Directors and Management Committees Beware: Insolvent Trading

June, 2017

BY Marcelle Chester

Australia has some of the most severe and wide-reaching provisions prohibiting insolvent trading. It is essential that organisations are aware of the indicators and consequences of insolvent trading, and implement processes to protect the organisations and their officers from harm.

How to determine if your organisation is solvent

To determine whether an organisation is insolvent, an organisation’s financial position should be considered as a whole. Organisations should employ a forward-looking cash-flow test, that is, can the organisation pay all its debts as and when they become due and payable?

Insolvency is not simply determined by whether an organisation’s assets exceed its liabilities. Organisations are able to take into account their ability to sell assets or borrow money. Organisations should note the difference between a ‘temporary lack of liquidity’ (the organisation may be solvent) and ‘endemic shortage of working capital’ (the organisation is likely insolvent).

You should be wary of the following common indicators of insolvency:

  1. continuing losses;
  2. unreliable forecasts and financials;
  3. aged creditors;
  4. debt recovery proceedings;
  5. cash on delivery terms with suppliers;
  6. poor liquidity ratios;
  7. dishonoured and post-dated cheques;
  8. special arrangements with some creditors;
  9. inability to raise equity or access finance; and
  10. deferred or overdue tax liabilities.

If your organisation is experiencing any of the above factors you should take immediate action.

Companies

When is a company insolvent?

“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.” Section 95A of the Corporations Act 2001 (Cth) (the Act)

When is a debt incurred?

A debit arises when a company becomes liable to pay a liquidated sum. A debt is distinct from a right to liquidated damages and can include contingent liabilities such as guarantees. The Courts will consider each case on its own facts, therefore when a company incurs a debt will depend on its own facts and circumstances.

Directors’ duty to avoid insolvent trading

Directors of companies are bound by a duty to avoid insolvent trading under the Act, the Australian Charities and Not-for-profits Commission Act 2012 (Cth) (the ACNC Act) and the common law. Unlike other directors’ duties under the Act, the duty to avoid insolvent trading and the penalties for a breach of this duty in the Act have not been switched off for companies registered as charities.

Directors of companies can be held personally liable for insolvent trading:

  1. there are reasonable grounds for suspecting such insolvency; and
  2. the person fails to prevent the company from incurring the debt where the person is, or a reasonable person would be aware of such grounds.
  1. there is suspicion of such insolvency; and
  2. the person dishonestly fails to prevent the company incurring the debt.

It is important to note that Directors can still be found liable even if the Director has acted honestly. Further, a Director’s liability is not absolved if a company’s position improves during the insolvent trading period.

Am I liable?

The following individuals can be found liable for insolvent trading:

  1. appointed Directors;
  2. de facto Directors (not properly appointed, but who act in the position of a Director);
  3. shadow Directors (person or company in accordance with whose instructions the Directors are accustomed to act as Directors of the company); and
  4. a holding company (can be liable for insolvent trading by a subsidiary).

What defences are available?

In the case of a Director facing liability for insolvent trading, the following defences are available:

  1. Director had reasonable expectation of continued solvency (s 588H(2) of the Act);
  2. Director reasonably relied on another person to provide information and on basis of that information, had expectation of continued solvency (s 588H(3) of the Act);
  3. non-participation in the management of the company due to illness (s 588H(4) of the Act);
  4. Director took all reasonable steps to prevent debt being incurred (s 588H(5) of the Act); and
  5. relief from liability granted by the Court (ss 1317S and 1318 of the Act).

Do Directors of companies owe duties to creditors?

Directors have various duties under the Act and common law. Generally, these duties are to act in good faith, not to improperly use their position or information, act with care and due diligence and in the best interests of the company.

Directors’ primary duty is always to act in the best interests of the company, however Directors’ considerations will shift if their company is approaching insolvency. When a company is solvent, a Director’s duty will be primarily to act in the best interests of the company, although if a company is moving towards insolvency, a Director must have regard to creditors, including employees.  There are few cases that have considered this in practice.

Incorporated Associations

Management Committee Duties

Management committee members are bound by duties under the relevant state or territory incorporated associations legislation, Standard 5 of the ACNC Governance Standards under the ACNC Act and the common law. These duties include the duty to act in good faith, not to act for an improper purpose, act with care and diligence, act in the organisation’s best interests and avoid conflicts of interests. Namely, the duty to act with care and diligence requires management committee members to inform themselves of the organisation’s financial position and avoid insolvent trading.

Am I liable?

There has been uncertainty about the application of insolvency provisions to incorporated associations and whether management committee members could be found personally liable for debts incurred while insolvent. The Supreme Court of Queensland found in Robson & Ors v Commissioner of Taxation [2015] QSC 76 (Robson case) that the insolvent trading provisions in the Act which allows liquidators to recover property from Directors does not apply to incorporated associations. The Robson case examined the application of the insolvent trading provisions in the Act to Queensland’s incorporated associations legislation and Justice Jackson noted in his decision that simple amendments to the Queensland legislation could reverse this position.

There is, however, scope for management committee members to be found personally liable for insolvent trading. It seems as though the legislature intended for the insolvent trading provisions in the Act to apply to incorporated associations as well as companies.

What defences are available?

In the case of a management committee member facing liability for insolvent trading, the following defences are available:

  1. the debt was incurred without the committee member’s authority or consent;
  2. at the time the debt was incurred the committee member did not have reasonable grounds:
    1. to believe that the association was insolvent; or
    2. to expect that if the association incurred the debt, it would become insolvent.

In the face of insolvency, what can we do?

  1. Keep detailed records and ensure continued awareness of the organisation’s financial position;
  2. ensure that the Board or management committee holds regular meetings and obtains all relevant information;
  3. seek expert advice including from lawyers and financial advisors;
  4. ask questions and regularly form views as to the organisation’s solvency;
  5. take positive steps to investigate financial difficulties and assess available options;
  6. increase checks and balances around debt incurrence including adding new protocols;
  7. put off debt incurrence, particularly large debts where possible; and
  8. ensure that the Board or management committee is continuously working on a plan to restore the organisation to solvency.

Contact Mills Oakley

Vera Visevic | Partner
T: +61 2 8289 5812
E: vvisevic@millsoakley.com.au

 

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