Insolvent trading

Section 588G of the Corporations Act 2001 (Cth) (Act) imposes a positive duty upon directors to prevent insolvent trading. But what defines ‘insolvent trading’? How can a director tell if the company is insolvent or not? And what can directors do to avoid personal liability?

When is a company insolvent?

Insolvent trading occurs when a company is unable to pay its debts as and when they fall due and continues to incur further debt. A director must ensure that a company is solvent prior to incurring additional debt.

If a director breaches his or her statutory duty under the Act, the director risks being held personally liable to pay compensation for the unpaid debts if the company later goes into liquidation.

ASIC’s regulatory guide 217 ‘Duty to prevent insolvent trading: Guide for directors’ is a useful resource to help directors understand their duty to prevent insolvent trading. It also lists matters which should be taken into account by directors when considering the solvency (or otherwise) of the company.

Key principles

The relevant provisions of the Act regulating insolvent trading are contained in sections 588G-Z and apply to all company directors. Be aware that the definition of ‘director’ under the Act includes shadow and de facto directors or any alternate director that is appointed and acts in that capacity.

In summary, a director will likely have breached the Act if:

• He or she is a director at the time the company incurs a debt
• The company is insolvent at that time or becomes insolvent by incurring that debt or other debts at that time
• There are reasonable grounds for expecting that the company is, or will become, insolvent
• The director is aware, or ought reasonably to be aware, that there are grounds for expecting insolvency in the company’s circumstances
• The director fails to prevent the company from incurring the debt.

What must directors do?

According to ASIC, directors should:

• Remain informed: Monitor profit and cash flow budgets, review financial statements, review the company’s level of lending facilities and keep an eye on creditor payments and arrangements
• Investigate financial difficulties: Make reasonable enquiries to keep themselves informed of the company’s financial position and investigate when the company is in distress
• Obtain advice: Ensure that their advisors and employees have the requisite level of skill and expertise so they can to rely on their advice and ask sufficient questions of advisors, such as chief financial officers and accountants, to remain well informed
• Act in a timely manner: Delay in acting when you suspect insolvency can be fatal to the company and expose you to personal liability
• Apply the ‘cash flow’ test: Determine the company’s anticipated current and future cash flows are sufficient to enable current and future liabilities to be paid as and when they fall due for payment
• Apply the ‘balance sheet’ test: Look at the company’s finances as a whole. For example, the company’s ability to raise finance in a timely manner, or whether surplus assets can be sold in a short time period to help the company trade on

Potential defences

Section 588H contains four available defences for a director who has breached s 588G:

• Reasonable grounds to expect solvency (s 588H(2));
• Reasonable reliance on information provided by others (s 588H(3));
• Absence from management (s 588H(4));
• Reasonable steps to prevent incurring of debt (s 588H(5)).

Directors bear the onus of proving the defences under the Act.

Insolvent trading consequences (s 588G)

A director may face civil and criminal sanctions if he or she is found to have breached s 588G of the Act, including a fine of up to $200,000 and/or imprisonment for up to five years (or both) and disqualification as a company director, particularly if an element of dishonesty was involved.

In addition, under s 588M of the Act, the liquidator may bring proceedings against the director to recover as compensation the amount of debts incurred, to be distributed to the creditors. An individual creditor may also bring a claim against the director personally for the sum of that creditor’s individual claim.

To avoid personal liability, directors should be careful to ensure they remain informed at all times and seek advice on a regular basis.