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Insolvent Trading - Directors be Aware

17 November 2008

The current global financial crisis has put many directors in a difficult position. The crisis has created uncertainty about cash flow and funding, this in turn has increased many company directors' exposure to the risk of insolvent trading.

What is Insolvency?

In order to examine insolvent trading, it is first important to understand what it is to be ‘insolvent.’

Put simply, a company is insolvent if it is unable to pay all of its debts as and when they become due and payable. This has generally been viewed as importing a cash flow test rather than a balance sheet or net assets test. This means that before you incur a new debt you must consider whether you have reasonable grounds to suspect that your company is insolvent or will become insolvent as a result of incurring the debt.

What is Insolvent Trading?

A director will engage in insolvent trading in breach of section 588G of the Corporations Act 2001 (Cth) (the Act), if the company incurs a debt and:

• The company is insolvent at the time of incurring the debt or becomes insolvent by incurring the debt;
  
  
• At the time the debt is incurred, there are reasonable grounds for suspecting that the company is insolvent or will become insolvent;
  
  
• The director is aware of such grounds or a reasonable person in a like position in a company in the circumstances of the company would be so aware; and
  
  
• The director fails to prevent the company from incurring the debt.

It is important to note that where a director incurs credit knowing that funds will not likely be available to pay the debt when it becomes due or shortly thereafter, such conduct will constitute insolvent trading.

Consequences of Insolvent Trading

There are three (3) primary consequences for directors that breach the insolvent trading provisions of the Act:

1. Civil Penalty – A breach may attract a pecuniary penalty for the director personally of up to $200,000. In addition, ASIC may apply for the disqualification of a director from taking part in the management of companies.
   
   
2. Compensation – If the relevant company is wound up, proceedings may be brought against a director personally to pay compensation to the company in an amount equal to the debts incurred in contravention of the section. A compensation claim may be brought against directors by a liquidator, a creditor (with the consent of the liquidator) or ASIC.
   
   
3. Criminal Liability – In some cases, where there is actual suspicion of insolvency and the failure to prevent the incurring of the debt is dishonest, criminal liability may apply with a fine of up to $200,000 or imprisonment for up to five (5) years, or both.

Summary

If a director continues to trade while insolvent, there is a serious risk of personal liability if the company ultimately goes into liquidation. The only absolutely safe course of conduct is not to incur further credit. If in doubt, the company should seriously consider entering Voluntary Administration.

There are a number of defences available to directors against an insolvent trading action. If you require any further information on these defences, or have general questions in relation to insolvent trading, please contact Tal Williams on (02) 9458 7241 or John Quinlan on (02) 9458 7034.