  Usually we do see them coming out from ASIC but I’ve not seen any coming through. It would be interesting to see what occurred last year, but like I say, looking forward, so many businesses are simply surviving on the JobSeeker payments and the tax payments that are coming through.

Sally:

We certainly want to discuss the impact of COVID a little later in the podcast, but I know that Keturah is keen to talk about some of the interchange between Family Law and insolvency.

Keturah:

As family lawyers, we are aware that bankruptcy sometimes intersects with family law litigation and we have had clients with businesses that have gone downhill and of course if the business reduces its value, then there is less to split up in any property settlement. Have you had any experience which involves litigation with family law and bankruptcy or other liquidation-type matters?

Paul:

I’ve got a situation where the family law just totally ignored the Bankruptcy Act or the Corporations Act regarding asset distribution and the Family Court obviously have their own issues, they tend to make their own rules regarding when it comes to dividing the assets between the spouses or when trustees get involved in the affairs   of the bankrupt and they make their own determination so there has not been much of a correlation between the Family Court versus the Supreme or County Court. The Family Court tends to take the view, and I think it’s the right view, that they are the  superior Court and as such they can make up their own rules with regard to distribution. So there is no hard and fast rule as to how the assets are split once you go to the Family Court.

Keturah:

Yes, I think there are fairly detailed rules in the Family Law Rules about how bankruptcy is dealt with and in some cases we get a situation where one of the parties is substituted by the Trustee in bankruptcy but of course we have always got the consideration of the other spouse who may not have been involved in some of the running up of debts or wants to hold onto the house – the family home – so it’s a bit of a weighing up and prioritising of parties’ interests and of course, the Family Court has to look at what is just and equitable between the spouses and having regard to the bankruptcy provisions which are in  the Family Law Act, so it probably does involve a little bit more priorities in a different order than perhaps the Supreme Court.

Malcolm:

Yes, that’s right, Keturah, but look, we do get involved in family law matters on a daily basis and there are many situations which we have had where we are dragged into the Family Court by the spouse of the bankrupt or by the wife of a director of the liquidating company making a claim over the assets of either the company or the bankrupt and certainly, from the business aspect, there is many at time when the wife will claim the Doctrine of Exoneration to try and make sure that their equity in a property, for instance, is protected and they get the benefit of it.  I’ve got a couple of examples – more recently…we won’t mention names because neither of these matters are finalised as yet, but the Family Court matter in one of them has been dealt with; that was a simple situation where the husband and wife ran a series of massage shops in shopping centres, not the type you are thinking about but just your in-effect Thai massages, but the business debts of those shops led to the downfall in the business being able to function properly, i.e. they were not paying suppliers and they were not paying body corporate fees and rent. Both individuals were made bankrupt by a sequestration Order and I was appointed as the Trustee over their bankrupt estates and the joint estate because they had joint assets as well. It was my job to appoint liquidators over the various entities and make sure that those entities were wound up properly so I engaged liquidators myself to go in and sell up all the assets of those companies, and I proceeded to sell a couple of properties – the family home and other bibs and bobs around the place to get a return to creditors. I sold those assets; we had a substantial amount of money in the estate. We needed to make a distribution between the individual estates because basically the money had all gone into a joint estate from the homes.

The wife was claiming 90% of the pool of funds after payment of the joint debts. There was still a substantial amount of money left over.  She then made a Family Court application to get money into the Family Court and have a settlement made.  We subsequently settled whereby the wife retained 70% of those net proceeds in her estate and the ex-husband got 30% in his estate. The costs out of those estates get paid, and the balance of funds – there was no dividend in the husband’s estate but the balance of funds were paid into the wife’s estate and she received a significant surplus. So this was a classic example of how we get engaged into a family court dispute, whether we like it or not, and we are required to settle it within the guidelines of the Family Court.

Keturah:

Yes, and I expect that there would be a lot less left over by that point, when the family home has been sold and all the debts have been paid off; there’s a lot less to go around, even if it is going to be split 70% in favour of one party, we are talking about a much smaller pot to split, I gather.

Malcolm:

That’s right, but you will be happy to know that I was a Good Samaritan and I discounted my fees, ensuring that the wife who had sole custody of the child, got a decent dividend out of it. That was my bit of goodness to the world!

Keturah:

That’s great!

Malcolm:

I have another situation which I’ve got on at the moment which is fairly typical too.  That is that I am the liquidator of the entity at the moment. The husband had an earth-moving business, and that business collapsed due to lack of cash.  He had also gone out and leased substantial amounts of equipment and then didn’t get the jobs that he thought he would in order to make the payments on the leases, so it all fell over; I was appointed as the liquidator. The company had built a substantial shed on the property; it was a country property, and about $165,000 for the shed. We then claimed that we had an interest in the land and the wife has made an application to the Family Court to try to get a priority over my claim as the liquidator of the company.

So that’s another typical example of how we get involved in a Family Court action on a daily basis.

Paul:

I think that what Malcolm has just explained is that the role of the practitioner has  0 changed.  When I first started 37 years ago, it was all crash and land. There was a stigma with liquidation, a stigma with bankruptcy, but now 37 years later, and also COVID-related, the role of the practitioner has completely changed, there is now more referency and we will take into account factors such as  (in the Family Court) the spouse, how many dependants there are, so there are now lots more other factors that we take into account, not just the hard and fast rule of 50/50 which was what occurred in the old days.

Sally:

We raised it before, Malcolm and Paul, about the impact of COVID, what do you believe the impact of COVID has been on insolvency trends, both internationally and within Australia?

Malcolm:

OK, well we have tried to dig up some meaningful stats on that for you and ASIC has, in the last week, released some information about the effect of COVID.  As I said, there was a moratorium on wind-ups, so what we have seen is a substantial drop in the number of appointments, not just in Australia but around the world. I think China was one of the few places where there was actually an increase, and it was because everybody introduced this legislation which prevented people from being wound-up during the COVID period.

Within Australia, we have got some information here which has been published by ASIC recently, suggesting that there has been a substantial decrease, in fact it is an average of about 51% on the appointment of liquidators or administrators, within the COVID period, so that is over the last 12 months.  So that is a substantial drop when you think that we are all geared up for the normal volume of jobs coming through and all of a sudden, our turnover drops by around 50%.  So you learn to live by love!

Keturah:

That’s to do with the Commonwealth Government extensions to temporary debt relief measures, is that right; I heard that they had extended them to the end of last year, at least?

Malcolm:

That’s correct.  At the start of COVID, they made several different changes to the legislation to ensure that the impact of COVID was not as big as it would have been otherwise.  What they did was to introduce a series of measures, in particular in respect of statutory demands; they increased the threshold amount for an individual or a corporation, both situations.  Under Corporations Law they increased it from $2,000 to $20,000 and in bankruptcy from $5,000 to $20,000 before you could issue a statutory demand. They also changed the time-frame for responding to a statutory demand. They increased that from the model 21 days to 6 months, meaning that you would have 6 months to respond to a statutory demand.  Both of those situations occurred until the 31st of December 2020.  What that meant was that there were very few wind-ups; in fact, most people did not issue any statutory demands during that period and what we have seen is that once January 1st came about, those temporary measures dropped off and we have seen a significant increase in the amount of statutory demands which have been issued.

So we are expecting that given the normal 21 days we will really see the impact of those coming around February to the middle of March, and that is when you will start to see the wind-up notices becoming much bigger, because those statutory demands will come into play and bankruptcy notices and wind-up notices will start to come about.

Keturah:

Sounds like there is going to be a real reversal of the statistics then on the decrease going to an increase in the number of bankruptcies and debtors?

Malcolm:

Absolutely, we are expecting that up to 30 March particularly, there will be a significant increase – I have referred to it as a tsunami of liquidations and bankruptcies and insolvencies.  We hope that that is not the case, as that would destroy the economy. So many people rely on the income from these businesses, in order to survive, and that’s just not going to be there – we will have a spiral thing.

Paul:

Other things that have come in as a result of COVID are changes to the Insolvency legislation; for example, the threshold of now in bankrupting an individual is now $10.000 increased from $5,000, so that may have some impact in regard to the volume of bankruptcies that occur. On the corporate side we’ve had two types of insolvencies introduced by legislation, the first called Simplified Debt Restructuring, and the other called Simplified Liquidation.

Now for Simplified Debt Restructuring to occur, the company must have debts of less than $1 million, the company must be insolvent or likely to become insolvent, and can appoint a small business practitioner which can be either a registered liquidator or a chartered accountant or CBA who has been registered with ASIC to conduct that type of administration.  The Simplified Liquidations are slightly different – again  the debts cannot be more in total than $1 million, you cannot be able to pay your debts within 12 months from the start of the liquidation, you must pay all your employee entitlements before you enter into an arrangement, and you must have your tax lodgements up to date.  As well, you can’t use this procedure any more than once every 7 years, so you put together a timetable.  If you are going to use this Simplified Liquidation process, you ought to ensure that when you use it, you use it wisely because once you have used it, you cannot have the benefit of those provisions for another 7 years.

So although it is expected that these new forms of insolvency to beat this pandemic if an insolvency has occurred, the general attitude of the industry is that neither of these new changes to the legislation are workable and the government and our professional bodies are now looking to make more appropriate amendments to make them more workable particularly for the general public, particularly.

Malcolm:

And in our view, most of the situations that we see today would fit that criterion.  I might just say; Keturah, what came into existence was that personal liability for insolvent trading during the COVID period, up till 31 December, and the changes in the legislation was that the directors were not going to be personally liable for insolvent trading and they had a temporary relief of their duty to prevent insolvent trading in relation to debts incurred in the ordinary course of business.

That also means that if I am appointed as the liquidator of a company, I couldn’t go back during that period and chase somebody for an insolvent trading action.

Keturah:

Yes, that would have given directors a false sense of security during that period, I imagine.  I’m also interested as well: what are the 12 warning signs of insolvency.

Malcolm:

We often refer to them as  (indecipherable).   You can imagine that there are a substantial number of warning signs, but these are the warning signs that we look for.

  • Obviously the first one would be a call or a no-cash-flow and most businesses that we find obviously have poor cash flows, before they go into liquidation:
  • The inability to pay your accounts as and when they fall due – so that is the big test: the “as and when they fall due” test:
  • Not paying staff their wages and other entitlements such as superannuation – and this is often a first indicator and the staff superannuation used to be one of the biggest debts that we saw, apart from the ATO, when staff super was not paid on time:
  • Poor quality of books and records, that is always a good indicator, as most places that do not keep books and records in a proper state, and they are in a state of disarray and often liquidation;
  • We look at the balance sheet – there are two types of insolvency tests, the cash flow test and the balance sheet insolvency test. We can go through those soon, but one of those tests is the net asset position and if it is in a negative position, that is an indicator that the business is not doing well and is possibly insolvent;
  • Often we see these clients who go into liquidation losing clients, so when you lose clients or you have a high turn-over of staff, these are both indicators that there is a problem occurring;
  • Securing special creditor payments or arrangements and this can be with the statutory bodies like the ATO or it could be with suppliers. Either way, once you start entering into such arrangements obviously you cannot pay those debts, as and when they fall due. So that is a real indicator;
  • Director Disputes – very often the cause of a business failing. In fact I’ve got one business that I am dealing with at the moment, where it was actually turning over about – worth about $140 million, at the time.  A big director dispute; they both really lost control and eventually, unfortunately, liquidators and receivers were appointed.  Receivers get very nervous- banks – and they appoint very quickly as they detect director disputes;
  • Bad debt write-offs, we are seeing bad debt write-offs, often we see poor workmanship happen and that causes people not to pay debts. Bad debt write-offs are an indicator of insolvency;
  • Physical deterioration of the business premises and assets. Paul and myself have dealt with many construction companies over time. We know that sometimes they have more maintenance getting done than they have building getting done and that is a clear indication that something is going wrong. It is often due to the poor staff that they have got, or the high turn-over of staff, and they therefore just lose money hand-over-fist;
  • The inability to access finance. I often see people or visitors using debtor finance facilities. Debtor finance to me is the last thing to rely on. It is costly and if they can’t get debtor finance, then they are in trouble and if they do get debtor finance, they might be heading towards trouble.

So basically, we have got those indicators, these are the main ones I can think of.

Paul:

One of the biggest ones is the non-payment of entitlements…..that cash flow is not going to come in…..so if they are going to survive…..if they do come back full-stream, they will have very few assets to deal with.  (Indecipherable) …their claims…..and as a result (indecipherable).

Sally:

We have made a note of your national managing partner, Brad Morelli, who said at the end of 2020 that the end of 2020 marked the end of insolvent trading moratorium in the first tranche of JobKeeper 2.0 which could mean crunch time. What did he mean by this?

Malcolm:

Well, Brad speaks his mind and what he was talking about there was the stimulus package being removed and directors of entities being forced to face the reality of  whether or not their business would survive without the support of government. So he is saying in effect that the end of that period, 31st of December was really the end of it, the statutory demands would start giving issues, insolvent trading and moratorium are finished so if you think you can hide behind that you can’t, you are now have to make a decision as to whether or not you are going to stick your head out and be chased for an insolvent trading action or are you going to make the decision to put the company into liquidation or some other form of voluntary administration so you can do a work-out program.

So they are going to need to make quick decisions – many of them have been dilly-dallying around for about 6 weeks now; they haven’t made a decision but they certainly need to. Those protections have stopped and they now a decision must be made as to where they are going to go with their business.

Paul:

And the other thing to remember is that directors have got duties to prevent insolvent trading and as a result the legislation provides consequences if they do undergo or allow insolvent trading to occur.  And that is you have got civil penalties; they may be forced to pay compensation back to the creditors or a lump-sum payment to the consolidated revenue at the time or now they can face criminal charges which have only just come back in in recent years – directors are now being charged with insolvent trading where there is intent. Up until now they had the protection of Safe Harbour (indecipherable) ….or someone who is abreast of the insolvency issues …they can always have the defence by stating that they had protection but that protection has now gone as of 31st March 2021, particularly.

Malcolm:

One of the duties of a liquidator is to look into the company’s affairs and determine the date on which the company became insolvent and from that date forward, any debts that were incurred, the directors can be liable for.  So it is important that directors make a decision early to prevent their personal assets becoming exposed.  Because what we are doing in an insolvent trading claim is that once we determine the date of insolvency and we have calculated what the debts are that have occurred in that period and not paid, we will then issue a demand against the directors personally to let them out.  Then we will pursue the action, if they hold property in their own name, then that property is at risk.

Keturah:

So can liquidators refer directors off to the police for the criminal sanctions? Or how does that happen?

Malcolm:

Yes, you can.  Ultimately ASIC is the one who pursues those sorts of charges or criminal activities, but yes, you can refer them to Victoria Police, depending on the nature of the charge.

Paul:

In that case (indecipherable)  you are really putting up a case of property by deception so this comes in under the Crimes Act, which deals with property by deception and insolvent trading provisions which deal with knowingly incurring a debt when you cannot repay it.  Those sort of claims are made to ASIC, and  ASIC can use its powers ….becoming the informant and laying the charges.

Keturah:

Right, well, it sounds like you are financial consultants in yourselves and Jirsch Sutherland can provide advice all round in terms of results of liquidation, those involved in liquidation, how to get yourself out tricky debt situations; so you pretty much cover the field, is that right?

Malcolm:

That is right, yes.  We hopefully do.  We certainly like to consider ourselves one of the leaders, or one of the leading organisations of insolvency. We deal with both personal insolvencies, corporate insolvencies and other consulting services such as business consulting, debt agreements, advisory work and re-structuring and we can also advise on the Safe Harbour.  We deal with forensic accounting as well, so we get involved in quite a bit of forensic accounting where we might be acting for a party in a matrimonial dispute where we need to know the business or we may pay a registered liquidator over a business or control over a business so that somebody independent is taking control.  We have a substantial brochure which we can hand out, too, for your clients, which outlines the types of appointments we can take and other ways in which we can help them and their clients to find a solution to any problems which they have got.

Sally:

Thank you very much for the assessment today and your participation in our podcase.  It is wonderful to have our old neighbours back in dialogue.  You feel distant but you are not that far away from us anymore.  Jirsch Sutherland were our physical neighbours but even in this virtual world, it does not feel that far away, Malcolm and Paul. Thank you for your stimulating description of insolvency in the context of 2020 and COVID and your expertise, not to mention your compassion and dedication to such a unique area which is well-known to all our colleagues and partners at Nicholes Family Lawyers. We wish you all the best until we talk again!

Malcolm and Paul:

Thank you!

 

Useful Links:

Jirsch Sutherland Insolvency Solutions: https://www.jirschsutherland.com.au/ 

 

Disclaimer: Nicholes Family Lawyers intends the information provided in this podcast as general information only, please contact Nicholes Family lawyers if you require specific information and advise in relation to any family law matter.

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