Safe Harbour Pressure Points and Warning Signs

INCREASING OBLIGATION UPON DIRECTORS

Over the years, the Courts have adopted the approach of expanding the role and responsibilities for directors, in relation to insolvent trading or elements that can affect an insolvent trading claim:

• The Commonwealth Bank of Australia v Friedrich (1991) – This was a landmark case about a director’s duty to prevent insolvent trading, setting expected standards for directors, and extending duties and obligations to non-executive directors.  It is a case that today’s NFP sector should continue to be reminded of for its consequences. 

Relevantly, our recent article “Not for Profits: Insolvent Trading and the Safe Harbour regime” explores insolvent trading and the Safe Harbour regime in further detail:

• ASIC v Plymin (2000) – Notwithstanding that creditors had accepted a Deed of Company Arrangement to compromise creditors’ claims, ASIC successfully prosecuted a civil proceeding against  John Elliot (Non-executive Director), Bernard Plymin (Managing Director), and William Harrison (Chairman) for ignoring the financial circumstances of Water Wheel, and therefore had failed to prevent it from incurring debts whilst it was insolvent.  This case is also notable for establishing some key indicators for insolvency.
• ASIC v Healey (2011) – Had profound implications for the duty to prevent insolvent trading by holding that directors; could not passively rely on others (management, or auditors) for financial matters, that there was a higher expectation for directors to financially literate in order to understand a company’s financial position and accounting policies, and to undertake an active oversight role which directly relates to monitoring an organisation’s solvency.

EARLY WARNINGS SIGNS TO IDENTIFY FINANCIAL DISTRESS

Anyone of the following cash flow situations should serve as an early warning sign to directors that their organisation may be experiencing financial distress:

• Negative operating cash flows – cash generated from core operating activities (selling goods or services) is less than the cash spent generating those inflows (suppliers, wages, and operating costs)
• Payments to suppliers and employees are higher than receipts from customers – identifies a fundamental deficiency between cash inflows generated from sales or services compared to fundamental direct costs
• Net operating cash flows are lower than profit after tax – identifies an issue between accrual profit earned versus cash generated from operations
• Lack of ability to self-generate investing/dividend activities – identifies a reliance on debt, or equity to meet its needs, and that there may be issues with its business model being unable to generate sufficient cash surpluses to fund investments, repay debt, or pay dividend policies

KEY INDICIATORS / RED FLAGS TO IDENTIFY INSOLVENCY

The infamous ‘Water Wheel case’ also known as ASIC v Plymin notably helped to establish a series of key indicators to help identify whether or not a company may be insolvent.  

A modern adaption of those concepts (key indicators of insolvency) is presented below:

FINANCIAL INDICATORS

• Continued trading losses - indicates the organisation is not generating sufficient revenue to meet expense, and raises the question as to how these loses have been funded
• Poor cash flow - delaying payments to creditors, expanding aged payables outside credit terms, reaching overdraft facility limits, difficulty paying wages or superannuation on time, dishonoured EFT payments are all examples of poor cash flow
• Balance sheet insolvency - liquidity ratios below 1, working capital deficiencies, net asset deficiencies are all indicators that there are insufficient assets to meet liabilities
• Overdue statutory obligations - ATO and State Revenue Offices (payroll tax, or land tax) are ordinarily common examples

OPERATIONAL INDICATORS

• Loss of key customers – usually an indication of financial pressures impacting on product or service quality
• Increase in inventory levels or obsolete inventory – an indication of increased cash usage and reduced cash inflows, or deteriorating revenue position
• Supply chain issues - revocation of credit terms, and demands for cash on delivery are two such examples
• Inability to produce financial information in a timely manner – indication of lack of control, oversight, and understanding of financial performance and position of the organisation.

BAHAVIOURAL INDICATORS

• Directors not taking a salary – indication of precarious financial position of organisation, and cash flow constraints
• Special arrangements with certain creditors - unusual payment arrangements, round sum payments, payment plans are common examples
• Poor relationship with current financial institution – a denial of further finance facilities, or a request to refinance with an alternative financier are common examples.

SAFE HARBOUR'S ROLE

Section 588GA of the Corporations Act 2001 provides a defence for directors against insolvent trading liability if the pursue a restructuring / turnaround plan (course of action) that would reasonably lead to a better outcome for an organisation that an immediate winding up.

This reiterates the importance for directors to identify early the warning signs of financial distress, so that early intervention can be implemented, and the benefits of the Safe Harbour regime can be utilised.