Avoid the pitfalls that could lead to insolvency

Despite its economic toll, COVID-19 has not yet led to an uptick in insolvent companies entering external administration or individuals declaring bankruptcy. In fact, the reverse is true. However, with JobKeeper ending and other temporary protections continuing to wind down, economists are predicting thousands of business failures and personal bankruptcies. For directors, it’s an important time to be aware of the increased risk of both business failures and personal insolvencies and take steps to protect their own companies from being dragged down by others.

The Australian Financial Security Authority (AFSA) administers the personal insolvency system and the Personal Property Securities Register. Company directors will know of the restrictions on managing a corporation while they are personally bankrupt. But there are other aspects of the systems administered by AFSA that directors should be aware of.

AFSA records indicate up to a four-year lag between previous economic crises and peak numbers of people entering the personal insolvency system, a potential sign that the economic effects of COVID-19 may be with us for some time yet.

Know who you are dealing with

Many companies are unaware of the insolvency risk in their customer base. In Australia, 40% of personal bankruptcies are business related. Of these, 70% are people operating as sole traders or in partnerships.

With the pandemic having the potential to undermine even the most previously stable companies, it’s important for directors to understand who their business is dealing with and whether they are subject to any formal insolvency process. That means going beyond a standard credit check. The Bankruptcy Register Search makes it easy for finance teams to access personal insolvency information about individuals directly from the National Personal Insolvency Index, which provides up to date information about whether a person is bankrupt or subject to a personal insolvency agreement or a debt agreement.

Such background checks are recommended as standard for major customers (old and new) and before new directors are appointed. 

Secure your balance sheet

It’s also important for directors to think about and understand the risk involved in extending trade credit. A recent finding of a review into business-related personal bankruptcies highlighted that trade credit exposure was at similar levels to bank debt. In the 2020 September quarter, people in businesses who entered into a personal insolvency owed 32% of their debts to a business, sole trader or individual. In contrast, 35% of their debts were to banks.

The fact that trade credit debt is almost as high as bank debt is significant for directors. Unlike bank debt, trade credit is rarely secured, leaving balance sheets unprotected.

Despite its name, trade credit isn’t just an issue for tradies. Any business that provide goods or services on credit needs to consider securing its trade credit risk. Sectors with the highest trade credit exposure risk include:

• commercial leasing and real estate
• equipment rental and leasing
• transport
• accounting
• legal services
• internet, communications and marketing.

Directors should consider the merits of using the Government’s Personal Property Securities Register (PPSR) to get ahead of the pack should customers become insolvent. An effective registration against a customer’s property on the PPSR can mean a business will have a legal right to proceeds of the collateral, or get their goods back, if their customer can’t pay or goes out of business. In many cases, with a PPSR registration in their back pocket, a small business may even find themselves ahead of the banks in the repayment queue.

With a PPSR registration only costing $6 per customer, which can cover future supplies of similar goods for up to 7 years, it’s a small investment in protecting a company’s balance sheet in these uncertain trading times. Importantly, PPSR registrations can also be used to unlock collateral in the company to access secured finance.

Be a responsible creditor

As protections recede, customers may experience temporary financial hardship. AFSA encourages creditors to first seek arrangements outside of formal insolvency processes. Individually negotiated formal payment arrangements between creditors and debtors are often to everyone’s advantage. Creditors have a better chance of receiving payment in full than if the customer declares insolvency; customers avoid the stigma of bankruptcy. Also, when informal payment arrangements work out, and customers bounce back, their long-term loyalty is likely to follow.

If a company becomes a creditor in a bankrupt estate, AFSA encourages them to get involved in the insolvency process to help ensure the returns received are optimised. The insolvency system works best if everyone involved engages, to promote fair and efficient operation.

As a creditor, it’s particularly important to engage in setting reasonable practitioner remuneration.

That means reviewing all the correspondence and using voting powers to support other creditors during insolvency meetings. If the remuneration being claimed appears to be unreasonable, concerns should be raised with the registered trustee. If directors have any concerns about the conduct of a bankruptcy trustee, they should speak up. AFSA can be notified of any issues at regulation@afsa.gov.au

Assess and mitigate insolvency risk

With the financial impact of COVID-19 still not clear, there’s never been a more important time for directors to assess insolvency risk in their customer base, proactively protect balance sheets and understand their power as creditors.