Insolvent Trading

Introduction

An increasing problem facing many Australian companies in today’s modern society is insolvent trading.  It is therefore essential for all directors of companies to be aware of the law associated with insolvent trading.

As a preliminary, insolvent trading occurs when a company incurs debts when it is insolvent.   For what seems like such a simple statement, the law behind it is quite complex.

The Law

Insolvency and the Corporations Act

Section 95A of the Corporations Act 2001 (Cth) (“Corporations Act”) provides that a company is insolvent if it is not solvent.  A company can only be classed as solvent if it has the ability to pay its debts as and when they become due and payable.

Pursuant to section 588G of the Corporations Act, a director has a duty to prevent insolvent trading by his or her company.  That is, the director must ensure that a company does not incur debts if he/she is aware or has a reasonable belief that their company is insolvent at the time of incurring a debt, or alternatively, that the company will become insolvent as a consequence of incurring the debt.   If a director breaches this duty they are taken to have committed an offence under Section 588G(3) of the Corporations Act.

Directors and the Corporations Act

It must be noted at this juncture that the Corporations Act has a broad definition for a director being:

1. “A person who:
2. Is appointed to the position of director; or
3. Is appointed to the position of an alternate director and is acting in that capacity, regardless of the name of their position.”

It is therefore possible for an individual who is not appointed as a director of a company to be held liable for insolvent trading, for example a shadow director that has control of the company.

Consequences

There are three key consequences a director may face if it is found to be insolvently trading, being civil penalties, compensation proceedings and criminal charges.

Civil penalties

If a director is found to have be committed an offence in breach of section 588G(3) of the Corporations Act , civil penalties can arise against the directors of that company.  This can include monetary penalties of up to $200,000.00.

Compensation proceedings

In situations where a company enters liquidation and there are still debts remaining owing, compensation proceedings can be commenced against the director.  These compensation claims can be made by wholly or partly unsecured creditors, The Australian Securities and Investment Commission (ASIC) and liquidators.

There are a number of factors that must be proven and section 588M of the Corporations Act sets out a time limit of six (6) years from the beginning of the winding up for such action to be taken.

Criminal Charges

Insolvent trading is a criminal offence, and if found guilty, directors may encounter a fine of up to $220,000.00 or imprisonment for up to five (5) years.

In addition to possible criminal charges, directors who are found guilty may also face disqualification.

Defences

There are a number of defences available to directors who are facing liability for breaching Section 588G of the Corporations Act.

Under Section 588H:

“It is a defence if it is proved that, at the time when the debt was incurred, the person had reasonable grounds to expect, and did expect, that the company was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time.

Without limiting the generality of subsection (2), it is a defence if it is proved that, at the time when the debt was incurred, the person:

had reasonable grounds to believe, and did believe:

(i) that a competent and reliable person (the other person) was responsible for providing to the first-mentioned person adequate information about whether the company was solvent; and

(ii) that the other person was fulfilling that responsibility; and

expected, on the basis of information provided to the first-mentioned person by the other person, that the company was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time.

If the person was a director of the company at the time when the debt was incurred, it is a defence if it is proved that, because of illness or for some other good reason, he or she did not take part at that time in the management of the company.

It is a defence if it is proved that the person took all reasonable steps to prevent the company from incurring the debt.”

When relying on a defence, the onus is always on the director.  If a director is able to adduce evidence to support that he or she had reasons to believe that the company was solvent, it will assist their defence greatly.  Such evidence can include documentation supplied to the director by accountants and/or company advisers.

What should Directors do?

It is crucial for directors to remain informed about the day to day running of the company.  To do this, directors need to ensure that the company keeps updated financial records.  In this way, they will be able to monitor the company’s financial position in terms of income, assets and liabilities and avoid adverse situations developing later on.

If a director finds themselves in a position where the company is suffering financially and is unsure if they have traded insolvency, the first step they must take is to seek professional help and guidance.  JHK Legal are ready, willing and able to assist directors with the directors’ legal needs.

Author: Belinda Emanuel, Lawyer

Published: January 2015