Insolvent Trading Explained

Insolvent trading occurs when a company incurs a debt when it is unable to pay its debts as and when they fall due.

The law imposes on the directors, a duty to prevent the company from engaging in insolvent trading.

Breaching this duty can expose the directors of the company to personal liability.


The Offence
The law places a duty on directors of an insolvent company to prevent the company incurring debts where a director has grounds for suspecting that it is insolvent.  The duty contains five elements:

1. The person is a director at the time when the company incurs that debt.

2. The company was insolvent at the time or became insolvent by incurring that debt, or by incurring at that time or became insolvent by incurring that debt, or by incurring at that time debts including that debt.

3. At that time there were reasonable grounds for suspecting the company was insolvent or would become insolvent.

4. The debt was incurred after 23 June 1993.

5. By failing to prevent incurring the debt, the director was aware that there are such grounds for suspecting, or a reasonable person in a like position in the company, would have been aware that the company was insolvent.

It is important to note that past directors of the company (notwithstanding resignation) can also be held liable for insolvent trading.


The Proof
Even if a company is insolvent, before a director becomes liable it must be established that there were reasonable grounds to suspect that the company was insolvent or would become insolvent.  The test requires that whatever is “suspected” must be based on reasonable grounds and imports into this section an objective test for suspicion.


Practical Considerations
The Courts have relied upon some practical factors that may indicate insolvency in the context of director liability for insolvent trading, including:

• Continuing losses.
• Liquidity ratios.
• Overdue taxes.
• Poor relationship with the bank resulting in inability to borrow further.
• No access to alternative finance.
• No ability to raise more capital.
• Suppliers only providing goods COD.
• Creditors unpaid outside trading terms.
• Issuing post-dated cheques.
• Dishonoured cheques.
• Special arrangements for selected creditors.
• Judgments solicitors letters etc. issued against the company.
• Payments to creditors of rounded amounts not payments of specific invoices.
• Inability to produce timely and accurate financial statements.

The Penalties
Civil penalty orders for insolvent trading include the power of the court to disqualify a person from managing a corporation or imposing a pecuniary penalty order up to $200,000.00.

However, a court may not order civil penalties disqualification if it is satisfied that despite the contravention, the person is fit and proper to manage a corporation nor order a pecuniary penalty where is considers a contravention not to be a serious one.

Only Australian Securities and Investments Commission (‘ASIC’), a commission delegate or some other persons authorised in writing by the Minister can apply for a civil penalty order.



Criminal Consequences
A director may be liable to criminal proceedings by ASIC through the Commonwealth Director of Public Prosecutions (the ‘Crown’) if they contravene a civil penalty provision.

A director will be convicted of such an offence where it is proven that the contravention was carried out in circumstances which established the following:

1. knowingly, intentionally or recklessly; and

either:

2. dishonestly and intending to gain, whether directly or indirectly, an advantage for that or any other person; or

3. intending to deceive or defraud someone.


Defences
A director can avail themselves of one of four statutory defences contained in the Corporations Act 2001 which can absolve directors of liability in certain circumstances.


Compensation Payable by Directors
An application initiated by ASIC or the Crown to pay compensation to the court may be enforced as though it were a judgment of the Court.  However, a liquidator does not have to wait for ASIC or the Crown to commence proceedings.

A liquidator may take recovery of compensation actions resulting from insolvent trading in circumstances where a creditor has suffered loss or damage and the company is being wound up