Director’s duty to prevent insolvent trading

It is widely accepted that the directors of a company have a duty to prevent insolvent trading.  The wake of high profile corporate collapses has brought the issue of insolvent trading to the forefront of many consumer’s minds.

Director’s duties

In section 588G of the Corporations Act 2001 (Cth) (Act), there is a table specifying the time a debt is deemed to have been incurred, depending on the type of action taken by a company.

Directors of a company contravene this section if they fail to prevent the company from incurring the debt if:

• they are aware that there are grounds for suspecting the company is insolvent;^[1] or
• a reasonable person in the same situation as the director would be so aware.

Offence creating provision

Section 588G(3) of the Act provides that a person commits an offence if:

• a company incurs a debt at a point in time;
• that person is a director when the debt is incurred;
• the company is insolvent at the time, or becomes insolvent because of the debt which has been incurred;
• the person suspected at the time that the debt was incurred that the company was insolvent or would become insolvent as a result of incurring the debt; and
• the persons failure to prevent the company incurring the debt was dishonest.

Contravention of section 588G(3) of the Act is a civil penalty provision which entitles the Australian Securities and Investments Commission (ASIC), once a declaration has been made, to seek a pecuniary penalty.

The test for solvency

The test for solvency is established in s 95A of the Act, which provides that:

• a person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.
• a person who is not solvent is insolvent.^[2]

Indicia of potential insolvency

A prudent director discharging their duty must take note of what’s going on with the company.  If creditors are calling daily and the Chief Financial Officer just went on stress leave its likely that the situation warrants further investigation for a Director to meet their duties.

ASIC has published ASIC Regulatory Guide 217 – Duty to Prevent Insolvent Trading – A guide for Directors (RG 217).  Section C of RG 217 provides a list of “Factors to take into account in considering whether a company is insolvent“^[3].  Examples cited include:

• a history of continued losses;
• the company is unable to produce accurate financial information;
• the company has defaulted or is about to default on an of its financing facilities;
• legal action is being threatened against the company.

Each of these factors when examined individually may not prove insolvency.  When examined cumulatively they may put the directors on notice that the company may be insolvent.

Defences

Directors may avail themselves of various defences to allegations of trading whilst insolvent.  For example:

Reasonable grounds to expect solvency

Section 588H(2) provides for a defence whereat the time the debt was incurred the director has reasonable grounds to expect that the company was solvent and would remain so even if it incurred the debt.

To establish the requisite “expectation of solvency” a director must establish more than a mere hope of solvency, but must prove the grounds on which the view was formed the view as to the company’s solvency considering the circumstances.^[4]

The seminal case on whether there are reasonable grounds to indicate solvency is the case of Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115 (Friedrich), which, among other things, explored this issue.

In Friedrich, a director who failed to be part of a compromise after the trial commenced, was held personally liable for $96,704,998 pursuant to the precursor of section 588G of the Act.  The Court held that the director was liable for debts incurred by the company that he had failed to prevent.

It was found that, as a director, he should have known of the contents of the accounts and the auditor’s report at the time of the annual general meeting.  It was insufficient for him to rely on the claims of the chief executive that the company was solvent where he had been put on notice of Friedrich’s deception.  The director had also failed to read the reports, which further added to his culpability.

Reliance on the information provided by subordinates

If, at the time the debt was incurred, a reliable subordinate was monitoring the company’s solvency position and keeping the director informed then under certain circumstances it may be appropriate to rely on this advice.^[5]

Absence from management of the company

A director may raise a defence if they can demonstrate that they did not take part in the management of the company because of illness or for some other substantial reason.^[6]  That said, it is not sufficient for a director simply not to be involved in a company in financial distress^[7] or to ignore their duties as director of the Company.

Notably in Tourprint v  Bott  [1999] NSWSC 581 (15 June 1999) exclusion from management by other directors may not be sufficient to enliven a defence against liability pursuant to s588G.

All reasonable steps to prevent the company incurring the debt

A defence is also available if the director took all reasonable steps to prevent the company incurring the debt.^[8]  Case law on this point provides that ‘unequivocal action’ must be taken in this regard by:

• a director to avoid incurring the debt directly;
• to bring the matter to the attention of the officer responsible for incurring the debt; or
• to call a directors meeting with the aim of stopping the company incurring the debt.^[9]

Conclusion

A director’s liability for insolvent trading is an area which is constantly evolving and fraught with danger where directors suspect insolvency.  There are many issues to consider.

The above article is only a cursory treatment of the issues involved in this area and is general in nature.  Directors must take positive steps which they can admit as evidence should they need to enliven a defence to insolvent trading.

Links and further references

ASIC Regulatory Guides

ASIC Regulatory Guide 217 – Duty to Prevent Insolvent Trading – Guide for Directors.

Sections of the Act

Corporations Act 2001 (Cth) section 95A

Corporations Act 2001 (Cth) section 588G

Case law

Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115

Tourprint v  Bott  [1999] NSWSC 581 (15 June 1999)

Further information

If you need advice as a Director on your duty to prevent insolvent trading, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

[1] See RG217.56 of ASIC Regulatory Guide 217 – Duty to Prevent Insolvent Trading – A guide for Directors.

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