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Whether your own business or a business partner is struggling with debts, you should understand how bankruptcy and insolvency work. This will help you to have difficult conversations successfully and find the right path forward. This article will provide an overview of the bankruptcy and insolvency processes.
What is the Difference Between Bankruptcy and Insolvency?
The key difference between bankruptcy and insolvency is who, or what, each applies to. Bankruptcy applies to individuals. If an individual becomes bankrupt, a trustee in bankruptcy takes control of their finances a set period. Apart from a small amount set aside for daily expenses, the trustee will recover debts owed to the bankrupt and use that money to:
- pay creditors;
- administer the bankrupt’s estate; and
- sell off the bankrupt’s assets to pay creditors.
Companies, on the other hand, cannot be declared bankrupt. Instead, they will enter insolvency and either:
- go through the process of ‘administration’; or
- divide their assets between their creditors before being liquidated and deregistered.
However, some individuals can become bankrupt due to their company’s debts. Usually, a business owner will not be responsible for the debts of a company. However, sole traders and partners within partnerships may be personally responsible. Also, if a company director has guaranteed their company’s debts by signing personal guarantees, they may face bankruptcy if the company cannot pay its debts.
What is Bankruptcy?
Bankruptcy is a legal process that gives relief to people who are unable to pay their debts. It allows them to make a fresh start after a set period of time (usually, three years and one day). During this period, a bankruptcy trustee controls their funds and assets apart from those set aside for their daily use.
How Does a Person Become Bankrupt?
Bankruptcy can be either voluntary or compulsory. Compulsory bankruptcy is a formal court process. During the process, a creditor attempts to recover debt from the debtor. The debtor has several opportunities to act and avoid becoming bankrupt. Alternatively, a debtor can choose to become bankrupt voluntarily. This may allow them to:
- lessen costs; and
- select their bankruptcy trustee.
If you are in the first stages of the compulsory bankruptcy process, you should seek legal advice as soon as possible.
A court may declare an individual bankrupt if they commit an act of bankruptcy. The most common act of bankruptcy is to fail to comply with a bankruptcy notice. The steps of compulsory bankruptcy are as follows:
- judgment debt (in order to issue a bankruptcy notice, a creditor must have a recent court judgment against the individual for an amount over $10,000).
- bankruptcy notice (once a bankruptcy notice issues, an individual has 21 days to either pay, dispute or come to an arrangement with the creditor concerning the debt).
- act of bankruptcy (if the individual has not complied with the bankruptcy notice, they are taken to have committed an act of bankruptcy. The creditor can then apply for either the Federal Court or Federal Circuit Court to declare them bankrupt. This application is called a creditor’s petition).
- creditor’s petition (at the hearing, the individual has a chance to convince the court that they can pay the debt within a reasonable time. If they cannot do so, the court will declare the individual bankrupt. This order is called a sequestration order).
- sequestration order (once a sequestration order has been made, a bankruptcy trustee will be appointed and the individual will be considered bankrupt from the date of the act of bankruptcy).
At any point until the individual is declared bankrupt by the court, they can present a debtor’s petition to seek voluntary bankruptcy. If you are considering voluntary bankruptcy, you should speak with a lawyer who can direct you to a:
- debt restructuring advisor; or
- bankruptcy trustee.
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What is Insolvency?
Insolvency, otherwise known as corporate insolvency, is a broad term that covers several different arrangements a company may seek if it cannot pay its debts. These arrangements may:
- allow the company to continue trading; or
- require the company to be liquidated.
How Can a Company Be Declared Insolvent?
There three main types of corporate insolvency are:
- voluntary administration;
- receivership; and
However, directors of companies who are at risk of insolvency can also seek to operate under a new regime called the ‘safe harbour’ regime whilst contemplating insolvency.
The purpose of corporate insolvency is to:
- ensure fair treatment of the company’s creditors;
- give the company a second chance, if possible; and
- investigate any misbehaviour.
What Is Voluntary Administration?
Under voluntary administration, a company’s directors hand control of the company over to external administrators. These administrators investigate the company’s affairs and look after the interests of creditors. Once a voluntary administrator is appointed, directors no longer control the company. Therefore, they are no longer at risk of insolvent trading. The administrator will see if it is possible for the company to continue trading, and will look at a number of ways to try and do this before deciding to liquidate a company. Typically, liquidation will only be necessary if the company in administration:
- cannot pay its debts; and
- appears unable to trade through its cash flow issues.
How Does a Company Enter Voluntary Administration?
The directors of a company can appoint a voluntary administrator by:
- making a resolution that the company is insolvent (or likely to become insolvent); and
- finding a registered administrator who consents to the appointment.
In other circumstances, a secured creditor or liquidator can also appoint an administrator. However, the company does not voluntarily undertake that process.
ASIC will then be informed that the company is in administration and its name will be changed by adding ‘in administration’ to inform creditors and potential creditors know that the company may not be able to pay its debts.
What Happens Next?
Voluntary administration is not a final step. It will end once the administrator completes their investigation and recommends that the company should:
- go into liquidation;
- enter into a Deed of Company Arrangement; or
- return to the directors’ control and end administration.
What Is Receivership?
Receivership is where a secured creditor appoints someone (a ‘receiver’) to recover money the company owes them. The powers of a receiver and extent of receivership depend on the secured creditor’s security agreement with the company.
Receivers are considered to be agents of the company. However, their duties are to the secured creditor, not the company or its other creditors.
Like voluntary administration, a company in receivership will have its name changed to include ‘receivers appointed’.
How Does a Company Enter Receivership?
Usually, a secured creditor will appoint a receiver after a company defaults under a security agreement. Typically, the only requirement is that the creditor follows any processes required by that agreement. However, the court can also appoint a receiver in certain circumstances.
What Happens Next?
Receivership ends when the receiver has:
- recovered the money the company owes to the secured creditor; or
- disposed of all of the company’s secured property.
If the company cannot pay its debts at that time (or during the receivership), then the company may be put into either administration or liquidation.
What is Liquidation?
Liquidation, also known as ‘winding up’, is a process of putting a company’s affairs in order and distributing its assets before deregistration. After deregistration, the company ceases to exist. Liquidation may be the result of a:
- court order;
- decision by a company’s shareholders (if the company is solvent); or
- decision by a company’s creditors (if the company is insolvent).
Court Liquidation Process
A creditor can apply to wind up a debtor company which cannot pay its debts. As secured creditors can appoint receivers, winding up applications are usually brought by unsecured creditors.
However, unsecured creditors are unlikely to be able to recover the full amount of their debts through this process. This is because any money in the company must be equally shared amongst its creditors. The stages of court liquidation are:
- debt (if a company owes at least $4,000 to a creditor, the creditor can commence proceedings to wind them up by issuing a statutory demand);
- statutory demand (if a company does not comply with or dispute a statutory demand within 21 days, the creditor may apply to the court for a winding up order. Unlike a bankruptcy notice, a court judgment debt is not necessary in order to issue a statutory demand);
- application hearing (at a winding-up application hearing, there are very few grounds for a company to prevent a winding-up order being made, as the failure to comply with a statutory demand creates a presumption that it is insolvent. The company must therefore either prove that it is solvent or that the creditor has failed to comply with the procedural rules); and
- winding up order (if the company is unsuccessful, the court will grant a winding-up order and appoint an official liquidator. On the appointment of a liquidator, the directors lose control of the company and the company’s name changes to the name ‘in liquidation’).
A company can also enter liquidation voluntarily by either a:
- creditors’ voluntary winding up; or
- members’ voluntary winding up.
This is usually what happens if a voluntary administrator recommends winding up a company at the conclusion of administration.
What Happens Next?
Once a company’s affairs have been investigated, and any assets distributed to its creditors (or members if solvent), a company is deregistered and ceases to exist.
What Is Safe Harbour?
Safe harbour is a recent addition to Australia’s insolvency regime. Safe harbour prevents directors from putting healthy companies into voluntary administration. It does this by protecting them from insolvent trading claims if they:
- comply with certain requirements; and
- take actions that are reasonably likely to lead to a better outcome for the company.
However, safe harbour has seen limited uptake due to the complicated requirements and lack of guarantee of protection for directors. Therefore, companies seem to prefer the certainty that comes with appointing a voluntary administrator.
There are many aspects of bankruptcy and insolvency. A court may declare an individual or a company bankrupt or insolvent. However, this is a complicated process for all parties. Therefore, creditors and debtors often make arrangements or agreements in order to meet on common ground. If you run a business, it is important to understand your responsibilities and the pathways available to you to repay your debts. If you need assistance in relation to bankruptcy or insolvency, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
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