22: Insolvency and Financial DistressWhy do businesses declare themselves to be insolvent? Financial distress does not automatically
mean insolvency. A company may try to work out a deal with its creditors by negotiating out of court,
rather than undertaking the legal process to become insolvent.
Potential insolvency, however, gives the debtor company a major bargaining advantage. Before
insolvency, creditors may threaten litigation or aggressive collection actions. A declaration of insolvency
means the debtor does not have to respond to these immediate threats. Without the threat of imminent
litigation or collection, the debtor may be in a better position to bargain with its creditors and to
restructure its operations.1 What is the difference between financial distress and insolvency?2 Does a company cease to exist when it declares itself to be insolvent?CONCEPT REVIEW QUESTIONS 22-1
Thus, while insolvency is not a dominant force in the overall economy, it often plays a
significant role for companies facing financial failure. An open question is whether reorganisations
from financial distress can be considered successful. Answering that question requires an
understanding of the basic principles of insolvency and how a company may employ them when
it faces failure.22-2 INSOLVENCY PROCESSES
The Australian Securities and Investments Commission (ASIC) has published a number
of useful documents providing clear descriptions of the insolvency process in Australia.
We borrow extensively from its documents, especially Information Sheet 74 Voluntary
Administration: A Guide for Creditors; Information Sheet 45 Liquidation: A Guide for Creditors;
Information Sheet 54 Receivership: A Guide for Creditors; and Information Sheet 85 Approving
Fees: A Guide for Creditors. There are also information sheets for employees, shareholders and
directors. The links to these documents may be found at http://www.asic.gov.au/regulatory-
resources/insolvency/.
Figure 22.1 gives a schematic view of the voluntary administration process in Australia.
Voluntary administration is designed to resolve a company’s future direction quickly once financial
distress is confirmed and the likelihood of insolvency is considered high. An independent and suitably
qualified person (the voluntary administrator) takes full control of the company to try to work out a way
to save either the company or its business.
If it is not possible to save the company or its business, then the aim is to administer the affairs of the
company so that there is a better return to creditors than they would have received if the company had
instead been placed straight into liquidation.
A voluntary administrator is usually appointed by a company’s directors, after they decide that the
company is insolvent or likely to become insolvent. Less commonly, a voluntary administrator may be
appointed by a liquidator, provisional liquidator or a secured creditor.LO 22.2
administrator
A person appointed to manage
the process of resolving a
company’s future in place of
the directors and management
of the company