Insolvent trading: How does a director become liable for insolvent trading?

Insolvent trading is when directors allow their company to incur debts when the company was insolvent. The liquidator can make a compensation claim against a director if those debts are unpaid when the liquidation commences.

A director may be held personally liable to compensate creditors for the amount of the unpaid debts incurred from the time the company became insolvent to the start of the liquidation.

Why do liquidators make these claims?
Liquidators are obliged under the provisions of the Corporations Act 2001 to investigate the existence of any insolvent trading claim, and if so, take appropriate action. Further, directors have a duty to stop a company from incurring debts it is unable to pay. Under the Corporations Act, failing to stop a company from incurring debts it is unable to pay is a breach of the directors’ duty. Directors may have to pay compensation to the company for losses creditors have incurred under that breach of duty.

Who makes insolvent trading claims?
Liquidators have the first opportunity to make insolvent trading claims. If they decide not to make a claim, creditors may start their own actions, but creditors’ claims are limited to the amount of their individual debt.

Can creditors take insolvent trading action?
Yes. If a liquidator does not pursue an insolvent trading claim, the creditors of the company (individually or in a group) can make a claim. Creditors may start an action either with a liquidators consent or if the liquidator fails to provide their consent, the creditors can seek leave of the court in certain circumstances.

Creditors can only take action against directors for their own debts. Whereas a liquidator can pursue an insolvent trading claim on behalf of all creditors’ unpaid claims.

A creditor cannot commence action when a liquidator has already begun proceedings or has intervened in an application for a civil penalty order. That is, claims are restricted when the liquidator has started their own action.

What are the factors in an insolvent trading claim?
Aside from the company being in liquidation, the factors in an insolvent trading claim are:

  1. The company must have been insolvent when the debts were incurred.
  2. The debts must remain unpaid at the time of the liquidation.
  3. The claims must be made against people who were company directors at the time debts were incurred.
  4. There were reasonable grounds for the director to suspect the company was insolvent.

Who are directors?
The status of ‘director’ of a company is not exclusive to those who are appointed as directors, recorded in the company register, or those notified to the Australian Securities and Investments Commission (ASIC). People who act as a director, even if not formally appointed, may be defined as a director. Shadow or de facto directors, or other parties that controlled the company at the time the company became insolvent can be exposed to an insolvent trading claim.

The Corporations Act defines a ‘director’ as:

‘(a) a person who:

(i) is appointed to the position of a director; or

(ii) is appointed to the position of an alternate director and is acting in that capacity; regardless of the title of their position; and

(b) unless the contrary intention appears, a person who is not validly appointed as a director if:

(i) they act in the position of a director; or

(ii) the directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes.’

The definition excludes people who give advice as part of their normal professional role. For example, accountants, solicitors and other paid consultants.

When is a company insolvent?
A company is insolvent when it cannot pay its debts as and when they become due and payable. The Corporations Act defines solvency and insolvency as:

Section 95A — Solvency and Insolvency

(1) A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.

(2) A person who is not solvent is insolvent. A person is defined to include a corporation.

What about accrued debts?
For an insolvent trading claim, the debt must be incurred, not just accrued, when the company is insolvent. Incurring a debt is the legal creation of a debt that did not previously exist. Accrued debts usually relate to ongoing contractual agreements.

Contractual agreements are incurred at the time of the original agreement and only become payable (or accrue) at a later date. If the original agreement was made while the company was solvent, and the later amounts only accrue because of that original contract, those debts will not form part of an insolvent trading claim. For example, reoccurring lease payments are under a contract that was entered into prior to the company’s insolvency.

How do directors become liable for insolvent trading claims?
Section 588G of the Corporations Act sets out the director’s duty to prevent insolvent trading and sets the parameters by which a liquidator can initiate the process for making a claim against a director. Directors contravene this section by allowing the company to incur a debt when they are aware of grounds to suspect the company was insolvent.

When directors breach their duty, the provisions of section 588M of the Corporations Act allow compensation to be recovered from that director. A claim is possible where the creditors suffered loss or damage because of the company’s insolvency and the debt was wholly or partly unsecured.

What defences are available to directors?
The Corporations Act provides statutory defences for directors. The burden of proving these defences is on directors. The statutory defences can be summarised as:

  1. the director had reasonable grounds to expect (not just suspect) the company was solvent
  2. a reasonable, competent person produced information that would reasonably lead to a belief that the company was solvent
  3. the director had a good reason for not taking part in the company management at the relevant time
  4. the director took all reasonable steps to stop the company incurring the debt, including attempting to appoint a voluntary administrator to the company.

The courts have made it clear that the position of director carries certain responsibilities, which cannot be avoided, including the duty to keep informed about the company’s solvency.

Is insolvent trading an offence?
Yes. Insolvent trading is an offence and can be referred to ASIC for further investigation and possible criminal prosecution. Directors should seek legal advice. Section 588G (Director’s duty to prevent insolvent trading by company) stipulates:

(3) A person commits an offence if:

(a) the person is a director of the company when it incurs a debt; and

(b) 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

(c) the person suspected at the time when the company incurred the debt that the company was insolvent or would become insolvent as a result of incurring that debt or other debts (as in paragraph (1)(b); and

(d) the person’s failure to prevent the company incurring the debt was dishonest.

How long do liquidators have to take action for insolvent trading?
Liquidators have six years from the beginning of the liquidation to commence an action for insolvent trading. Proceedings must be commenced by way of the filing of an application with the court within that six-year period. It is not sufficient to just issue a letter of demand.

What should directors do if a liquidator makes an insolvent trading claim?
A liquidator should be asked to demonstrate:

  1. that the company was insolvent during the appropriate period
  2. that the debts were incurred after that time
  3. proof of director status at that time, whether formally appointed or not.

In settling claims with the liquidator, the settlement must be sanctioned by the court, usually by way of a consent order. This consent order protects directors from any future claims made by creditors of the company.

The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Last Updated: 3.11.2017


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