| Insolvent Trading - News Article 07/11/08
Directors of companies have a number of duties and responsibilities under the Corporations Act 2001 (the Act). One such duty, which has perhaps become more relevant during this time of economic turmoil, is the director’s duty to prevent insolvent trading.
Duty to Prevent Insolvent Trading
The Act imposes a duty on directors to prevent insolvent trading from occurring. This means that where a company incurs a debt and there are reasonable grounds for a director of that company to believe that the company was insolvent when it incurred that debt, that director may have breached their duty under the Act. The director need not necessarily have been aware of the company’s insolvency – it is sufficient that a reasonable person in a similar position within the company would have been aware of the insolvency. This therefore imposes a significant burden on directors to make sure that they are at all times fully informed of the financial wellbeing of the company. This applies equally to executive and non-executive directors and it is not a defence to say that a particular director didn’t have control of the books, was not involved in day to day decision making, or did not attend directors’ meetings.
To assess whether a company is insolvent, the courts will review all the circumstances of a company. This will involve not just an examination of financial records, but also an analysis of the company’s ability to pay its debts as and when they fall due. Therefore it is not sufficient for a company to be able to prove that they have certain capital and assets at their disposal, as they will also need to prove that these can be used to pay off upcoming debts. Cash flow is all important.
The penalties for not preventing a company from trading while insolvent can be heavy. In particular, a director may be personally liable for any debts incurred by the company after it becomes insolvent. Further, a director can be fined up to $200,000 or they can be ordered to pay compensation to the creditor. Further, in some cases if a director is involved in 2 or more failed companies in a period of 7 years, ASIC can disqualify them from being involved in the management of a company for up to 5 years.
Just because a company is insolvent when a debt is incurred, this does not necessarily mean that a director will be found to have breached the Act. There are various defences that may be available to a director.
The director’s state of mind must be considered, and this can be done in two ways.
- If a director can show that they did not know that the company was insolvent when the debt was incurred, then that director may not have committed an offence against the Act.
- Alternatively, if it can be shown that a reasonable person in a similar position in the company to the director could not have known about the company’s insolvency, then the accused director may not be guilty of breaching the Act. The reasons for this are that the director has a responsibility to know whether the company is solvent or not and therefore if the director can show that there was no way to know of the insolvency, then this may be sufficient to prove that they have complied with the statutory duty.
Therefore if a director can prove that not only did they not know about the insolvency but also that there was no way for them to know, then they may have a valid defence. Further, if the director can show that they took all reasonable steps available to him or her to prevent the debt from being incurred, then this may be a valid defence.
In this current economic climate where companies may be finding it increasingly difficult to pay debts, directors should be even more vigilant in monitoring a company’s financial position. If a director is concerned that the company may be insolvent, then they may need to consider ceasing all trading activity so that no further debts are incurred, at least until the company’s solvency can be confirmed. There are other options that can be explored as well including placing a company into voluntary administration to deal with creditors or potentially, look to winding up the insolvent company.