Restructuring & Insolvency

Insolvent trading claims against Directors

Directors have a responsibility to prevent their company from trading whilst insolvent. When directors allow their company to continue incurring debts whilst insolvent, they can become personally liable for those debts.

Insolvent trading is when directors allow their company to incur debts when the company is insolvent. Section 95A of the Corporations Act 2001 (the Act) states that:

  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.

For the purposes of section 95A, a person also means a company.

Insolvent trading is against the law. 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 external administration. If the director was reckless or dishonest and that behaviour contributed to the insolvent trading, then criminal charges may also apply.

A liquidator commences the insolvent trading claim
Only a liquidator can sue a director for insolvent trading. Administrators and receivers cannot.

Statute of limitations for insolvent trading claims
Liquidators have 6 years from the beginning of the liquidation to commence an action for insolvent trading.

A statement of claim must be lodged with the Court within that 6 year period. It is not sufficient to just issue a letter of demand. However, it is common for liquidators to initially write to directors outlining their claim and seek an out of Court settlement.

How directors become liable for insolvent trading
Section 588G of the 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 breach this section of the law by allowing the company to incur a debt when they are aware, or a reasonable person would have been aware, of grounds to suspect the company was insolvent. The reasonable person test is important because it changes the question from what the director actually knew to what he ought to have known.

When directors breach their duty in respect of insolvent trading, the provisions of section 588M of the Act allow the liquidator to recover compensation from the director equal to the value of the debts incurred whilst the company was insolvent.

Who are considered to be directors?
Individuals appointed as director are not the only ones who may be liable for insolvent trading. ‘Shadow’ or de facto directors, or other parties that controlled the company at the time the company was insolvent can also be exposed to an insolvent trading claim.

The 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) 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 acting 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.

The elements of an insolvent trading claim
Aside from the company being in liquidation, the elements for 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 (and at the time the claim is made by the liquidator);
  3. The claim must be made against people who were company directors at the time debts were incurred; and
  4. There were reasonable grounds for the director to suspect the company was insolvent. 

What about debts that have been accrued?
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 – for example, when a service is rendered or when delivery of goods is accepted. Accrued debts, on the other hand, usually relate to ongoing contractual agreements. An accrued debt is an incurred debt if the corresponding contract was entered into after the company became insolvent. If the contract was signed before the date of insolvency then the accrued debts will not be incurred. For this reason, rental arrears are usually excluded from an insolvent trading claim. 

Asic’s view of insolvent trading
Insolvent trading is an offence that is reported to ASIC as part of a liquidator’s reporting requirements. Depending on the depth and breadth of the offence, ASIC may request further investigations and possible civil and/or criminal prosecution and/or director banning.

Reporting between a liquidator and ASIC is confidential. There is no requirement that their communications be shared with the directors. In fact, the liquidator is specifically prevented from sharing such information as doing so may compromise further actions ASIC may wish to take.

ASIC can fund the liquidator to further investigate director-related offences in accordance with the Act. However, ASIC will not fund the liquidator to sue the director. The funding is purely for investigative purposes. 

Defending an insolvent trading claim
The Act provides statutory defences for directors faced with an insolvent trading claim. However, the directors have the burden of proving the defences apply. This is different from the liquidator having to prove the defences do not apply. Statutory defences include:

  1. the director had reasonable grounds to expect (not just suspect) the company was solvent;
  2. a reasonable, competent person-produced information, on which the director relied, 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; and
  4. the director took all reasonable steps to stop the company incurring the debt, including attempting to appoint a voluntary administrator to the company.

In cases brought before the Courts, the decisions have made it clear that the position of director carries certain responsibilities which cannot be avoided, including the duty to keep herself informed about the company’s solvency.

If your business is experiencing financial difficulty, contact us to arrange a free, no-obligation discussion to give you clarity on your position and options available.

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