What Directors need to know about corporate group solvency risks
In brief
Directors in corporate groups can take greater comfort when relying on financial support from related entities, following a recent Full Court of the Federal Court decision.1
Last year, doubt was cast on the adequacy of financial support that is not fully documented or binding to establish the solvency of a related company. This decision has reset that position in favour of such arrangements potentially being sufficient, provided actual support is given.
Key takeaway
Directors of companies within a corporate group must ensure that, on a company-by-company basis, each company to which they are appointed is solvent. Solvency is not purely assessed at a group level.
Subsidiaries in that situation regularly rely on informal or non-binding arrangements. This reliance may include consistent intra-group funding (without more formality), and non-binding letters of comfort backed by actual payment.
Directors should note in absence of formal, binding, inter-company support arrangements, having a system in place to pay debts on an as-needed basis may constitute effective financial support to show solvency. However directors will need to have the confidence that they can in fact rely on such a system in respect of debts that are knowingly and voluntarily incurred.
In more detail
Project Sea Dragon Pty Ltd (Subject to a Deed of Company Arrangement) (Project Sea Dragon) was a special purpose vehicle set up to develop a prawn aquaculture business. The project was in its construction phase, was not generating income, had no substantial assets of its own, and had no financing facilities. It received financial assistance from its parent company to meet its obligations on an as-needed basis. Project Sea Dragon’s indebtedness over time steadily increased.
Canstruct performed construction work for the project. A dispute arose over the amounts owed by Project Sea Dragon to Canstruct which was resolved against Project Sea Dragon. At this point its parent company, not wishing to pay amounts that it had otherwise in part budgeted for, withdrew its financial support. The directors of Project Sea Dragon appointed administrators. Canstruct challenged the Deed of Company Arrangement that resulted.
One issue in the case was whether the parent company’s support was enough to establish solvency to the date it was withdrawn. The trial judge had determined, notwithstanding actual support, Project Sea Dragon had always been insolvent. With no legal certainty of funding, coupled with amounts advanced being repayable on demand, it was not solvent. That particular conclusion has now been reversed, the evidence being, that as a matter of commercial reality the internal group loan would not have been called upon.
Further, it was reaffirmed that the later confirmation of a liability that had been disputed should not retrospectively qualify the solvency of a company, when it has the actual financial support of a related corporate entity for known debts. Subsidiaries need to have financial support for debts that are knowingly and voluntarily incurred.
The course of this case before the courts otherwise highlights the scope for legal uncertainty as to matters of solvency where a company has a contractual dispute over its liabilities. Courts have the benefit of 20/20 hindsight when assessing solvency. As ever, directors faced with such risks would be prudent to consider whether to seek advice about managing solvency risks by reference to the insolvent trading safe harbour.
1 Canstruct Pty Ltd v Project Sea Dragon Pty Ltd (Subject to a Deed of Company Arrangement) [2024] FCA 112
