A recent decision of Justice Rees of the Supreme Court of New South Wales confirms the importance of keeping proper financial books and records in the context of insolvency.
In Substance Technologies Pty Ltd  NSWSC 612 the liquidator of a company, Substance Technologies Pty Ltd, had written to the current director of the company on several occasions requesting the company's books and records. The director failed to comply with the requests, and the liquidator sought to rely upon this failure to prove that the company was insolvent while it traded and to obtain compensation from the current and former company directors personally for loss to the company resulting from insolvent trading.
The main issue in the case was whether the company was insolvent when the debts were incurred, either by reason of the presumption of insolvency which arises where a company fails to comply with its obligations to keep financial records, or by reason of other evidence pointing to insolvency. This article will focus on the presumption of insolvency aspect of the case.
What is the presumption of insolvency in relation to financial records?
Section 588E(4) of the Corporations Act 2001 (Cth) (Act) contains a presumption of insolvency in relation to a "recovery proceeding" (as defined in section 588E(1)) commenced by a liquidator against a company. It provides that if a company has failed to keep financial records or retain financial records for the 7 year period mentioned above, the company is to be presumed to have been insolvent throughout the period.
Section 286 of the Act sets out a company’s obligation to keep financial records. It provides that a company "must keep written financial records that:
a) correctly record and explain its transactions and financial position and performance; and b) would enable true and fair financial statements to be prepared and audited."
Further, the financial records "must be retained for 7 years after the transactions covered by the records are completed." “Financial records” is defined in section 9 of the Act. It includes:
a) invoices, receipts, orders for the payment of money, bills of exchange, cheques, promissory notes and vouchers; and b) documents of prime entry; and c) working papers and other documents needed to explain:
i. the methods by which financial statements are made up; and ii. adjustments to be made in preparing financial statements.
The facts of the case
The company operated a scrap metal business. In early 2014 the company decided to buy scrap metal from Ausgrid, a state owned corporation. Ausgrid rendered five invoices to the company for scrap metal in the sum of just over $78,000. The company failed to pay these invoices, and Ausgrid commenced proceedings in the Local Court of New South Wales to recover the invoice amounts. Ausgrid succeeded, and in November 2015 it served a statutory demand on the company in relation to the judgment debt. The company did not comply with the statutory demand and in March 2016 Ausgrid applied to the Court for an order winding up the company. In June 2016 the Court ordered that the company be wound up and a liquidator was appointed to the company.
The liquidator wrote to the current director of the company on two occasions requesting the company's books and records but did not receive a specific response to the request. In October 2018 the liquidator commenced Court proceedings seeking orders for compensation from the former and current directors of the company. To establish that the company traded while insolvent, the liquidator relied upon the presumption of insolvency arising under section 588E(4) of the Act. The liquidator argued that it could be inferred from the director's failure to respond to his requests that the company had failed to keep or retain financial records.
The Court found that the company had failed to comply with its obligations to keep proper financial books and records under s 286 of the Act and therefore a presumption of insolvency arose under section 588E(4) of the Act. The evidence established in making this finding was as follows:
• The company had not lodged tax returns for Business Activity Statements since 2013;
• The company did not have any financial records for its final years of operations;
• Very few documents were tendered by the company; and
• A failure by both directors to co-operate with the liquidator's repeated requests to provide records.
The Court confirmed that the obligation to keep proper financial books and records under s 286 of the Act (and on which the presumption in s 588E(4) relies) is twofold. Firstly, the obligation to keep records which record company transactions and financial performance, and secondly the obligations to retain those records for 7 years. Also, the obligation to retain financial records applies to the underlying financial records, as opposed to any financial statements which have been prepared from those records.
In addition to the presumption of insolvency, the Court found actual insolvency based on the presence of a number of the insolvency indicia set out by Mandie J in ASIC v Plymin (No. 1) (2003) 46 ACSR 126.
Insolvent trading was established against both of the Company's directors and orders made against the former and current directors requiring them to compensate the sums of $128,901 and $15,377 respectively, including costs of the application.
The key takeaways and reminders from this decision are:
• A Company's failure to keep proper financial books and records will result in a presumption of insolvency.
• The obligation to keep proper financial books and records is twofold: keep records that record company transactions and financial performance AND retain such records for 7 years.
• The obligation to retain financial records applies to the underlying financial records, as opposed to any financial statements which have been prepared from those records.