Directors often ask about "Insolvent Trading" or "Trading While Insolvent" provisions. The simple explanation is that if a company is insolvent and the directors continue to incur new liabilities, then the directors can be personally liable for the new debts.
A range of options is available to directors who suspect insolvency, but most importantly you need to act if you suspect your company is insolvent.
Figuring out if your company is insolvent is critical because there are many legal consequences that can follow if you get it wrong.
The Corporations Act tells us that the overriding question a director must answer is: Is the company able to pay all of its debts as and when they become due and payable?
What do I do If my Company is insolvent?
- Act now to avoid insolvent trading penalties.
- Consider if your company can be restructured or if it needs to be liquidated. Try our online test Ask IRA - Test 2 on the right side of this page.
The Insolvent Trading - The Law
Section 588G of the Corporations Act 2001 makes directors responsible for ensuring that their company does not trade while insolvent. This is in addition to their general duties to act with care and diligence, in good faith, in the best interests of the company and not to improperly use their position or information received for personal gain. To fulfil these duties and responsibilities, directors must closely monitor their organisation's financial situation, question and challenge management and act when they suspect problems are occurring.
Insolvent trading leaves a director open to civil and possibly criminal penalties as well as opening the door to being personally liable. The onus is on directors to ensure they regularly receive all necessary financial and management information, read it, seek professional advice when issues arise, and keep adequate records and be active at board meetings.
Legal Definition of Solvency
"Solvency" is defined in section 95A(1) as the ability to pay all debts as and when they become due and payable. A person or company which is not solvent is insolvent (s95A(2)). The courts generally take into consideration cash flows, balance sheets and the overall situation of the company when determining insolvency. The definition of "debt" includes dividends, share buy backs, capital reductions and issuing redeemable preference shares. "Directors" are defined as those formally appointed plus de facto and shadow directors and those managing while disqualified. Note that section 588G only applies to directors and not to management.
Although solvency appears to be a simple issue it is a very complicated area of the law with many legal cases addressing the issue. We have developed a simple test to help you answer the question Is my company insolvent?
Breaches of Insolvent Trading Laws
The Corporations Act says that a breach of Insolvent Trading laws occurs when a person is a director and:
- the company is insolvent when it takes on a debt or becomes insolvent as a result of taking on a debt;
- there are reasonable grounds for suspecting insolvency or the potential for insolvency;
- the directors were aware of, or a reasonable person in a similar position, would have been aware of the insolvency or potential insolvency; and
- the director's failure to prevent the company acquiring a debt is dishonest.
Directors of a parent company should also be wary of an insolvent subsidiary. A holding company will be liable for debts incurred by insolvent subsidiaries where the directors of the holding company think there are reasonable grounds for suspecting insolvency or the potential for insolvency as a result of taking on a debt. The onus of proof is on the person trying to make a director liable.
Defences to insolvent trading actions
As a director you don't really want to have to worry about the legal defences to an Insolvent Trading action. If you are in doubt, it is far better to seek expert advice and avoid the possibility of an action being commenced. However, the law does understand that at times a director should not be held accountable even if a company did trade while insolvent.
The Corporations Act allows for the following defences to be made by a director:
- There were reasonable grounds to expect solvency;
- It was reasonable to rely on information from a competent and reliable manager;
- The director was not involved in management because of illness or for some other good reason;
- All reasonable steps were taken to prevent the company incurring the debt.
A director can't use these defences in criminal proceedings that are based on dishonesty.
Insolvent Trading Penalties
The main idea of Insolvent Trading laws is to make directors personally liable for debts incurred after a company was insolvent. That is because those creditors who provided credit to the company will have suffered a loss as a result of the directors allowing the company to trade while insolvent. So the Corporations Law says that the liability for debts after a company becomes insolvent lies with those who were directors at the time the debt was incurred.
The Liquidator, a creditor or even ASIC may bring civil penalties against directors. ASIC can also seek orders against a director:
- disqualification them from managing a company;
- fining them up to $200,000;
- to pay compensation to the company equivalent to the loss suffered by creditors.
The Department of Public Prosecutions can even bring criminal proceedings for insolvent trading if fraud or dishonesty is involved.
It is clearly better not to be pondering these possibilities so if you are in doubt about the solvency of your company you should CALL US NOW and discuss the problem with one of our advisors.
