Insolvency is an extremely complicated area of law. Furthermore, the consequences of insolvency can be devastating for the company concerned, and company director(s). However, do not worry too much. There are certain insolvent trading defences that directors may utilise to protect themselves from personally incurring the companies debts. This article outlines the 4 main insolvent trading defences. But, what is insolvent trading and what are the consequences?
A Quick Overview of Insolvent Trading
Insolvent trading occurs when a registered company engages in trade or commercial transactions, even though they have existing debts they are unable to pay. In other words, a company that accrues debts that are unable to be paid, may be an insolvent company. Insolvent trading is illegal under the Corporations Act 2001 (Cth). Furthermore, all companies are under a positive duty to refrain from insolvent trading.
Accordingly, a company may be guilty of insolvent trading if:
- That company has debts it is unable to pay, yet the company continues to enter into commercial transactions,
- The company will likely become insolvent if it does not attempt to pay back its debts,
- The company makes no reasonable efforts to pay back its debts.
The Consequences of Insolvent Trading
If a company has engaged in insolvent trading, it is the company directors that will suffer the legal consequences. Thus, liability for the companies insolvency will extend to the companies directors, personally. Although directors enjoy the perks of limited liability when they choose to incorporate, they will be liable if the company engages in illegal activity. Specifically, the directors may face the following consequences for trading whilst insolvent:
- Civil penalties of up to $200,000,
- Criminal penalties of up to $220,000,
- Disqualification by ASIC from managing other corporations for up to 5 years,
- Compensation paid to creditors or liquidators, equal to the amount of the debt owing.
These consequences are extremely serious. Not only can they be damaging to the reputation of a particular director, but they can be extremely damaging to their livelihood. For more information on the consequences of insolvent trading, see our article “What are the Consequences of Insolvent Trading?“.
What are the Defences to Insolvent Trading?
Although the consequences of breaching insolvent trading laws under the Corporations Act are quite severe, there are a few defences available. In total, there are four defences available to company directors. In general, these defences prove that a director acted reasonably, innocently and did not participate in allowing the company to trade whilst insolvent. Each defence lives within section 588H of the Corporations Act. Importantly, the director must not fraudulently or knowingly engaged in the insolvent trading. If they do, these defence will not be available. Each of these 4 defences are discussed below:
1. The Reasonable Grounds Defence:
This defence is provided for under section 588H(2) of the Corporations Act. A director will enjoy protection from the consequences of insolvent trading, if they are able to prove:
- At the time the companies debt was incurred, there were reasonable grounds to expect that the company was solvent, and would remain solvent.
In other words, if there were reasonable grounds to expect that the company would remain solvent, even if it incurred some debt, then directors may receive protection for incurring that debt personally. In this content, Australian case-law tells us that the term “reasonable grounds” refers to ones “expectation and confidence that the company was in fact solvent”. However, it is no defence for the director to say they were “completely unaware of the company’s financial position”. After all, the director must be aware of all aspects of their company, especially its financial position.
2. A Competent and Reliable Person Defence:
The competent and reliable defence is outlined under section 588H(3) of the Corporations Act. This defence is especially useful for directors of larger companies where they receive advice and guidance from company management. In order to rely on this defence, the director must show that at the time the company incurred the debt:
- Some competent and reliable person, whom is responsible for providing the director with adequate financial information, believed the company to be solvent.
A competent and reliable person may be another managing director or the companies management team. However, directors will not be able to rely on this defence if they suspected the companies insolvency and failed to demand information, from a managing director, about their suspicions.
3. The Illness/Absent from Management Defence:
This defence is referred to in section 588H(4) of the Corporations Act. Now, this defence is especially important for directors who are absent from management for ‘some good reason‘. Accordingly, this defence will apply to protect a director from personally incurring the companies debt, when:
- The director was absent from management, because of some illness or ‘some other good reason‘, at the time the company incurred the debt.
But what would count as “some good reason” if the director was not ill? As seen by Australian case-law, if a director chooses not to participate in the management of the companies business, this does not satisfy the “some good reason” requirement. However, if a director did not take part in some board decision because they had a material personal interest regarding the decision, this may satisfy the “some good reason” requirement. As with many legal defences, the court will look to the entirely of the circumstances.
4. The Reasonable Steps Defences:
This defence is provided for in section 588H(5) of the Corporations Act. Importantly, this defence provides that:
- If a director is able to prove they took all the reasonable steps necessary to prevent the company from incurring the debt, they will be protected from liability for that debt.
So, what will the court consider ‘reasonable steps’ to be? Well, simply telling the company’s managing director about reservations or expressing that the director does not agree that the company should incur further debts, falls short of ‘reasonable steps’. Accordingly, the most reasonable steps the director can take is to encourage voluntary administration.
Insolvent trading is a serious breach of the insolvent trading laws stipulated in the Corporations Act. Although the consequences and liabilities of engaging in this illegal conduct will likely extend onto the directors of the company, there are a few defences available. If you suspect that your company may be conducting insolvent trading, or you would like specialised advice regarding your directors duties and obligations, you should consult with a Business Lawyer or Insolvency Specialist.