What You Need to Know About Australia’s Corporate Insolvency and Liquidation Regime Amid the Wave of Insolvencies

Introduction

Following the end of the pandemic, the number of companies entering liquidation proceedings in Australia has shown a marked upward trend, driven by the combined effects of slowing economic growth, rising interest rates, the cessation of government pandemic subsidies, and the Australian Taxation Office (ATO) intensifying its tax collection efforts. According to statistics published by the Australian Securities and Investments Commission (ASIC), 7,942 companies commenced external administration proceedings (in the broad sense) in the 2022–2023 financial year, compared to only 4,235 and 4,912 in the 2020–2021 and 2021–2022 financial years respectively. In this environment, Australia’s corporate insolvency and liquidation regime is no longer confined to specific industries. Across all industries, company managers, investors, supply chain partners, and even ordinary employees may find themselves directly or indirectly caught up in Australia's corporate insolvency and liquidation regime.

*Number of companies entering external administration or having a controller appointed (external administration proceedings in the broad sense) per month from the 2020 to 2023 financial years, sourced from the Australian Insolvency Statistics published by ASIC on 11 September 2023

As the Parliamentary Joint Committee on Corporations and Financial Services noted in its report in July of this year: Australia’s corporate insolvency and liquidation regime is overly complex and difficult to navigate, creating additional costs and considerable difficulties for both debtors and creditors. As a practising lawyer, I have represented creditors, registered liquidators, and companies in liquidation proceedings and related court proceedings. I therefore have a deep appreciation of the confusion that the general public experiences in relation to Australia’s corporate insolvency and liquidation regime.

This article aims to provide a clear explanation of the legal framework and core concepts of corporate insolvency and liquidation in Australia, in the hope that readers will come away with a solid foundational understanding of how these procedures work.

I. What Is Corporate Insolvency and Liquidation?

The term “Insolvency” or “Winding up in Insolvency” refers to the entire process in which, when a company is unable to pay its debts as and when they fall due, an external administrator (usually a registered liquidator) takes control of the company’s assets and management, realises the company’s assets to repay its debts, and ultimately brings the company’s operations to an end.

When determining whether a company is solvent, Australian courts apply a “cash flow test” rather than a “balance sheet test”. The specific details will be discussed in Part III below.

II. Types of Company Liquidation

There are three types of company liquidation:

1. Members’ Voluntary Liquidation: Where a company is solvent, its shareholders may, by resolution, elect to undertake a voluntary liquidation.

   
   

2. Creditors’ Voluntary Liquidation: This refers to the situation where, for a company that is insolvent, the shareholders resolve to voluntarily liquidate the company; or where, after the company enters voluntary administration, the creditors vote to place the company into liquidation.

   
   

3. Court-Ordered Compulsory Liquidation, which can be further divided into the following two categories:

   
   

   3.1 Winding up in insolvency as provided for in Part 5.4 of the Corporations Act 2001, which typically refers to the situation where a company fails to pay the amount specified in a Statutory Demand within 21 days and is thereby presumed to be insolvent, following which the creditor applies to the court for an order that the company be wound up in insolvency;

   
   

   3.2 Court-ordered compulsory liquidation based on other grounds, for example: the company has no members, a director has breached their fiduciary duties, or the company has ceased to carry on business.

   
   

This article primarily discusses winding up in insolvency as defined in the first part above, namely the situation where a creditors’ voluntary liquidation or a court-ordered compulsory liquidation occurs when a company is unable to pay its debts as and when they fall due.

III. How to Determine Whether a Company Is Insolvent

Under section 95A of the Corporations Act, a company is only regarded as solvent if it is able to pay all of its debts as and when they become due and payable; otherwise, the company is considered to be insolvent. In interpreting this provision, Australian courts apply a “cash flow test” rather than a “balance sheet test”. This means that the court’s focus is not on whether the company’s total assets exceed its total liabilities, but rather on the company’s liquidity. When assessing whether a company is insolvent, the court will place greater weight on the company’s current debts, debts that are about to arise, the due dates of each debt, as well as the company’s existing and anticipated sources of cash, making a comprehensive assessment in light of the company’s actual operating circumstances.

Court decisions and ASIC have identified a range of indicators for determining whether a company may be insolvent. When a company exhibits several of the following indicators, it may be facing the risk of insolvency:

If you are a director of a company and observe that the company is exhibiting several of the above-mentioned indicators, you should be highly alert as to whether the company is facing, or is about to enter, a state of insolvency. Continuing to trade in such circumstances may constitute a breach of section 588G of the Corporations Act, which imposes on company directors a duty to prevent insolvent trading. In simple terms, this duty means that company directors have a responsibility to prevent the company from incurring new debts while it is insolvent or while doing so may cause the company to become insolvent. If directors fail to discharge this duty, they may face civil liability, civil or administrative penalties, and even criminal prosecution.

If you are a creditor of a company and observe these indicators of insolvency, you should first contact the company immediately to ascertain its financial position and demand payment of debts that have fallen due. At the same time, you should consider adjusting the terms of trade with that company, such as requiring cash on delivery, to reduce future credit risk. To protect your interests, you should obtain professional legal and financial advice, understand available avenues of recovery, monitor the company’s financial reports, and even maintain communication with other creditors to assess the company’s ability to repay. Where necessary, you should also consider taking legal action against the company, such as having a lawyer prepare and serve a Statutory Demand, and, if the company fails to pay the amount owing within 21 days, applying to the court for the company to be placed into insolvency and liquidation.

IV. How to Prove That a Company Is Insolvent

For creditors, proving that a company is insolvent is difficult. Determining whether a company is insolvent is a question of fact that requires a substantial body of evidence, including the company’s financial statements (such as profit and loss statements, balance sheets, and cash flow statements), the opinion of expert witnesses (usually experienced accountants or registered liquidators), and evidence demonstrating indicators of insolvency. However, external creditors often face many obstacles and significant costs in obtaining the debtor company’s financial records or engaging expert witnesses.

To address this problem, section 459C of the Corporations Act sets out six circumstances in which a company may be presumed to be insolvent (Presumption of Insolvency), thereby reducing the evidentiary burden on external creditors when applying for insolvency proceedings to prove that the company is actually insolvent. These six circumstances are:

1. The company has failed to comply with a Statutory Demand;

2. Execution or other process issued on a judgment, decree, or order of a court in favour of a creditor of the company is returned wholly or partly unsatisfied;

3. A secured creditor has appointed a receiver to manage the secured assets pursuant to the security documents;

4. The court has appointed a receiver to manage the company’s secured assets to satisfy the security obligation;

5. A person has taken possession or control of the company’s assets for the purpose of satisfying a security obligation;

6. A person has been appointed to take possession or control of the company’s assets for the purpose of satisfying a security obligation.

Regarding the presumption of insolvency, two points must be noted. First, the presumption of insolvency has a time limit of three months; any application to the court for insolvency proceedings must be made within this period. Second, although it is very difficult to do so, the presumption of insolvency may be rebutted during court proceedings. Once a company is presumed to be insolvent on the basis of any of the above six circumstances, it must provide sufficient evidence to demonstrate that it is in fact solvent.

The process of serving a Statutory Demand on a debtor company, the company’s failure to respond to the demand resulting in a presumption of insolvency, and the creditor’s subsequent application to the court for an order winding up the company, is a common legal issue. This topic will be addressed in a separate article.

V. Purpose and Function of Corporate Insolvency and Liquidation

1. Enforcement of debts: Corporate insolvency and liquidation is an important avenue for creditors to realise debts that have fallen due. Although in recent years the courts have emphasised that the liquidation process should not be used as a routine debt collection strategy, particularly where there is a dispute as to the debt, in practice, the liquidation process is frequently used as an effective tool to compel debtor companies to discharge their obligations.

   
   

2. Collective action by creditors: The original purpose of corporate insolvency and liquidation is not merely to protect the interests of a single creditor, but to provide a mechanism for collective relief for all creditors. For example, if Company A commences insolvency and liquidation proceedings against Company B, then Company B’s other creditors, such as Company C and Company D, may also participate in the liquidation process and receive payment proportionate to the size of their respective claims。

   
   

3. Proof of debt mechanism: Since once a company enters liquidation it can generally no longer be sued as a defendant, the insolvency and liquidation process provides an opportunity for creditors to lodge and prove their claims against debtor companies that can no longer appear as defendants in court proceedings.

   
   

4. Preservation and tracing of assets: During the liquidation process, the registered liquidator (hereinafter referred to as the “liquidator”) is vested with statutory rights and duties to safeguard the company’s assets and to trace assets that may have been concealed or misappropriated.

   
   

5. Holding responsible persons legally accountable: During the liquidation process, the liquidator is not only responsible for dealing with the company’s assets, but also possesses statutory powers to pursue claims against the company’s decision-makers, particularly directors and officers, to ensure that they are held legally accountable for conduct that has harmed the interests of the company and its creditors.

   
   

6. Protection of the public interest: The existence of the insolvency and liquidation process ensures that companies which are unable to pay their debts do not continue to engage in improper trading activities that may harm the public interest.

VI. What Happens After a Company Enters Insolvency and Liquidation?

1. Changes to management upon commencement of liquidation: Once a company enters insolvency and liquidation, the liquidator immediately assumes the leading role and takes full control of the company’s operations and assets. This means that the former directors and senior management lose control of the company. This transfer of power is not merely formal. In practice, directors and officers are under a legal obligation to deliver to the liquidator all documents, books, records, and assets relating to the company. This is to ensure the transparency and integrity of the liquidation process. In addition, they must submit a “Report on Company Activities and Property” (ROCAP) to the liquidator within the prescribed timeframe. This report provides the liquidator with important information about the company’s operations and financial position, assisting the liquidator in making decisions.

   
   

2. Restrictions on the company’s participation in legal proceedings: Once a company enters insolvency and liquidation, its capacity to take legal action is severely restricted. Specifically, the company may only continue as a defendant in new or existing proceedings in very limited circumstances. This restriction is designed to protect the company’s assets and prevent additional losses during the insolvency process. Under section 471B of the Corporations Act, unless prior leave of the court has been obtained, creditors of the company are prohibited from commencing or continuing any legal proceedings to recover their debts. This provision ensures the orderliness and efficiency of the liquidation process.

   
   

3. Adjudication of creditors’ claims: During the liquidation process, one of the liquidator’s core tasks is to examine and verify all claims lodged by the company’s creditors. This process involves a detailed examination of each creditor’s proof of debt and supporting evidence to confirm its legitimacy and authenticity. Following this examination, the liquidator will determine which claims are valid and legitimate, and which require adjustment or rejection. In addition, the liquidator will determine the order of priority in which each creditor is to be paid during the liquidation process, based on the nature and amount of the claim. This process is designed to ensure that all creditors receive payment fairly and in accordance with the law from the company’s remaining assets.

   
   

4. The liquidator’s investigative duties: The liquidator will conduct a thorough investigation into the company’s various business activities and transactions to ensure fairness and legality. The core areas of investigation include:

a. Unfair Preference Payments: The liquidator will investigate whether, in the period leading up to insolvency, the company made preferential payments to specific creditors. For example, if a company, within three months prior to becoming insolvent, repaid in full the outstanding amount owed to a supplier closely connected to a director or shareholder, while other suppliers remained unpaid, this may be regarded as an unfair preference payment.

b. Uncommercial Transactions: The liquidator will assess all of the company’s transactions, particularly those that appear inconsistent with ordinary commercial judgment. For example, if the company, when facing the risk of insolvency, sold assets to a related party at a price significantly below market value, this may be regarded as an uncommercial transaction.

c. Creditor-Defeating Dispositions: The liquidator will examine whether the company deliberately sold or transferred assets at below market value for the purpose of preventing creditors from recovering the amounts owed to them from those assets. For example, if the company, aware that insolvency was imminent, deliberately transferred a property worth AUD 1 million to a related company for AUD 500,000, this may have been done to prevent other creditors from making a claim against that property.

d. Conduct by directors or officers in breach of statutory duties: The liquidator will investigate in detail the conduct of the company’s senior management, particularly the directors, to determine whether there has been any breach of the Corporations Act. If any unlawful or non-compliant conduct is identified, the liquidator may commence legal proceedings to pursue the legal liability of the relevant directors or officers. For example, if a director has breached their fiduciary duties and misappropriated the company’s assets, such conduct may result in the director being held legally accountable.

e. Illegal Phoenix Activity: The liquidator will also examine whether the company has been involved in illegal phoenix activity, that is, where the company’s directors transfer the company’s business and assets to a new company and cause the original company to enter insolvency and liquidation in order to avoid the debts incurred during its prior operations.

5. Liquidator’s report to ASIC: The liquidator is not only responsible for the company’s liquidation process, but is also obliged to report key investigation findings to the ASIC. This report primarily covers the specific reasons for the company’s insolvency and liquidation, as well as any unlawful conduct involving the company discovered during the liquidation process. ASIC relies on these reports to ensure that the company’s insolvency proceedings have been conducted in accordance with the law, and to take appropriate steps to hold those who have committed wrongdoing or unlawful acts accountable.

   
   

6. Liquidator’s detailed report to creditors: The liquidator must also ensure that the company’s creditors are fully informed of every aspect of the liquidation process. To this end, the liquidator will provide creditors with regular and detailed reports. These reports not only set out the investigation findings mentioned above, but also outline subsequent investigation or recovery plans, helping creditors to understand the returns they can expect. In addition, the reports clearly set out the company’s asset and liability position, the status of asset realisations, projected recovery rates for creditors, and a detailed breakdown of the liquidator’s fees and expenses.

   
   

7. Meetings of creditors: The liquidation process is a collective action that requires the active participation of creditors. To this end, the liquidator or other qualified creditors may convene meetings of creditors. The purpose of such meetings is to keep creditors informed of the progress of the liquidation, to participate in key decision-making, and to express their wishes by way of vote. The agenda of a meeting may include whether to replace the liquidator, how to allocate the costs of the liquidation, or to put questions to the liquidator concerning the company’s affairs.

   
   

8. Legal proceedings and seeking funding: The liquidator’s duties extend beyond dealing with the company’s assets and liabilities. If the liquidator discovers unlawful conduct during the course of the investigation, the liquidator has the power to commence legal proceedings on behalf of the company to recover losses caused by such unlawful conduct. For example, if it is discovered that the company’s directors or officers have engaged in unlawful conduct, the liquidator may pursue their legal liability. However, conducting such proceedings requires funding, and if the company’s assets are insufficient to cover the legal costs and the liquidator’s fees, the liquidator may seek funding from creditors or apply to ASIC for additional funding.

   
   

9. Realisation of assets and distribution to creditors: The ultimate objective of liquidation is to realise the company’s remaining assets in order to repay the company’s debts. The liquidator is responsible for valuing and selling the company’s assets to ensure the best possible return. Once assets have been realised, the liquidator will distribute funds to creditors in accordance with the pre-determined order of priority.

VII. Order of Priority for Payment of Creditors

When a company enters insolvency and liquidation, it usually means that its assets are insufficient to pay all of its creditors’ debts. Under Australian corporations law, a core principle governing the liquidation process is the principle of “rateable/pari passu distribution”. To take a simple example, if the company’s assets after liquidation amount to $1 million, and the total debts owed to all creditors amount to $2 million, then in theory each creditor would receive 50 cents for every dollar of debt owed.

However, it should be noted that certain debts are paid with priority. The following sets out the order of priority for the payment of debts in a corporate insolvency and liquidation:

1. Costs and expenses of the liquidation: This primarily includes the liquidator’s remuneration and third-party expenses incurred in the realisation of assets. In some complex liquidation cases, the liquidator’s fees may accumulate to hundreds of thousands of Australian dollars within a short period of time.

   
   

2. Secured debts: Creditors who have been granted a mortgage or other form of security over the company’s assets in exchange for loans or other amounts. For example, if a company has a commercial property that serves as security for a bank loan, and that property is sold, the proceeds will first be applied to repay the bank’s principal and interest. In many cases, secured creditors may appoint a receiver to manage and dispose of the secured assets before or during the liquidation process.

   
   

3. Employee-related claims:

   
   

a. Wages and superannuation: Unpaid wages, bonuses, and superannuation contributions owed to employees of the company in liquidation.

b. Other entitlements: For example, employees’ accrued annual leave, sick leave, and other entitlements.

4. Unsecured debts (ordinary debts): These are ordinary debts without any security or priority. They will only be paid in part or in full after all of the above priority debts have been satisfied.

   
   

5. Shareholder contributions: Finally, after all debts have been paid, the company’s shareholders may receive any remaining assets on the basis of their contributions.

VIII. Proof and Lodgement of Debts

In a corporate insolvency and liquidation, lodging and proving debts is a critical step to ensure that creditors receive the amounts to which they are entitled. The following is a brief summary of how to lodge and prove debts in a corporate insolvency and liquidation:

1. Submitting a proof of debt: Creditors must submit a formal proof of debt form (Proof of Debt) to substantiate the amount of their claimed debt.

   
   

2. Providing sufficient evidence: Creditors should provide relevant invoices or other supporting documents together with the proof of debt form. Because the liquidator exercises a quasi-judicial function, claims may be rejected if insufficient evidence is provided.

   
   

3. Compliance with deadlines: The liquidator will usually notify creditors of the deadline for submitting proofs of debt in advance, typically providing at least 14 days’ notice. All necessary documents should be submitted before this date.

   
   

4. The liquidator’s adjudication: The liquidator will examine all proofs of debt submitted and decide whether to admit or reject them. If the liquidator decides to reject a creditor’s claim, the liquidator must notify the creditor within seven days of making that decision and provide the reasons for the rejection.

   
   

5. Appealing the liquidator’s adjudication to the court: If you disagree with the liquidator’s adjudication of your proof of debt, you may appeal the liquidator’s decision to the court within the prescribed time.

   
   

Conclusion

Corporate insolvency and liquidation is a rigorous legal process, designed to deal with a company’s assets and liabilities in a fair and transparent manner. The legislation governing liquidation is voluminous, and its procedural steps and time limits are strictly prescribed. Accordingly, for all parties involved in a liquidation - whether company directors, senior management, employees, shareholders, or creditors - understanding the liquidation process and how to protect their interests is critically important. At the same time, for companies burdened by debt, recognising the potential consequences of corporate insolvency and liquidation and the legal liability that directors and officers may face is equally vital.

Although this article seeks to provide a comprehensive explanation of the key concepts in corporate insolvency and liquidation, each individual liquidation case has its own unique characteristics. Therefore, when facing specific legal issues, please seek professional legal advice.

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Ausjuris Legal team has extensive experience in corporate law as well as insolvency and liquidation matters. Please contact us to obtain professional legal services.

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The information provided in this article is for general informational purposes only and does not constitute formal legal advice. Receipt of this information does not create a lawyer–client relationship. Ausjuris Legal and Yang Wenjun accept no liability for any loss arising from the use of, or reliance on, the information contained in this article.