Under Australian law, board directors have a duty to prevent insolvent trading by corporations. Though certain exceptions may apply, failure to do so can expose directors to personal liability for losses incurred. In times where cash flow is tight, directors need to remain acutely aware of their duties. 

The solvency test

‘Solvency’ is defined in section 95A(1) of the Corporations Act as the ability to pay all ‘debts’ as and when they become due and payable. A person or organisation which is not solvent is ‘insolvent’ (s 95A(2)).

The definition of ‘debt’ includes dividends, share buybacks, capital reductions and issuing redeemable preference shares.  There is a common misconception that debts arise on the date they are due for repayment.  However, by law a  debt arises on the date on which it was incurred, not on the date it is due to be paid.

The Corporations Act does not provide guidance on how to assess whether an entity has the ‘ability’ to pay debts. In Sutherland v Hanson Construction Materials Pty Ltd (2009), the New South Wales Supreme Court observed:

“ …solvency is to be determined primarily according to the company’s cash flows. It is important to note, however, that the state of the balance sheet, although not the primary test, remains relevant to the [question of solvency].”

When does a director breach s 588G?

Directors of a company have a duty under section 588G of the Corporations Act to prevent insolvent trading. More broadly, under common law, the obligation to only trade whilst solvent there is a fiduciary duty owed to creditors of the company.

The definition of a ‘Director’ typically means one who has been duly appointed by the Board or shareholders to act in that capacity.  However the test is one of substance as well as form.  It can extend to de facto and shadow directors who have not been officially appointed, and those managing whilst disqualified.[1] On the other hand, managers of a company who are not directors do not have a statutory or fiduciary duty to prevent insolvent trading (provided they do not meet the test of a de facto and shadow director).

Under section 588G, a director has a duty to prevent insolvent trading where:

• They are a director of the company at the time the entity incurs a debt;
• The company is insolvent at that time, or becomes insolvent by incurring that debt or by incurring at that time debts including that debt; and
• At that time, there are reasonable grounds for suspecting that the company is insolvent or would become insolvent.

If the director fails to prevent the company from incurring the debt in the circumstances set out above, the director will prima facie contravene section 588G, where:

• The director is aware at that time that there are such grounds for suspecting the insolvency; or
• A reasonable person in a like position would be so aware.

Further, the director commits an offence if the failure to prevent the company incurring the debt was ‘dishonest’ (s 588G (3)).

The onus of proof is on the person alleging that the director is liable for insolvent trading.

Are there any defences for directors?

In the event that a prima facie breach of section 588G has occurred, the question is what defences arise?  Section 588H of the Act provides the following defences to a director under for failing to prevent insolvent trading:

1. At the time when the debt was incurred, the director had reasonable grounds to expect, and did expect, that the corporation was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time;
2. At the time when the debt was incurred, the director:
   • had reasonable grounds to believe, and did believe, that a competent and reliable person was responsible for providing adequate information about whether the corporation was solvent and that other person was fulfilling that responsibility; and
   • expected, on the basis of that information, that the corporation was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time;
3. At the time when the debt was incurred, the director did not take part in the management of the corporation because of illness or for some other good reason; or
4. The director took all reasonable steps to prevent the corporation from incurring the debt — the matters which will be considered include but are not limited to any action the person took with a view to appointing an administrator of the corporation, when that action was taken and the results of that action.

However, where the director is the subject of criminal proceedings based on dishonesty, these defences are not available.

What are the penalties for insolvent trading?

A director responsible for insolvent trading is exposed to the risk of civil and criminal penalties, as well as being personally liable to compensate for losses. From the time the company is deemed to be insolvent, the responsible directors are liable for the debts.

If insolvency occurs, directors must take the interests of creditors into account. This includes helping the administrators in every required way.

ASIC can impose civil penalties on directors. These include:

• Disqualification from managing a company;
• Substantial fines;
• Paying compensation to the company equivalent to the loss suffered by the creditors (s 588J); and
• Criminal proceedings for insolvent trading may be brought if dishonesty is involved. Directors can be ordered under section 588K to pay compensation to the company for the loss suffered by the creditor.

Concluding Remarks

Insolvent trading carries significant potential liabilities for responsible directors, both civil and criminal. While exceptions and safe harbour provisions under the Corporations Act may in certain circumstances aide directors who have acted honestly and responsibly, this is a high risk area for directors with serious consequences for not remaining alert.

The above information is general in nature. If you would like to learn more about how the duty to prevent insolvent trading affects you, please contact us below.