Directors made liable under insolvent trading provisions

Relying on creditors to allow continued trading when a company is close to insolvency is unwise.

The insolvent trading provisions of the Corporations Law have always been a major problem for directors, especially in smaller companies. There is now a positive duty on the part of directors not to engage in insolvent trading. This duty has continually been strengthened, the most recent "innovation" being to link it to the recently enacted Employee Entitlements legislation which we have mentioned briefly in another note in this month's Law Reporter. While in the past it was possible for creditors to bring proceedings against directors for insolvent trading, now, as a general rule, the liquidator of a company must be the appropriate plaintiff. But, as the recent decision in Powell and Duncan v Fryer, Tonkin and Perry ((2000) 18 ACLC 480) has suggested, such claims may be readily brought by liquidators and, in special cases, by creditors. The decision is one of the Supreme Court of South Australia (Prior J being the relevant judge). It is an interesting case because it tells the story of a set of facts that may well be familiar in many situations where businesses in particular find that they need some indulgence on the part of creditors to allow them to continue to trade.

Basically, the liquidators of a company, Noelex Yachts Australia Pty Ltd, sought to recover from the directors of the company the amount of the debts that the company had incurred when it was insolvent. The facts are taken from the CCH Report. The company had been in financial trouble for a number of years, and the evidence clearly established that the company had been trading while insolvent. The directors, who had been sued under the appropriate provision - section 588M (linked as it is to the insolvent trading provision - section 588G) sought to rely on section 588H(2) of the law which provided a defence if the director had reasonable grounds to expect, and did expect, that the company was solvent at the time the debts were incurred and would have remained solvent even if the company had incurred those debts and any other debts at that time. The principal director argued that, throughout the relevant period, he was able to conduct the financial affairs of the company on the basis that most creditors would not have pressed for payment, asserting that there was an understanding that creditors would not take recovery action against the company provided the company paid within a reasonable time after 30 days. On this basis, that director argued that there were reasonable grounds to expect the company to be able to pay its debts as and when they became due and payable.

The directors also argued that taxes, employee entitlements and penalties for late payment of taxes were not debts incurred for the purposes of the insolvent trading provisions, because the incurring of a debt involved an element of choice; and that taxes, penalties, and levies were not chosen to be incurred by the company. The directors also sought to limit their personal liability by arguing that the amount of the loss or damage was the difference between the amount of the debt and what creditors might have received on a winding up of the company. Prior J held that the application by the liquidators should succeed. In his view the indulgence showed by the creditors was not a ground on which the directors could reasonably rely under section 588H(2) that the company was in fact able to pay its debts as and when they fell due. It is interesting to examine his language: "This company was not one experiencing a temporary lack of liquidity. No variation by agreement or estoppel by course of conduct has been made out. The fact that creditors did not insist on payment by the ordinary commercial expectation of 30 days is not a ground on which the directors can reasonably form an expectation as to the company's solvency and make good the defence identified in section 588H(2) with respect to any of the incurred debts in issue here. The evidence with respect to payments made or contemplated by directors does not help either. The evidence does not establish solvency or the expectation of it at the time particular debts were incurred. The commercial reality of the situation here was that the company was at all relevant times unable to pay debts as and when they became due and payable." (18 ACLC at 486 para 33)

Prior J endorsed the remarks of Debelle J in an earlier case, Carrier Air Conditioning Pty Ltd v Kurda ((1993) 11 ACLC 773 at 779) where he noted: "A reasonable and prudent director would acknowledge that, while his company might have enjoyed periods of grace in the payment of its debts, there could be no reasonable expectation that that situation would continue." This company was one not experiencing a temporary lack of liquidity. In those circumstances there was no evidence to suggest that any particular creditor had agreed not to take action. The court also noted that obligations imposed by the Law, for example such as taxes and penalties, could be debts for the purposes of determining whether a company was insolvent or not. In all the circumstances the amounts that had been incurred by the directors while the company was insolvent were properly recoverable by the liquidators. The decision is a tough one but not surprising in the context of the general approach taken in this area of the law. It simply emphasises the need for directors to be particularly careful in trading when things get tough. The decision will be a particular reminder to directors of companies at this time when the New Tax System comes into operation, liquidity becomes tight, and the government, through the Commissioner of Taxation, seeks to recover monies collected by companies on behalf of the government.

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The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.