Small business - going broke

It is imperative that directors understand the key drivers of a business in which they are involved, even those approaching insolvency, writes Alexandra Cain.

David Grace OAM FAICD has been on the insolvency front-line for more than 25 years. Currently a consultant with Cooper Grace Ward Lawyers, where he advises directors and senior management on insolvency issues, he has also held directorships in listed, unlisted and private companies and has been involved in two companies where administrators had to be appointed by the boards due to concerns about likely company solvency.

Therefore, he is well aware of the risks directors face when a business is threatened with insolvency, which is a company’s inability to repay its debts as and when they fall due.

Be vigilant

The first time Grace faced this situation he was on the board of a business that trained apprentices. “At one point an apprenticeship was not seen as a preferred career choice for school leavers. There was pressure there because we had employers, but no apprentices,” he explains.
The business noticed a slowdown, but approached a government agency for a loan that was subsequently approved.

“Then one morning we received a report that indicated there were no young people applying for apprenticeships in the two industries we were involved in. Without apprentices, we couldn’t agree to the loan. The change was so dramatic we formed a view that if we continued to trade we would end up insolvent, so we appointed an administrator,” Grace explains.

Because the board moved quickly, it was able to pay more than 50 per cent of its creditors. “If the market falls away you have to protect the best interests of the company and stop trading or incurring debts you can’t repay,” he explains.

In the second incident, Grace was appointed to the board of a food processing business because other directors were concerned about the company’s financial position. The directors put in place a turnaround strategy. But again, circumstances meant the business eventually had to trade on a cash basis – that is, not incur any debts – while it started negotiations with potential acquirers.

“We couldn’t sell the business and its assets in time so it was placed into administration. When we realised where we were going, we were very clear in the minutes of board meetings about how the expectations about the business were reasonable because we knew there was the potential for administrators to be involved. We were meeting every few days at the end,” he explains.

Grace stresses that meeting minutes are vital when it comes to demonstrating the directors acted in good faith and reasonably under the circumstances. He notes that when a business is operating on a cash basis it must not incur any debts or even operate a credit card.

“Although the business ended up in liquidation, the administrator’s report clearly stated we were solvent when we went into administration. We had to ensure the directors understood the risks around insolvent trading and we got the auditor to address the board about this,” he says.

Seek advice

David Proudman, a senior partner with law firm Johnson Winter & Slattery, says if the board suspects a business may be headed for insolvency, the first step is to obtain expert insolvency advice from both legal and accounting advisers who can act for the company.

The next step should be to check the business’ directors’ and officers’ policy, then consider the parent entity’s financial position as the insolvent trading laws place similar obligations on the parent company as they do on directors, which is not to trade while insolvent. “Then make sure you raise the issue with the company’s bankers before they find out from others,” he advises.

His advice to directors who suspect the company may be headed towards insolvency is to have a plan in place. “You need to find a way forward and establish defences for reasonable expectations about solvency. Above all, directors should not put their heads in the sand,” he says, adding that, “always remember that whatever you do will be tested [in the courts] in hindsight with 20/20 vision.”

It is essential, says Proudman, if the company has a secured debt facility to understand if a breach of its covenants produces an immediate obligation to repay or only an entitlement by the financial institution to make a demand on the business to settle the debt.

“So understand your debts, your ability to repay them and when those debts are actually incurred,” he says.

Stay alert

If there’s a fear a business is approaching insolvency, directors are expected to understand and be across the key drivers of the business, says Wayne Kelcey, a partner at law firm Hall & Wilcox. “They need to maintain that constant vigil and be alert to changes in the company’s performance,” he warns.

Kelcey says when courts review a director’s role in an insolvent company typically three questions are asked. These questions are:

1. What were the circumstances leading to the company’s demise?
2. When should the director have become aware of the problem?
3.What could or should they have done to avoid it?

“There are many indicators that liquidators and the courts will look to in determining whether a company was insolvent and whether the directors should have held a suspicion that it was.

“If directors are seeking to understand the types of indicators that will be considered in establishing a claim of insolvent trading, the Australian Securities and Investments Commission website provides a comprehensive list on Info Sheet 42,” he advises.

Kelcey says one of the most common questions he is asked is: how should a director know if the business is insolvent? “Generally, the fact the director is asking that question might indicate that they already are.”

If you are sitting on a board of a business that is at risk of trading while insolvent, the main message is to act as soon as you have this suspicion to be able to demonstrate you have discharged your duties as a director.

The worst thing a director in this situation can do is sit on his or her hands because directors who are found to have allowed a company to continue trading while it was insolvent potentially face both civil and criminal proceedings, a situation in which no director wants to find themselves.

Tips for directors

If you think a business on whose board you sit is approaching insolvency you should:
• Ensure the business does not incur any new debts.
• Seek legal and financial advice immediately.
• Closely minute every action the board takes to demonstrate directors have met their obligations.

Helping hand

Check out our Business Owners Resource Centre for dedicated information and tools to help with your company’s governance and performance. Or enrol in our Directing Growth Program, a one-year series for owners and directors of mid-size companies that want to find new routes to sustainable growth.