Allowing a company to trade while insolvent could have serious ramifications for individual directors. If a director is found to have knowingly allowed a company to trade while in financial difficulty, he/she could be held personally liable for the debts incurred to liquidators or creditors – and could even be found guilty of criminal action. From Corporate Governance to following ASIC guidelines, Directors have many legal obligations that they must adhere to when leading a company. This plain English guide clarifies what insolvent trading is and when the safe harbour protection would come into effect.
What is Insolvent Trading?
Section 588G of the Corporations Act 2001 (Cth) outlines certain duties a director (or a person who acts a director) must follow to prevent a company from trading while insolvent. The company would be prohibited from incurring further debts if the director of the company (or a reasonable person in a like position within the company), had reasonable grounds to suspect the company is or may become insolvent.
Although there are some defences available to a claim for insolvent trading, a claim can expose a director to civil or possibly criminal penalty, or orders for compensation of loss to a creditor. Some Director and Officer policies may not provide indemnification for insolvent trading claims.
What is insolvency?
In its simplest definition, this means that the company is unable to pay its debts as and when they fall due. Some indicators of insolvency are set out in ASIC Reg 217 and include the following:
- a history of continuing trading losses;
- cash flow issues;
- difficulties selling its stock or collecting debts;
- tax debts not being paid;
- limits are reached on funding facilities and inability to obtain further finance to fund operations;
- inability to produce accurate and timely financial information to show the company’s financial position or trading performance;
- legal action threatened or commenced, or judgments entered; and
- concerns raised by employees, bookkeeper, accountant or financial controller about the company’s ability to meet, and continue to meet, its financial commitments.
Safe Harbour and the idea of a ‘better outcome’?
Section 588GA of the Corporations Act 2001 (Cth) provides a ’Safe Harbour’ from civil insolvent trading provisions while a company is attempting to restructure or turnaround its financial position.
The Safe Harbour provisions will apply if:
(a) after a director suspects insolvency;
(b) the director starts to develop one or more courses of action that are reasonably likely to lead to a better outcome for the company; and
(c) the debt is incurred directly or indirectly in connection with such course of action starting when they take that course of action and ending at the earliest of:
(i) the director failing to take steps to put the proposed course of action into effect within a reasonable time frame; or
(ii) the director ceasing to take any such course of action; or
(iii) when the course of action ceases to be reasonably likely to lead to a better outcome for the company; or
(iv) when an administrator or liquidator is appointed to the company.
A ‘better outcome’ means an outcome that is better for the company than the immediate appointment of an administrator or liquidator of the company.
The plan developed by the director does not need to succeed in order to attract the Safe Harbour protection, however, it will still apply to debts incurred by a director during that period as long as the course of action was still likely to lead to a better outcome at the time the decision is made.
Document the proposed course of action
The proposed course of action should be documented and identify the assumptions behind the plan and give an explanation of why the director believes it will result in a better outcome. It should set out the steps required to put the plan into action within a measurable time frame.
The benefit of the Safe Harbour provisions does not apply in relation to a person and debt if the debt is incurred when the company fails to do one or more of the following:
- pay employee entitlements when due;
- give returns, notices, statements, applications or other documents required by taxation laws;
and that failure
- amounts to less than substantial compliance with the matter concerned; or
- are one of two or more failures by the company to do any or all the matters during the 12 months leading up to when the debt is incurred;
unless the Court orders otherwise.
What is reasonably likely to lead to a better outcome’?
The following may be considered:
- the director properly informed themselves of the company’s financial position; or
- taking appropriate steps to prevent misconduct by employees or officers that could affect the ability to pay company debts; or
- obtaining advice from a qualified entity who was given enough information to give appropriate advice; or
- is developing or putting a plan of action together for restructuring the company to improve the financial position of the company.