What is insolvent trading?

By Michael Quinlan

Section 588G of the Corporations Act (the Act) imposes liability on a director of a company who allows the company to incur a debt at a time when the company is insolvent where, at the time that the debt was incurred, there existed reasonable grounds for suspecting that the company was, or may become as a result of incurring the debt, insolvent. A director will be liable if at the time the debt was incurred he or she was actually aware of the existence of reasonable grounds to suspect insolvency or a reasonable person in a similar position within a similar company would have been so aware. A director will commit an offence (under s588G(3)) if at the time the debt was incurred the director actually suspected that the company was insolvent (or would become insolvent by incurring the debt) and the director’s failure to prevent the debt being incurred was dishonest. One of the main problems directors and liquidators face is being able to identify when a company is insolvent. The somewhat vague definition of insolvency does not assist. Prior to 23 June 1993 no statutory definition of insolvency existed. The Act now1 contains section 95A which states that a person (including a company) is insolvent if they are not solvent. A company is only solvent if it is able to pay all of its debts as and when they become due and payable. The emphasis is on the ability to discharge all of one’s debts, rather than merely particular debts. Insolvency is not usually determined merely by looking at the balance sheet of a company and determining whether there is a surplus of assets over liabilities. Rather, the emphasis is on cash-flow. Of course companies may experience both types of insolvency simultaneously. The Act specifies two rebuttable presumptions of insolvency. The first states that where it is proved that a company was insolvent at a particular time during the 12 months ending on the ‘relation back day’ (most often the date on which an application to wind up was filed or an administrator was appointed) it is presumed that the company was insolvent from that time until the relation back day. Under the second presumption a company will be presumed insolvent where it is proved that the company failed to keep proper accounting records which correctly explain and record its transactions and financial position and which enable true and fair financial statements to be prepared and audited (s588E(4)). These presumptions can be rebutted. The term ‘debt’ has a wide meaning which often varies according to the context in which it is used. The courts have stated that the terms ‘debt’ and ‘incurs’ are not terms of precise definition but are to be applied flexibly in a practical and commonsense manner. The Full Court of the Supreme Court of South Australia considered the key issues of:
  • what is a debt;
  • when is a debt incurred; and
  • what constitutes insolvency in the 2001 decision of Powell v Fryer2. The issue of when a debt is incurred was also considered in 2001 by Mandie J in the Supreme Court of Victoria in the decision of Harrison v Lewis4. Available Defences A number of defences are available to directors against whom an insolvent trading action is brought:
  • The director had reasonable grounds to expect that the company was solvent and would remain solvent even if it incurred the relevant debt. This requires a director to prove that he or she had an actual expectation of solvency as well as the existence of reasonable grounds for that expectation (section 588H(2)).
  • The director relied upon information regarding the solvency of the company which was provided by another and which led to an expectation of the actual solvency of the company based on that information. The director also needs to show that he had reasonable grounds to believe and did believe that a competent and reliable person was responsible for providing him with information of the company’s solvency and that that other person was fulfilling that responsibility (section 588H(3)).
  • The director did not participate in the management of the company at the time the debt was incurred because of illness or some other good reason. There must be a connection between the non-participation and the ‘good reason’ (section 588H(4)).
  • The director took reasonable steps to prevent the company incurring the debt, such as appointing a voluntary administrator to the company (section 588H(5)). The court can also excuse the director from liability if he or she has acted honestly and ought fairly to be excused (section 1317; section 1318). What liability is imposed for insolvent trading? The liability which may be imposed on a director for insolvent trading falls into a number of categories: civil penalties, criminal penalties, compensation orders (available on either an application for a civil penalty order (section 588J) or a criminal prosecution (section 588K), liquidator recovery actions (under section 588M(2) and creditor recovery actions (under sections 588M(3), 588R, 588S, 588T and 588U). Where a director allows a company to trade whilst insolvent and this is done knowingly, intentionally or recklessly and was dishonest (with a view to gaining an advantage or was intended to deceive or defraud someone) then the director is guilty of a criminal offence. The maximum penalty payable for such criminal offence is a fine of $200,000 and/or imprisonment for 5 years. A director who is guilty of a criminal offence is prohibited from managing any company for 5 years. Under section 588K the Court in criminal proceedings can, whether or not it imposes a penalty, order the director to pay compensation to the company equal to the amount of loss and damage. Civil penalties do not include an automatic disqualification from managing companies. A director can be made to pay a pecuniary penalty, or a fine, to ASIC. This fine can be for an amount of up to $200,000. A director can also be ordered to pay compensation to the company under either of two provisions facilitating the ordering of compensation. Under one (ss588J(1)) the compensation payable is equal to the loss and damage suffered by an unsecured creditor. Under the other (s1317H) the compensation payable is equal to the ’damage’ suffered by the relevant unsecured creditor or creditors. Presumably these two standards are the same, or at least substantially similar. Finally, a director can be prohibited from managing any company for a specified period if he or she is not a fit and proper person to manage a company. Under section 588M(2) where a director has breached subsection 588G(2) or (3) whether or not the director has been convicted of an offence or had a civil penalty order made against him or her the liquidator can recover the amount which a creditor has suffered by way of loss or damage. Under section 588M(3) creditors are given some rights to sue directors direct for compensation for insolvent trading:
  • with the liquidator’s consent (under section 588R);
  • with the Court’s leave after giving the liquidator notice under section 588S (pursuant to section 588T);
  • unless the liquidator has already sought orders under sections 588FF or 588M in relation to the debt or in relation to a transaction under which the debt was incurred or has intervened in an application for a civil penalty order. This is the first part of a series of articles on directors' and officers' insurance. Footnotes 1 At the time of writing section 95A had been repealed by Act No 122 of 2001, s3, Sch 1, Pt 2 (329) (effective 11 March 2002). The writer understands that the legislature intends to reintroduce section 95A to have effect from 11 March 2002. 2 Unrep, 8 March 2001 4 Unrep, 23 February 2001

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