Directors duties – Insolvent Trading

Posted by: Administrator SellersMuldoonBenton | Date: July 14, 2014 | Tags: , ,

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As well as other directors’ duties, company directors have a positive duty to prevent insolvent trading.

This means that directors are required to prevent a company from incurring a debt:

  • If the company is already insolvent at the time the debt was incurred; or
  • Would become insolvent as a result of incurring that debt (or a range of debts of which that debt forms part); and
  • At the time there would be reasonable grounds for a reasonable person to suspect the insolvency of the company either prior to or due to the debt being incurred.

A Director’s duty to prevent insolvent trading is governed by Section 588G of the Corporations Act 2001 and any claim against a director for insolvent trading must be determined by the Court.

The Courts have said that the statutory purpose of Section 588G (Directors’ duty to prevent insolvent trading) is to discourage and provide a remedy for a particular type of commercial dishonesty or irresponsibility.

A director’s primary duty is to shareholders however the duty extends to creditors when the company is or becomes insolvent.

This duty applies not only to appointed directors but also those persons who, although not formally appointed, may act in the role of director or pursuant to whose instructions and wishes the company’s directors act.

When is a Company Insolvent?

A company is insolvent when it cannot pay its debts as and when they fall due.

This should be determined by actual circumstances and involves conducting a cash flow test. Directors need to ask “will the company’s anticipated current and future cash flows be sufficient to enable current and future liabilities to be paid as and when they fall due for payment”.

It may also be appropriate to apply the balance sheet test to assess the company’s financial position as a whole.  As part of a balance sheet test, directors should, in particular, note:-

  • The company’s ability to collect debts owing to it;
  • Whether arrangements have been negotiated with creditors to defer payment of outstanding debts;
  • Whether the liquid assets or working capital of the company is sufficient to pay current liabilities when they fall due;
  • Whether additional funds can be raised in a timely manner (eg: by issuing additional shareholdings, or by increasing future borrowings); and
  • Any surplus assets available that can be sold to help pay debts without damaging the company’s ability to continue to trade and pay its on-going debts as and when they fall due.

Directors need to take into account all relevant information about the company’s financial position when considering solvency issues and if there are any concerns they should consider seeking appropriate advice.    It is not enough for the director to merely receive the relevant advice, but they must then consider and act appropriately in a timely manner.

What are the Penalties for Insolvent Trading?

Penalties for Insolvent Trading can include:

  • Civil penalties up to $200K, and/or
  • Compensation proceedings that could lead to bankruptcy; and/or
  • Criminal Charges leading to fines of up to $200K and/or imprisonment of up to five years. (NB for a criminal charge to apply, the director’s failure to prevent the company incurring debt whilst insolvent must have been dishonest).

The Court may also disqualify the director from managing a corporation for a period of time.

How can Directors Prevent Insolvent Trading?

In order to avoid Insolvent Trading, directors need to understand the financial position of the company at all times.  This includes being properly informed about the financial circumstances of the company and ensuring that it does not trade whilst insolvent.  This can be done by taking the following measures:-

  • Being involved with or supervising the preparation of management accounts and budgets and the on-going comparison of same;
  • Reviewing the collectability of debtors;
  • Understanding when creditors are due to be paid; and
  • Being familiar with the extent of lending facilities and the ability to access additional funding if required.

An understanding of the financial position of the company only at the time year-end reports are signed is insufficient.   It is more appropriate to be considering same on at least a monthly basis.

It is a requirement for a company to keep adequate financial records.  If these records are not appropriately maintained the company will generally be presumed to have been insolvent throughout the period where it can be shown to have failed to keep adequate financial records.

There is no “one size fits all” approach here, instead the appropriate steps taken by a director to comply with their duty to prevent insolvent trading will partially depend on:-

  • The size and complexity of Company’s business; and
  • The skills and experience of Company Management and Staff.

Directors can rely on an external adviser in relation to a company’s solvency, however in order to comply with their duties, directors must ensure that:-

  • Those people relied upon have the necessary level of knowledge, skill and experience given the company’s business circumstances;
  • Appropriate systems are operating effectively to provide the requisite information to the director;
  • Directors make the proper inquiries to remain informed about the financial position of the company; and
  • If directors are repeatedly not receiving the information how or when they have requested it, they need to revise the systems they have in place (including potentially replacing the external adviser).

Defences Available to Directors

There are a number of defences upon which a director against whom an insolvent trading claim has been made can rely, including:-

  • Reasonable expectation of solvency.
  • Reliance on a suitably qualified and competent person who had provided the director with advice that the company was solvent and would remain so with the incurring of relevant debts.
  • Not being involved in the management of the company during the relevant time due to illness or some other good reason.
  • The taking of all reasonable steps to prevent the debts being incurred by the company (including any action taken to appoint an administrator to the company where appropriate).

It is important to note, however that the above defences do not apply for a criminal insolvent trading claim.

If you have queries with respect to Insolvent Trading or External Administrations in general, please do not hesitate to contact me on aruhe@smbvic.com.au

This article is intended to provide general information only in summary format on relevant issues. It does not constitute legal or financial advice, and should not be relied on as such.