Trading while insolvent occurs when a company has met the threshold for insolvency and is continuing to trade. Directors can become personally liable for debts incurred by the company, or face worse consequences. Keep reading this Legal Kitz blog to learn more about the risk of insolvent trading.
What is trading insolvent?
“Solvency” is defined in section 95A(1) of the Corporations Act 2001 as the ability to pay all debts as and when they become due and payable. “Debts” include dividends, share buy-backs, capital reductions and issuing redeemable preference shares. If an entity is not solvent, it is considered insolvent (s95A(2)).
Directors have a duty pursuant to section 588G of the Act to prevent their company from trading while insolvent. A director will breach a duty if they cause the company to incur a debt in the circumstances where the director knows, or ought to know, that the company is insolvent, or likely to become insult from that transaction.
Assessing a company’s solvency
In assessing a company’s solvency, section 95A of the Act has been found to “enshrine the cash flow test of insolvency” which focuses on the liquidity and viability of the business, according to His Honour Dodds-Streeton J in Crema Pty Ltd v Land Mark Property Developments Pty Ltd (2006). Generally, if assets listed on a balance sheet cannot be liquidated to pay debts, then this may indicate insolvency.
The assessment of a company’s solvency requires an analysis of the totality of the company’s circumstances, including industry norms and available credit. The Australian Securities & Investments Commission (ASIC) has published a regulatory guide on the warning signs of insolvency for directors, which can be a helpful resource for businesses.
Director’s duty to prevent insolvent trading
Directors have a legal obligation to prevent their company from trading while insolvent. The duty applies when there are reasonable grounds of suspecting that the company is, or is becoming insolvent. There is a potential breach of this obligation if:
- the individual was a director at the time the company incurred the relevant debt;
- the company is insolvent at the time of incurring debt, or becomes insolvent due to additional debt;
- the individual has reasonable grounds to believe the company is insolvent, or likely will be become insolvent;
- the director is reasonably aware that these grounds exist; and
- the director fails to take any steps to prevent the company from incurring debt.
Reasonable grounds include, but are not limited to:
- when the company liabilities exceed the company assets;
- where there are cash flow shortages;
- when there are assets can’t be liquidated;
- when there are overdue taxes and superannuation liabilities;
- where there are legal demands for unpaid debts;
- where there are debt collection issues; and/or
- where there are declined debt facilities.
What must a director do?
If there are reasonable grounds to believe insolvency, to avoid liability a director must:
- Act with due care and diligence by taking proper care to manage business affairs and act honestly with the company’s best interest.
- Remain informed with the company’s financial affairs to make informed decisions on how to proceed with trading activities.
- Investigate financial difficulties.
- Obtain advice from advisors such as chief financial officers and accountants.
- Apply the ‘cash flow’ test to determine the company’s financial position.
- Ensure that the company stops trading if there is reason to believe the company may be insolvent.
How a liquidator proves insolvency
Where a director’s company enters liquidation, a liquidator may commence court proceedings against the director for allowing the company to incur debts when they reasonably suspected that the company was trading insolvent.
Proving the date of insolvency
An insolvency practitioner will review the available books and records of a company, including those obtained from third party sources like creditors, banks and statutory authorities, to determine the date of insolvency. Section 588E(3) of the Act provides that where there is proof that a company become insolvent within 12 months prior to the company being wound up, it is presumed they were insolvent throughout that entire period.
Evidence of this date can include:
- Overdue trade creditors;
- Overdue tax liabilities;
- Recovery action being initiated by creditors;
- No access to alternate finance; and
- Payment of debts by way of instalments.
If the company has not maintained adequate books and records in compliance with section 286 of the Act, section 588E(4) of the Act imparts a presumption of insolvency for the period of inadequate bookkeeping
Debts incurred
Using the date of insolvency, the liquidator will then assess the debts incurred after that date, to find the personal liability of a director for trading insolvent. Then, the liquidator may make a claim for trading while insolvent.
Claim for trading insolvent
Prosecution of insolvent trading
Where a liquidator has found a company to have been trading insolvent, they may report this with ASIC in accordance with either sections 422, 438D or 533 of the Act.
They may also take steps to seek compensation for the debts incurred by the company after it became insolvent. This usually involves a letter of demand to the director(s) for repayment of a fixed sum of money. They may then instruct a solicitor to further pursue the claim where initial demand is ignored or unsuccessful.
Defences to insolvent trading
Section 588H of the Act provides four available insolvent trading defences for a director who has breached s 588G of the Act:
- Reasonable grounds to suspect solvency (s 588H(2)), where the director had reasonable grounds to believe that the company was solvent at the time it incurred the debt, and that it would remain solvent even after incurring the debt.
- Reasonable reliance on information provided by others (s 588H(3)), where the director can prove that the person in charge of providing accurate information concerning the company’s financial status and solvency was performing this task, and the director believed that the company was solvent.
- Absence from management (s 588H(4)), where the director had good reasons not to be involved in the management of the company when it incurred the new debt. For example, where the director stepped away as a result of a serious illness.
- Reasonable steps to prevent incurring of debt (s 588H(5)), where the director can prove they took all reasonable steps as explained above.
Consequences of trading insolvent
Directors who are not successful in establishing a defence against trading insolvent can face serious penalties, including civil penalties, criminal charges, and compensation proceedings.
- Civil penalties: directors may face pecuniary penalties of up to $200,000.
- Compensation proceedings: the director can be personally liable for any debts the company incurred while insolvent.
- Criminal charges: where the director has been found to be dishonest, they can be penalised with a $220,000 fine or five-year imprisonment.
Legal advice
It can be difficult understanding obligations around trading while a company is insolvent. You don’t need to do it alone: Legal Kitz can help! Click here to book a FREE consultation, or contact us at [email protected]. If you would like to read more of our blogs, have a look at our Knowledge Centre!