In the recent decision of First Strategic Development Corporation Limited (in liq) and Anor v Chan and Ors [2014] QSC 60, the Supreme Court of Queensland considered the solvency of a company with no assets or formalised line of credit, but with a director who claimed to be willing to fund the $2.5 million that the company had committed to spending.

FACTS

The liquidator of First Strategic Development Corporation Limited (First Strategic) brought proceedings against its three directors for compensation for losses from First Strategic’s alleged insolvent trading.

First Strategic had agreed in late 2009 to, among other things, spend $2.5 million exploring certain iron ore tenements with a view to later selling it to Macarthur Minerals Limited (MMS) for equity in MMS. MMS would manage the exploration program but First Strategic would pay the contractors directly.

First Strategic had no assets. The understanding among the directors appeared to be that the first defendant, an entrepreneur and businessman in Hong Kong, would provide the $2.5 million required.

The first defendant paid approximately $80,000 in respect of work done on the tenements prior to 6 August 2010. On 6 August 2010, the first defendant requested that MMS suspend the exploration program and requested the accounts owing as at that date. The total amount owing was said to be $856,365.19. None of those accounts were paid.

THE DECISION

In considering whether First Strategic was insolvent, McMurdo J noted that it had no assets, no line of credit or other financial support from a party at arms length, and no contractual entitlement to receive funds from which it could have paid the debts incurred. Its prospects of paying its debts depended entirely on the means and preparedness of the first defendant, who stood to benefit from its operations.

His Honour noted that s 95A of the Corporations Act requires the court to have regard to “commercial reality” in assessing whether the company is able to pay its debts as they become payable.[1] This involves considering not just the company’s legal rights and obligations, but also other circumstances such as the likelihood that it will have funds available to it from sources with which it has no formalised agreement or understanding,[2] such as loans from related corporations or directors.[3]

The key consideration is the company’s ability to pay its debts as and when they fall due. When assessing the ‘ability’ of the company to obtain necessary funds from a party which is not obliged to provide them, there must be a sufficient likelihood for the company to be able to rely upon the availability of those funds when incurring the relevant debts, and the company must have something more than a chance of paying its debts.

While his Honour accepted that the first defendant had some inclination to, and did in fact, provide some funds to the company, they were relatively small amounts and provided in light of a prospective, profitable transaction with MMS.McMurdo J found that the first defendant’s degree of commitment was low and dependent upon so many contingencies that, had there been an independent board of directors, they could not have considered him a reliable source of funds. His Honour found that First Strategic was therefore insolvent at all material times.

COMMENT

This decision makes it clear that while the court will look behind a company’s legal rights and obligations in determining solvency, the key question is whether there is a sufficient likelihood that the company will be able to rely on those funds being available when incurring the debts. Directors should be careful to ensure that when their company is relying upon funds from informal sources in order to repay debts, that there is more than a chance of the company paying its debts, otherwise directors run the risk of being liable for the company’s insolvent trading.