Companies are a unique type of legal structure in that they are a separate legal entity and provide limited liability. However, there are certain situations in which the corporate veil can be lifted and directors are held personally liable for the company’s dealings.
This commonly occurs when a company continues trading whilst insolvent. Directors have a duty under Section 588G of the Corporations Act 2001 to prevent a company from trading when it’s insolvent.
Here, we look at the duty and what it means for directors.
A director’s duty to prevent insolvent trading
Insolvent trading occurs when directors allow their company to incur debts when insolvent. In turn, the state of being insolvent is defined as not being able to pay all debts when they fall due. Under Section 588G(c), the duty applies not only when the company is officially insolvent, but also when there are reasonable grounds for suspecting it’s insolvent, or would become insolvent. Furthermore, liability can be found if the director is shown to be aware of reasonable grounds for suspecting this, or simply when a reasonable person in a similar position in a similar company would have been aware of these reasonable grounds.
In practice this means directors can’t escape their duty by demonstrating they were ignorant of the situation. Company directors need to, before incurring new debts, always check whether there are reasonable grounds for believing the company is insolvent or will become insolvent as a result of the new debt being incurred. In effect, this duty to prevent insolvent trading charges directors with the responsibility of being constantly aware of the company’s financial status through maintaining adequate financial records, and other reasonable steps.
As a director you should know if your company is in financial difficulty. Cash flow is usually emphasised when comparing assets versus liabilities, but other signs of financial trouble include low operating profits, low cash flows, trouble paying suppliers and creditors on time, and problems with obtaining further credit from suppliers. Financial difficulty can also include inability to meet repayments on time and legal action.
The exact time when a company first becomes insolvent can be a critical, as recent cases have demonstrated. With complex company structures and/or accounting definitions, it may not always be immediately obvious when a company is in fact insolvent.
Generally speaking, if you’re having trouble repaying debt obligations on time it’s possible your company is at risk of insolvent trading. Time is of the essence in these situations, so contact an insolvency expert for advice if you have any doubts. This will ensure you start taking preventative measures and exploring your options sooner, rather than later.
Consequences of insolvent trading
The law takes insolvent trading very seriously, and directors that don’t fulfil their positive duty to prevent their company from trading while insolvent can face various penalties and consequences. These include civil penalties, criminal charges, and compensation proceedings.
- Civil penalties – Civil penalties for directors can include pecuniary penalties of up to $200,000.
- Compensation proceedings – The ASIC, a liquidator, or a creditor can initiate compensation proceedings on behalf of creditors against the director of a company on a personal basis. These compensation amounts can be unlimited.
- Criminal charges – Directors could face criminal charges where dishonesty is found to be a factor in insolvent trading cases. If convicted, the director can be fined up to $220,000 and/or be sentenced to up to five years in prison.
Defences to insolvent trading
In some cases it’s possible to successfully defend a charge of insolvent trading. Defences include reasonable grounds for believing the company was solvent, that the director had good reason for not taking part in the management of the company at the time, or the director took all reasonable steps to stop incurring the debt.
Options for insolvent companies
Directors of potentially insolvent companies should obtain accounting, financial, and legal advice as soon as possible. Seek advice from insolvency experts who can help you explore your options as far as improving the chances of your company’s survival. At the same time, actively work to prevent your company from incurring further debt.
If you can quickly restructure, refinance, or obtain equity funding to recapitalise your company, you might consider doing so. If that’s not possible, your options might be to appoint a voluntary administrator or liquidator to either save or liquidate the company, so as to improve the outcome for its creditors.
- Voluntary administration – An independent or registered administrator is appointed to take control of your company and work out how to save the business. This could involve setting up a deed of company arrangement. To proceed with voluntary administration the board simply has to resolve that the company is insolvent, or likely to become so, and that an administrator should be appointed.
- Liquidation – If you decide winding up your company is the best course of action, you can appoint a liquidator to realise the company’s assets, make appropriate recoveries, and distribute the proceeds to creditors, among other things.
Avoiding insolvent trading
As a company director you should know your legal duties and the consequential obligations. Keeping adequate records is crucial to fulfilling your legal obligations as a director. Without adequate, detailed financial records, you cannot fully understand the trading status of your business and meet your duties. You company’s accounting records should be up to date at all times, and you should monitor and review them to make sure you’re discharging your duty to prevent insolvent trading.
If you have any doubts about your company’s solvency seek professional advice in a timely manner. An insolvency expert can help you identify whether your company is insolvent and assist you with exploring your options.