Deemed insolvency through a lack of proper records

For a Liquidator, forming a view about the insolvency of a company is relatively straightforward. There are a number of indicators of insolvency that arose from a landmark case dealing with the matter (ASIC v Plymin). I have written about these indicators in a separate article here. We use those indicators to point us towards a period or date when a company becomes insolvent.

Proving insolvency is difficult however. Even with the benefit of accurate records and 20/20 hindsight, free from the distraction of financial distress that clouds the judgement of directors when particular debts are incurred, it is still complex and can be costly to pinpoint and quantify. We start with the indicators of insolvency, however drilling down to a specific point in time requires a high degree of analysis.

Take into account the defences that are available to directors, and it becomes even more challenging to achieve a recovery from directors for breaches of the insolvent trading provisions of the Corporations Act 2001 (“the Act”).

An exception to this general position is when a company does not maintain proper books and records as required by section 286 of the Act, thereby allowing a Liquidator to enliven section 588E of the Act.

Let’s unpack these two provisions first.

Section 286 says a company [and other types of entities] must keep written financial records that –

• Subsection (1)(a): correctly record and explain its transactions and financial position and performance; and
• Subsection (1)(b): would enable true and fair financial statements to be prepared and audited.
• Subsection (2): The financial records must be retained for 7 years after the transactions covered by the records are completed.

Section 588E of the Act says that if a company has –

1. failed to keep financial records in relation to a period as required by section 286(1); or
2. failed to retain financial records in relation to a period for 7 years required by section 286(2);

Then the company is to be presumed to have been insolvent throughout the period.

At HLB Mann Judd Insolvency WA, we have dealt with several cases that turn on a lack of proper books and records. Typical indicators include –

1. Poorly maintained management accounting software (or worse yet, no MYOB or equivalent)
2. Undisclosed liabilities
3. Assets recorded at higher than recoverable values
4. Unreported and unrecorded superannuation and tax liabilities
5. No banking reconciliations
6. Or simply rare cases where no records are delivered up at all

In a recent-ish case dealing with this matter, Substance Technologies Pty Ltd [2019] NSWSC 612, the directors of the company in liquidation refused to deliver the records of the Liquidator on the basis that by doing so, it would lead to self-incrimination.

With no records to examine, the Liquidator had little choice other than to enliven section 588E.

The wash up was that the company was found to have not maintained proper books and records, and accordingly was deemed to be insolvent during the entire seven year period set out in section 286(2).

The message here for directors and their accountants is clearly to ensure that books and records comply with the requirements of section 286 and if a company does end up in liquidation, that directors comply with their requirements to deliver the books and records of the company to the Liquidator.