What to do when a client goes bust?

Are you worried about a client who isn’t calling, writing, or paying you?  They may have run out of money and become insolvent.

Given the uncertain economic outlook of the year ahead, now is a good time to familiarise yourself with key concepts of Australian insolvency law.

What can I do if my client won’t pay?

When a client can’t or won’t pay it be can really stressful for a small business or start-up.  You may not realise it but you’ve become a creditor to that company, so if it goes into insolvency, you’ll need to apply to be paid the money owed to you in accordance with the relevant insolvency regime. Below we outline the steps you should take if this occurs.

It’s always best to start with a call with your lawyer to let them know what has occurred.  If they have experience in insolvency law (like us) they will be able to guide you through the process and protect your rights, otherwise they may refer you to a lawyer with specialist expertise in this area.

Understand insolvency and your rights

As a creditor, you have the right to participate in the insolvency process and to receive payment of your debts, if possible.  Where a liquidator or administrator is appointed, they will try to run the company in the best interests of you and all other creditors.  They’ll do this by trying to preserve the value of the business and by selling any valuable assets.  However, the amount you receive will depend on the assets of the company and the priority of your debt.  As set out in the section above, in most cases, secured creditors, such as banks, are paid before any unsecured creditors, such as service providers.

Am I a priority creditor?

It's important to check if you are a priority creditor, as this will affect the amount you receive if the company is wound up. Priority creditors are those who have a security interest over the company's assets, such as a mortgage or charge. If you are a priority creditor, you will have a better chance of recovering your debts in full.  Most service providers won’t be priority creditors, however if you supply goods to the company and have a retention of title on the goods, you may have a priority claim over those goods.  

Raise your claim ASAP

If a company runs out of money then an insolvency practitioner (generally either an administrator, liquidator or in some cases a receiver) will be appointed to manage the process. As a creditor, it's important to notify the insolvency practitioner of your claim as soon as possible. You can do this by sending a letter to the practitioner, outlining the amount you are owed and any supporting documents, such as invoices or receipts.  You can also call to provide any necessary context to your claim.

Participate in creditors meetings

If the company goes into voluntary administration, the administrator may hold meetings with creditors to discuss the company's financial situation and to propose a plan for the future. As a creditor, you have the right to attend these meetings and to vote on the proposed plan. You’ll get a much better understanding of the state of the company, how it went bust and what the other creditors think should occur. It's important to attend these meetings, as the outcome will affect your ability to recover your debts.

Consider further legal action

If the insolvency process does not result in payment of your debts, you may consider legal action against the directors personally or related parties depending on the circumstances that led to your debt. However, it's important to keep in mind that legal action can be time-consuming and expensive, and there is no guarantee that you will recover your debts in full. Before taking legal action, you should seek the advice of a solicitor who specializes in insolvency law.

Further information

Below we set out a (very long) overview of insolvency law in Australia. If the word count is daunting and you’d prefer to speak with us over the phone to better understand your rights, you can reach us here. The lawyers at Dexterity Law have experience in managing a range of insolvency claims for small businesses in Melbourne, across Australia and the Asia-Pacific.

What is insolvency?

‘Insolvent’ is the legal term we use to describe a company that has run out of money.  If a person runs out of money we refer to them as ‘bankrupt’.  Whether or not a company is actually insolvent can often be a complicated legal question, but for the purpose of this blog its sufficient to consider an insolvent company as a company that can’t pay its debts when they fall due.

Small businesses are the backbone of the Australian economy, but every year a significant number come insolvent. In these situations, small business and start-up owners will need to consider restructuring their operations to get back on track. This can involve changes to the way the business is run, its operations, or its financial structure.

In Australia, there are several options for small businesses to consider when restructuring. These include informal arrangements with creditors, formal debt restructuring plans, and insolvency processes. In this blog post, we'll discuss the different options available to small business owners in Australia and what they need to know to make an informed decision.

In such cases, the Australian insolvency process comes into play. The process has a number of regimes aims to ensure a fair outcome for both the company and its creditors, while also protecting the interests of employees and other stakeholders.

What are the different processes for managing insolvency in Australia?

There are two ways to an insolvency process may commence in Australia: voluntary and involuntary.

Voluntary insolvency occurs when the directors of the company decide that the company is no longer viable and take the necessary steps to place it into administration or liquidation.

Involuntary insolvency occurs when a creditor initiates court proceedings against the company. This is usually done when the creditor is owed a significant amount of money and has been unable to recover the debt through other means.

The insolvency process

The insolvency process in Australia is managed by licensed insolvency practitioners. The process is complex and can take several months to complete so it is important to understand the steps involved.  A brief summary of each step is set out below:

1.     Appointment of an administrator or liquidator: The first step in the insolvency process is to appoint an administrator or liquidator to manage the company’s affairs. An administrator is appointed when the company is in financial distress but may be able to be rescued (ie it may become profitable again in the future). A liquidator is appointed when the company is unable to pay its debts and must be wound up. 

2.     Insolvency protections: once and administrator or liquidate is appointed there is a complete stop on most creditors being able to enforce their debts (so court action against the company will also most often be stopped).  This allows the insolvency professional time to potentially rescue the company.  There are certain exceptions for perishable goods (no benefit the liquidator holding onto crates of oysters for several weeks), enforcement that has already commenced and for secured creditors.

3.     Review of the company’s financial position: The administrator or liquidator will conduct a thorough review of the company’s financial position, including its assets and liabilities. This will involve reviewing the company’s records and financial statements and assessing the value of its assets.

4.     Notifying and meeting of creditors: Once the administrator or liquidator has been appointed, they will notify the company’s creditors.  They will generally communicate the result of their review and their proposed plans for the insolvent company. Normally at least two meetings are held to review the state of the company and discuss any restructure.

5.     Restructure: At this point, if the administrator or liquidator considers the company may be rescued, it will propose a compromise with the company’s creditors.  Under administration this is known as a Deed of Company Administration or DOCA.  A DOCA will be binding on key stakeholders including the company, its shareholders and its creditors (save for secured creditors who do not vote in favour of the DOCA).  There is a separate process known as a Creditors Scheme of Arrangment, which does require involvement of the Court so it is more costly but has the ability to bind more parties and less option for creditors to set it aside when compared to a DOCA.

6.     Sale of assets: In most cases, the liquidator will sell the company’s assets to pay its debts. This may include selling the company’s property, equipment, and inventory. The proceeds from the sale of these assets will be used to pay the company’s creditors.

7.     Determining the distribution of funds: The liquidator will determine the order in which creditors will be paid. This will be based on the priority of each creditor, as set out in the Corporations Act 2001, which requires certain creditors (such as employees and secured creditors) to be paid ahead of others (namely unsecured creditors).

8.     Winding up: Once assets are sold and the proceeds are distributed, liquidator will commence the process of winding up the company. This will involve deregistration of the company with ASIC.

9.     Reporting to stakeholders: The administrator or liquidator will provide a final report to stakeholders, including the company’s creditors, employees, and shareholders.

The role of administrators, liquidators, provisional liquidators and receivers

The insolvency process is managed by licensed professionals, including administrators, liquidators, and receivers. Understanding the difference between these three roles is important for anyone who may be affected by the insolvency of a company.

Administrator

An administrator is appointed when a company is in financial distress but may be able to be rescued.  It is intended to be quick and (relatively) affordable as it does not require court involvement.  It can also avoid breakdown in commercial relationships that may occur if a company is placed into liquidation. The administrator's role is to assess the company's financial position, determine the best course of action, and manage the company's affairs whilst it is in administration. The administrator will also be responsible for preparing a report on the company's financial position, which will be provided to creditors. If the administrator determines that the company can be rescued, they will work with the company's directors and stakeholders to develop a plan to restructure the company's finances and operations.  The plan will generally require existing creditors to compromise on their debts (ie reduce them) in order to permit the company to survive.  If the company cannot be rescued, the administrator will appoint a liquidator to commence the winding-up of the company.

Liquidator

A liquidator is appointed when a company is unable to pay its debts, has no likely prospect of returning to profitability and must be wound up. The liquidator's role is to manage the winding-up of the company, including selling the company's assets, distributing the proceeds of the sale to creditors, and paying the company's employees their entitlements. The liquidator will also be responsible for preparing a report on the winding-up of the company, which will be provided to creditors. The liquidator's role is to ensure that the company's assets are distributed fairly and in accordance with the law.

Provisional Liquidator

A Provisional Liquidator will have most of the functions of a Liquidator but, they’re generally appointed if there is uncertainty as to whether or not the company must be liquidated and where the creditors want an independent party to control the company until the state of the company can be confirmed.  The appointment of a provisional liquidator is quite rare as it can only happen between the filing of a wind-up application and the hearing and decision on the application.

Receiver

A receiver is appointed when a secured creditor, such as a bank, is owed money by a company and has the right to appoint a receiver to recover the debt. The receiver's role is to sell the company's assets and use the proceeds of the sale to pay the secured creditor. However, a Receiver must still pay out the money collected in the order required by the Corporations Act.

The receiver’s main duty is to the secured creditor that appointed them. The duty owed to unsecured creditors is an obligation to take reasonable care to sell the secured assets for not less than its market value or, if there is no market value, the best price reasonably obtainable. A receiver also has the same general duties as a company director.

Receivership is different to liquidation or administration in so far as the directors remain in control of the Company save in respect of the secured assets.  Of course, if the secured creditor has security over the company’s entire assets they will in effect substantivley replace the directors.

The receiver has no obligation to report to unsecured creditors, including employees, about the receivership.

Who gets paid from a liquidation or administration?

There are nearly always insufficient funds to pay all creditors in full so under Australian Law the order that those funds is paid out is mandated by statue.  There are very complex rules for determining priorities which may change depending on the nature of the remaining assets.  A very simplified overview of the priorities of payment as follows:

·       First, the expenses incurred by the administrator or liquidator;

·       Second, the costs and expense of obtaining an order for liquidation;

·       Third, certain priority claims, including employee entitlements (if the liability for these has not been transferred to a new owner);

·       Fourth, repayment of the secured creditor’s debt; and

·       Fifth, repayment of unsecured creditor’s debt.

Note the ATO no longer has priority over other unsecured creditors, but has additional powers to pursue directors personally for the tax debts of a company.

Would you like further information on insolvency law, you can reach out to schedule a call with our dispute resolution lawyers here.