Director’s Duty to prevent Insolvent Trading - A Warning in Difficult Times

In these times of financial turmoil, market weakness and credit tightening, it is perhaps timely to revisit the obligation imposed on directors of companies to prevent insolvent trading. Trading while insolvent is a serious breach of the Corporations Act, and it is a concept which directors must be fully aware of should their company come under financial pressure.

• Director's duty to prevent insolvent trading
  • Section 588G of the Corporations Act deals with the liability of directors for insolvent trading by their company.
  • Section 588G applies where:
    • a person is a director of a company when the company incurs a debt;
    • the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and
    • at that time, there are reasonable grounds for suspecting that the company is insolvent or would so become insolvent, as the case may be.
  • If the conditions described above are met, the director will contravene section 588G if:
    • the director fails to prevent the company from incurring the relevant debt; and
    • either:
      • the director is aware at the time the debt was incurred of the existence of the reasonable grounds for suspecting insolvency; or
      • a reasonable person in a like position in a company in the company's circumstances would be aware.
• What is insolvency?
  • The Corporations Act defines solvency as an ability of a person to pay all the person's debts as and when they fall due.
  • Accordingly, a company will be regarded as insolvent for the pruposes of section 588G of the Corporations Act if it is unable to pay all its debts as and when they become due and payable.
  • Where a company has incurred several debts at the same time, none of which on their own are sufficient to push the company into the state of not being able to pay its debts as they fall due, it will be sufficient for the purpose of section 588G if the totality of the debts have this effect.
  • The issue of insolvency is a question of fact, to be decided as a matter of commercial reality in light of all the circumstances and focuses on longer term rather than temporary liquidity problems of a company. For example, under Australian case law, proof that a creditor's debt has not been paid, standing alone, may not be sufficient of itself to establish insolvency.
  • Consequently, an assessment of a company's solvency requires more than just an examination of the company's financial statements – it should involve an evaluation of the company's ability to pay its debts as and when they fall due.
  • The test requires ascertainment of the company's existing debts, its debts within the near future, the date each will be due for payment, the company's present and expected cash resources, and the date each item will be received.
  • This involves a consideration of the following three issues:
    • Which debts are to be taken into account?
      

      Those debts currently due and those which will become due in the near future are the ones to be taken into account.

      However, prospective debts and contingent debts may have to be considered, depending upon the size and imminence of the contingent or prospective liability.

    • When are debts due?
      

      Depending on the circumstances, a court may consider the terms actually extended to the company rather than those to which it was legally entitled. As a result, a debt may not be due on the date originally stipulated if there is a relevant course of dealing amounting to a long-standing arrangement, so that the parties do not expect it to be payable until a later time.

    • What assets should be taken into account?
      

      A company is insolvent if it cannot pay its debts utilising such cash resources as the company has or can command through the use of its assets. The company's available assets are therefore not restricted to cash resources immediately available, but extend to money's procurable by realisation or mortgage or pledge of assets within a relatively short time. Available resources would also include the amount that the company could borrow on the security of its property generally.

      Obviously, the degree to which assets of the company may be realised will be an important consideration in determining the importance of this factor to the company's solvency.

      In considering the availability of credit to the company for the purposes of assessing solvency, the continuing nature of that credit needs to be considered. Similarly, the time allowed to the company to pay its credit providers, on the one hand, and the times within which it will receive payment of debts owing to it on the other hand, must also be considered.

• The director's state of mind
  • There will be no contravention of section 588G unless:
    • the director was aware at the time of the debt being incurred that there were reasonable grounds for suspecting insolvency; or
    • a reasonable person in a like position in a company in the company's circumstances would have been so aware.
  • The first alternative is a subjective test and is concerned not with the knowledge of a reasonable person, but the inferences to be drawn from the situation as it affects the particular director whose knowledge is in issue. The second alternative appears to be an objective test, with the addition of the phrase 'in a like position', enabling the court to take into consideration any special expertise held by individual directors and the distribution of functions within the corporation.
• Reasonable grounds for suspecting insolvency
  • Before section 588G can apply to a director there must, at the time the debt was incurred, have been reasonable grounds for suspecting that the company was insolvent or that it would become insolvent upon the debt being incurred. This involves an examination of the company's circumstances known at the time to see whether a reasonable person in the director's position would have suspected that the company was insolvent.
  • The term 'reasonable grounds' refers to grounds that should be judged 'reasonable' according to the standards of a director of ordinary competence, one who is expected to be capable of reaching a reasonably informed position about the financial capacity of the company.
  • The concept of 'reason to suspect' insolvency would appear to mean more than a mere idle wondering whether it exists or not. It is a positive feeling of actual apprehension or mistrust, amounting to 'a slight opinion, but without sufficient evidence'.
• Consequences of contravention
  • A director who is in breach of the insolvent trading provisions may be personally liable for company debts incurred after the company becomes insolvent or the incurring of which pushes the company into insolvency.
  • Where the Court is satisfied that a director has committed a contravention of section 588G, the Court may:
    • make a pecuniary penalty order of up to $200,000;
    • make an order disqualifying the director from managing corporations for a specified period of time; or
    • order compensation equal to the amount of loss or damage suffered by a creditor.
  • Criminal sanctions may also be imposed where a director suspects that the company was insolvent, permits the debt to be incurred and the director's failure to prevent the company incurring the debt was dishonest.
• Defences
  • The Corporations Act does provide some defences to proceedings against a director for contravention of section 588G (other than criminal proceedings where liability depends upon dishonesty).
  • These defences are:
    • expectation of solvency on reasonable grounds
      

      To establish this defence the director must prove that, before the time of incurring the relevant debt, the director had reasonable grounds to expect and did expect that the company would be solvent and remain solvent after the time of incurring the debt.

      Reasonable expectation of solvency can only be established if the directors can show that they applied their minds to the overall position of the company and took a diligent and intelligent interest in the information about the company available to them or which they could obtain by active enquiry.

    • reasonable reliance on information provided by a competent and reliable person
      

      In order to rely on this defence a director would have to prove that he or she:

      • had reasonable grounds to believe, and did believe, that a competent and reliable person was responsible for providing to the director adequate information about whether the company was solvent;
      • had reasonable grounds to believe that that person was fulfilling that responsibility; and
      • expected, on the basis of information provided by that person, that the company was solvent at the time of incurring the debt and would remain solvent even if it incurred the debt and any others incurred at the same time.
    • justifiable non-participation
      

      This defence is available to a director who was, because of illness or for some other good reason, not involved in the daily affairs or management of the company.

      Exactly what will constitute a 'good reason' remains, as yet, unexplored by the courts. However, it is likely to include situations where the director took no part in the decision which led to the debt being incurred because of a conflict or a material personal interest, or where the director goes overseas and asks for another director to be appointed in their place.

      This defence is unlikely to be available to inactive directors who by reason of their inactivity claim that debts incurred while the company was insolvent were incurred without their authority.

    • taking all reasonable steps
      

      To establish this defence a director must prove that he or she took all reasonable steps to prevent the company from incurring the debt.

      Section 588H(5) provides guidance as to what will be viewed as taking 'all reasonable steps' to ensure that the company did not incur the debt.

      The Court will take into account any action the director may have taken to appoint an administrator. Whether this action will be construed by the Court as reasonable will depend upon when this action was taken and its subsequent result.

      In order to rely upon this defence directors must show that they did more than simply voice their concern or dissent at board meetings. They must point to some positive action which they took to prevent the company incurring the relevant debt(s).

If you would like any further information in relation to this article, please do not hesitate to contact Kevin Elkington of EKM Legal via email: kevin.elkington@ekmlegal.com or phone: 03 9829 0999.