Insolvent Trading Explained

What is Insolvency?

Insolvency is defined by the Corporations Act 2001 (Cth) (the Act) in that a company is solvent If it is able to pay all of its debts as and when they become due and payable. If a company is not solvent, it is insolvent.
Directors have a duty under the Act to prevent a company from trading if it is insolvent. This duty requires directors to be constantly aware of the company’s financial position as a director is required to prevent the company from incurring a debt if:

• The company is already insolvent at the time of incurring the debt; or
• By incurring the debt(s) the company will become insolvent; and
• At the time of incurring the debt(s) there are reasonable grounds for suspecting the company is already insolvent or would become insolvent by incurring the debt(s).

The Act sets out two levels of contravention (criminal and civil) which includes different penalties for each type of contravention. A civil contravention involves a director failing to prevent a debt being incurred where there was reasonable knowledge of the company being or becoming insolvent. A criminal contravention is based on the same failure however that failure must also be found to be dishonest.

Who is a Director for the purposes of Insolvent Trading?

The duty to prevent insolvent trading applies to persons appointed to the position of director or any alternate director appointed and acting in that capacity. However, the duty also applies to persons that are not formally or validly appointed as directors. This includes a De Facto Director (or commonly known as Shadow Director) who is someone that is not validly appointed but is acting in a position of director and is someone the appointed directors are accustomed to following directions from.

What are the consequences of Insolvent Trading?

As mentioned above the penalties differ depending on if the contravention is civil or criminal. The civil penalties include:

• An order to pay compensation to the company equivalent to the loss suffered as a result of the failure to prevent the company incurring debts whilst insolvent;
• Disqualification from managing companies; or
• Fines of up to $200,000
Criminal penalties include fines of up to $444,000 (current rate) and/or imprisonment for up to 5 years.

Who can commence an Insolvent Trading Action?

A liquidator of a company has the right to pursue an insolvent trading claim. A liquidator is not required to commence a legal action, but may do so to pursue the claim. In addition, a creditor of the company can commence an insolvent trading action themselves, if the liquidator does not pursue an insolvent trading claim. In this instance a creditor can only take action against a director in respect of the debt owed to them and cannot pursue claims on behalf of all creditors like a liquidator can.

Defences?

The Act also sets out a number of defences to civil contraventions that are available to directors if it can be proved at the time the debt was incurred that the director:

• Had reasonable grounds to suspect, and did expect, that the company was solvent and remain insolvent on incurring the debt(s);
• Had reasonable grounds to believe, and did believe, that a competent and reliable person who was responsible for providing adequate information about the company’s solvency was fulfilling that responsibility, and the director expected that, based on the information that person provided to the director, the company was, and would remain, solvent even if it incurred the debt(s);
• Because of illness or other good reason did not take part in the management of the company at that time;
• Took all reasonable steps to prevent the company incurring the debt.

What should I do if I suspect my company is Insolvent?

If your company is insolvent, or you suspect it may be insolvent, the first thing is to ensure is that your company does not incur any new debts. You should then seek professional advice on your options. You should consult a registered liquidator, appropriately qualified specialist insolvency accountant or lawyer, or financial advice service about your company’s financial situation as soon as you suspect your company cannot pay debts when they are due.

If you are concerned that you or a client may be trading whilst insolvent and would like assistance or more information regarding the possible implications, please get in touch with one of our qualified and experienced experts.