Duty to Prevent Insolvent Trading Under the Corporations Act
Managing cashflow in any business is critical from an operations perspective, but it is also critical from the perspective of a director of a company.
There can be serious consequences if a director of company allows (whether deliberately or unknowingly) fails to prevent a company from trading insolvent or from trading in a way that will make the company insolvent.
Depending on the circumstances, a breach of this duty could attract criminal or civil penalties.
It’s Essential to Seek Legal Advice
Our firm has lawyers who specialise in civil litigation and criminal law and we pride ourselves on providing high quality services to assist clients navigate their issues with the benefit of a collective and collaborative approach.
It is essential that if you are a director of a company and have any concerns about the solvency of a company that you act quickly and seek professional assistance as soon as possible.
If allegations have been raised that you have breached your director duties, we recommend that you seek legal advice as soon as possible. Our civil litigation team and criminal solicitors are experienced and well adept at assisting with matters involving alleged breaches of director duties which may have criminal or civil penalties attached.
We offer a free and confidential initial consultation to discuss your matter. Feel free to contact us on 07 5532 3133.
This article will discuss a director’s duty to prevent insolvent trading under the Corporations Act 2001 (Cth) (‘Act’).
We have discussed other director duties which arise under the Act in our other articles:
This article is general in nature and should not be relied upon as legal advice.
Duty to prevent insolvent trading
What is the duty?
Each director of a company has a duty to prevent the company from trading whilst insolvent and to prevent the company from trading in a way that will make it insolvent under section 588G of the Act, and can be personally liable if this duty is breached.
What is insolvency and insolvent trading?
Insolvency occurs when a company is unable to pay its debt when they are due. Insolvent trading occurs when a company incurs a debt whilst insolvent or becomes insolvent as a result of incurring a debt.
Justice Middleton in Strawbridge, Re Virgin Australia Holdings Ltd (admins apptd) (No 2) held that:
‘A company incurs a debt when, by act or omission, it is rendered liable for a debt, even one imposed by statute’
Chief Justice Gleeson stated in Hawkins v Bank of China that:
‘The words “incurs” and “debt” are not words of precise and inflexible denotation…they are to be applied in a practical and commonsense fashion, consistent with the context and with the statutory purposes.’
A debt may also include a ‘contingent debt’ being a debt where it has been incurred pursuant to a contract between a company and another entity or individual with an unavoidable obligation to pay a sum of money at a future time.
How to determine whether a company is insolvent or is engaging in insolvent trading?
If you are a director of a company and are concerned about whether the company is insolvent or is trading insolvent we recommend that you seek independent financial advice as soon as possible.
There are different methods applied by the Court, but the general and preferrable method is generally a cash flow assessment to determine a company’s solvency.
Who does this duty apply to?
A director is defined under section 9 of the Act as:
A director of a company or other body is defined under section 9 of the Act as:
a) A person who (regardless of the name that is given to their position):
i. Is appointed to the position of a director; or
ii. Is appointed to the position of an alternative director and is acting in that capacity; 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 (also known as a de facto director); or
ii. The directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes (also known as a shadow director).
This means that this duty may extend to a person who has never been formally appointed as a director of a company.
Are there defences available if this duty is breached?
If there is an allegation that this duty has been breached by a director, there are a limited number of available defences such as:
- The director can prove that they took reasonable steps to prevent the company from incurring debt;
- The director had reasonable grounds to expect, and did expect, the company to be solvent when the debt was incurred;
- The director received adequate information about the solvency of the company from a competent and reliable, had reason to believe that person and did believe the company was solvent and would remain solvent when the debt was incurred;
- The director was not taking part in the management of the company as a result of illness or being incapacitated or another good reason when the company traded insolvent; or
- The director acted honestly and reasonably in the circumstances when the company traded insolvent.
What are the potential penalties for breaching this duty?
Breaching this duty may attract civil or criminal penalties.
Generally, whether a breach of this duty attracts a civil or criminal penalty depends on whether the breach was dishonest or reckless.
Civil penalties include an order requiring a person to pay compensation to the company or others, and the person may be prohibited from managing a company.
Criminal penalties may apply if a director (or directors jointly) dishonestly or recklessly allows a company to enter insolvency or dishonestly or recklessly traded whilst being insolvent, which may mean that a person is fined and/or sentenced to a term of imprisonment.
In any case, it is important that if you are a director and are concerned that you may have breached this duty that you seek independent legal advice as soon as possible.
Our firm, having lawyers who specialise in civil and criminal law, are uniquely positioned to advise on both the civil and criminal aspects of any breach of director duties. Our litigation and criminal team regularly work in tandem to protect our client’s interests and provide timely and strategic advice.
You can rest assured knowing that our lawyers will be able to deal with all aspects of your matter where there could be a cross-over between civil and criminal law matters.
We offer a free and confidential initial consultation to discuss your matter.
Feel free to contact us on 07 5532 3133.