Insolvent trading

The COVID-19 pandemic crisis is presenting a number of rapidly changing developments in the practical application of director duties. Some of these developments are temporary and designed to help manage this crisis. For more specific guidance on the impact of this crisis on the practical application of the duty to prevent insolvent trading, refer to the Australian Institute of Company Directors' COVID-19 Resources website.

Of particular note, refer to:

• COVID-19: What directors need to know about the lifting of director liability for insolvent trading.
• Directors’ duties in uncertain financial times.

When is a company insolvent?

Section 588G of the Corporations Act 2001 (Cth) (Act) contains the director’s duty to prevent insolvent trading by a company. “Solvency” is defined in s 95A(1) of the Act as the ability to pay all debts as and when they become due and payable. A person or organisation who is not solvent is 'insolvent' (s 95A(2)). The Act does not provide any guidance on how to assess whether debts can be paid by the corporation. In Sutherland v Hanson Construction Materials Pty Ltd (2009) the New South Wales Supreme Court made the point that:

The definition of “debt” includes dividends, share buybacks, capital reductions and issuing redeemable preference shares. A debt happens on the date on which it was incurred, not when it is due to be paid.

When does a director breach s 588G?

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

• he or she is a director of the company at the time the company incurs a debt; and
• 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 contravenes s 588G of the Act if:

• 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 seeking to make a director liable for insolvent trading.

What are some warning signs of insolvency?

Directors are responsible for monitoring a performance and informing themselves of the company's true financial position. If problems are caught early, there is a greater chance of remedying them and ensuring the company's survival.

The Australian Securities and Investments Commission’s (ASIC) Regulatory Guide 217: Duty to prevent insolvent trading: Guide for directors provides the following list of potential insolvency indicators: 1

• the company has a history of continuing trading losses;
• the company is experiencing cash flow difficulties;
• the company is experiencing difficulties selling its stock or collecting debts owed to it;
• creditors are not being paid on agreed trading terms and/or are either placing the company on cash-on-delivery terms or requiring special payments on existing debts before they will supply further goods and services;
• the company is not paying its Commonwealth and State taxes when due (for example, pay-as-you-go instalments are outstanding, goods and services tax is payable or superannuation contributions are payable);
• cheques are being returned dishonoured;
• legal action is been threatened or has been commenced against the company, or judgements are entered against the company, in relation to outstanding debts;
• the company has reached the limits of its funding facilities and is unable to obtain appropriate further finance to fund operations – for example, through:
  - negotiating a new limit with its current financier; or
  - refinancing or raising money from another party;
• the company is unable to produce accurate financial information on a timely basis that shows the company's trading performance and financial position or that can be used to prepare reliable financial forecasts;
• company directors have resigned, citing concerns about the financial position of the company or its ability to produce accurate financial information on the company's affairs;
• the company auditor has qualified their audit opinion on the grounds there is uncertainty the company can continue as a going concern; 
• the company has defaulted, or is likely to default, on its agreements with its financiers;
• employees, or the company's bookkeeper, accountant or financial controller, have raised concerns about the company's ability to meet, and continue to meet, its financial obligations;
• it is not certain that there are assets that can be sold in a relatively short period of time to provide funds to help meet debts owed, without affecting the company's ongoing ability to continue to trade profitably;
• the company is holding back cheques for payment or issuing post-dated cheques.

Every year, ASIC publishes an overview of corporate insolvencies based on statutory reports lodged by external administrators. ASIC’s Report 596: Insolvency statistics: External administrators’ reports (July 2017 to July 2018) identified the following top three indicators for directors to suspect insolvency: 2

• non-payment of statutory debts (for example, pay-as-you-go withholding (PAYGW), super guarantee charge (SGC) and goods and services tax (GST));
• difficulties paying debts when they [fall] due (for example, evidenced by letters of demand, recovery proceedings and increasing age of accounts payable); and
• financial statements that disclose a history of serious shortage of working capital, unprofitable trading.

ASIC’s Report 2013: National insolvent trading program report 3 sets out the view that a director is less likely to breach their duties under the Act if they take into account the following key principles in carrying out their role:

• maintain appropriate books and records;
• identify insolvency concerns and assess available options;
• seek professional advice; and
• act in a timely manner.

What are the key principles directors should keep in mind?

ASIC’s Regulatory Guide 217: Duty to prevent insolvent trading: Guide for directors 4 (also referenced above) contains the following four key principles that ASIC considers directors need to take into account in performing their duty to prevent insolvent trading:

• keep themselves informed about the company’s financial position and affairs;
• regularly assess the company’s solvency and investigate financial difficulties immediately;
• obtain appropriate professional advice to help address the company’s financial difficulties where necessary;
• consider and act in a timely manner on the advice.

What should be done if insolvency is suspected?

A range of options is available to directors who suspect insolvency in their organisations:

• Seek professional advice (the advice might be to use voluntary administration with a view to restructuring affairs and continuing trade or to invite a secured creditor to appoint a receiver or appoint a liquidator);
• Do not incur further debts;
• Possibly cease trading;
• Obtain financial support.

Company directors must ensure, as they deal with their company’s affairs, especially when the company faces financial uncertainty, that they do not allow the company to trade while insolvent nor incur a debt that would lead the company to insolvency.

This is in addition to a director’s general duties to act with care and diligence, in good faith in the best interests of the organisation and not to improperly use their position or information received for personal gain (ss 180-183 of the Corporations Act 2001).

What is the insolvency safe harbour? 5

In 2017, a ‘safe harbour’ protection was introduced as a form of defence for directors facing an allegation of insolvent trading.

In the spirit of the duty to take care and act with diligence in their role as a director of the company, the new safe harbour provides some protection, in specific circumstances, for directors who try to turn around a company’s unfavorable financial position in order to prevent a total business collapse.

This safe harbour protection begins (and the usual insolvent trading prohibitions do not apply during the period) when directors start suspecting their company may become insolvent (in a state of financial distress and at risk of being unable to pay its debts as and when they fall due) and determine one or more courses of actions which are reasonably likely to lead to a better outcome for the company other than immediate administration or liquidation (ss 588GA-GB).

When deciding appropriate courses of actions, directors should:

• properly inform themselves of the company’s financial position;
• take appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts;
• keep appropriate financial records consistent with the size and nature of the company;
• obtain advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; and
• develop or implement a plan for restructuring the company to improve its financial position.

To ensure this safe harbour protection is available, the company must ensure employees’ entitlements are paid and company’s tax reporting obligations are met during the safe harbour period (s 558GA(4)). At all times, directors must still continue to exercise care and diligence and make decisions in the best interest of the company.

The safe harbour protection’s operation has not yet been tested in any court and a number of technical aspects remain unclear. For instance, what do the terms ‘reasonably likely and ‘a better outcome’ look like? What are the timeframes in which that a better outcome should be assessed? What is a better outcome and for whom: company creditors, employees, or shareholders?

An independent review is legislated to be undertaken by 2020 to assess the impact of the safe harbour protection on directors’ conduct, creditors’ interests and employees’ interests (s 588HA).

Are there any defences?

In addition to the safe harbour protection mentioned above, the following defences are available to a director under s 588H of the Act for failing to prevent insolvent trading:

• 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;
• 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;
• 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;
• 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.

These defences are not available in criminal proceedings based on dishonesty.

What are the penalties for insolvent trading?

Insolvent trading leaves a director open to civil and criminal penalties as well as being personally liable to compensate for losses. Directors are defined as those duly appointed, including de facto and shadow directors 6 and those managing while disqualified. 7

Note that s 588G only applies to directors and not to management.

If insolvency occurs, directors must take the interests of creditors into account. This includes helping the administrators in every required way. Creditors make the decision as to whether to save the company.

The liability for debts after a company becomes insolvent lies with those who were directors at the time of acquiring the debt.

ASIC can exact civil penalties against directors. These include:

• disqualification from managing a company;
• substantial fines; and
• paying compensation to the company equivalent to the loss suffered by the creditors (s 588J).

Criminal proceedings for insolvent trading may be brought if dishonesty is involved. Directors can be ordered under s 588K to pay compensation to the company for the loss suffered by the creditor.

What is ASIC’s national insolvent trading program (NITP)?

Directors should be aware of ASIC’s national insolvent trading program (NITP). This is a focused approach by ASIC to deal with possible insolvent trading before it occurs. It involves a review of a company to ensure compliance by directors of their duty of care under s 180 (1) and insolvent trading.

A number of sources are used to identify the companies selected for the program, including:

• complaints received from the public, including complaints from credit managers and company employees;
• listed companies that have their annual accounts reviewed as part of ASIC’s accounts surveillance program and are identified as financially stressed;
• information from liquidators; and
• referrals from other areas within ASIC.

A director is required to provide all documents requested under a notice issued under the Australian Securities and Investments Commission Act 2001. Generally, the review will take place at the principal place of business of the company, however, in certain circumstances, notices can also be complied with by delivering records directly to an ASIC office. The managing director should attend a review. However, where appropriate, other directors, finance staff, external accountants and lawyers may also attend.

On completion of the review, ASIC may write to the company setting out concerns about its potential insolvency. To assist with the assessment of a company's financial position, ASIC may ask that the company prepare up to date management accounts. Where appropriate, ASIC may ask that the company approach an insolvency professional for advice on the possible appointment of an external administrator. In certain cases, ASIC may take action directly. Cases of suspected breaches of the insolvent trading provisions of the Corporations Act 2001, and where directors are not seeking to comply with their responsibilities in this area, are considered for possible enforcement action.

Illegal phoenixing measures and Director Identification Numbers

The Treasury Laws Amendment (Combatting Illegal Phoenixing) Bill 2019 was passed through Parliament in February 2020 and now forms part of the Government’s insolvency law reforms, intended to counter illegal phoenix activity (involving the transfer of assets from one company to another by individuals or entities to avoid paying debts). 8

It introduces a number of significant reforms that apply to all directors, including reforms that:

• restrict back-dating of resignations (any late lodgement of resignation to ASIC will now be taken to apply from the date the notice was received by ASIC);
• prevent directors from resigning if the resignation would leave the company without a director; and
• extend the director liability regime to cover a company’s GST liabilities in certain circumstances.

The Federal Government has also proposed the introduction of Director Identification Numbers (DINs). The DINs enable regulators, and possibly the public, to easily track the directorships record of every company director, including for example, how many director’s roles are currently active for that director, whether a director has been disqualified from managing a corporation and whether a director has been involved in insolvent trading, illegal phoenix activities or unlawful activities. The AICD is broadly supportive of the proposed framework for the implementation of DINs, as an important step in improving the accountability of directors to assist with the detection of fraudulent phoenix activity. 9

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Footnotes

1 ASIC, 2010, Regulatory Guide 217: Duty to prevent insolvent trading: Guide for directors, July, p 21, https://download.asic.gov.au/media/1241384/rg217-29july2010.pdf, (accessed 10 May 2020).

2 ASIC, 2018, Report 596 Insolvency statistics: External administrators’ reports (July 2017 to July 2018), November, p 32, https://download.asic.gov.au/media/4936726/rep596-published-14-november-2018.pdf, (accessed 10 May 2019).

3 ASIC, 2010, Report 2013: National insolvent trading program report, October, p 3, https://download.asic.gov.au/media/1343486/rep213.pdf, (accessed 10 May 2020).

4 ASIC, 2010, Regulatory Guide 217: Duty to prevent insolvent trading: Guide for directors, July, https://download.asic.gov.au/media/1241384/rg217-29july2010.pdf, (accessed 10 May 2020). 

5 Refer to the AICD Director Tool The insolvency safe harbour.

6 I M Ramsay and R P Austin, 2018, Ford, Austin and Ramsay’s Principles of Corporations Law, 17th edition, LexisNexis Australia, p 412. 

7 Ibid, p 438.

8 Australian Institute of Company Directors, 2020, "Combating Illegal Phoenixing Bill 2019 passed", 12 February, The Boardroom Report, Vol 18, Issue 2, https://aicd.companydirectors.com.au/membership/the-boardroom-report/volume-18-issue-2/combating-illegal-phoenixing-bill, (accessed 10 May 2020). 

9 L Petschler, 2018, Consultation on the draft legislation for Modernising Business Registers and Director Identification Numbers, 26 October, Australian Institute of Company Directors, http://aicd.companydirectors.com.au/-/media/cd2/resources/advocacy/policy/pdf/2018/subm-2018-mbr-dins-final.ashx, (accessed 5 June 2019).

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