Written by Maggie Lau in September, 2010

Directors of companies are the brains of the organisations. They determine how their companies are run and control the direction of the companies. Attached to the domineering powers that directors enjoy are onerous duties, one of which is the duty to prevent insolvent trading.

The idea behind setting up a company is so that the business has its own separate legal entity and shareholders and the Directors of the Company are not held personally liable for liabilities of the company. However, Section 588G of the Corporations Act 2001 provides an avenue for Creditors to pierce this corporate veil and pursue the Director of an insolvent company personally if it can be proven that the Director has traded the company whilst insolvent.

Section 588G of the Corporations Act 2001 (Cth) provides that a company Director may be liable to civil liability and/or criminal penalty if:

• they are a Director of a company at the time when the company incurs a debt;

• the company is insolvent at that time, or becomes insolvent by incurring that debt; and

• at that time, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent.

Directors who breach insolvent trading laws can face pecuniary penalties of up to $200,000, plus disqualifications from acting as a Director or managing a company, and/or an order requiring the payment of compensation.

Where a Director intended to defraud Creditors, a Director can be liable to a maximum penalty of $220,000 or five years imprisonment, or both on top of any civil penalties.

According to statistics portrayed on the Australian Securities and Investments Commission’s (“ASIC”) website, it is evident that the recent economic downturn has attributed to a significant rise in the number of corporate collapses. It is believed that Directors, and particularly Directors of small to medium size enterprises, do not fully understand their duty to prevent insolvent trading.

Whilst there are defences provided in Section 588H (2)-(6) of the Act which may be used by a Director accused of trading whilst insolvent, such defences are often costly and/or difficult for a Director to prove in legal proceedings. Things can be much simpler if precautionary steps are taken.

On 29 July 2010, ASIC released “Regulatory Guide 217 Duty to prevent insolvent trading: Guide for Directors”. The Regulatory Guide seeks to provide guidance to Directors to understand, comply with, and minimise the risk of breaching their duty to prevent insolvent trading which is imposed by section 588G of the Act.

ASIC Commissioner Michael Dwyer said, “It is important that directors focus on their obligations to prevent insolvent trading and we expect this guidance will assist Directors of small-to-medium enterprises, in particular, to fulfil this fundamental responsibility.”

There are four principles which ASIC considers Directors, in particular Directors of companies under strain, should follow when seeking to meet their duty to prevent insolvent trading. Although not legally binding on Directors, the objective of the principles is to make Directors aware that they need to remain properly and fully informed about the financial affairs of the company at all times so they can reasonably form a view about the company’s present financial viability and the impact of incurring any further debts.

The four principles as discussed in the Regulatory Guide are as follows:-

• Confirming the company’s financial position and realistically assess the options available to deal with the company’s financial difficulties so the company can meet its obligations.

• Ensuring that systems are in place to carefully consider the company’s solvency before the company incurs each new debt.

Directors should obtain appropriate professional advice to help address the company’s financial difficulties.

This involves:-

• Obtaining appropriate advice from a suitably qualified, competent and reliable person about the financial position of the company and how the financial difficulties can be addressed.

• A Director is only able to rely on advice where the adviser is given full, complete, accurate and up-to-date instructions by, or on behalf of, the director to enable the adviser to properly and adequately provide competent advice.

• A Director may obtain appropriate professional advice from a number of sources, including an appropriately experienced accountant, lawyer or other person whose business involves advising directors and companies about solvency issues and the options available for dealing with financial difficulties.

Directors should consider and act appropriately on the advice received and in a timely manner.This involves:-

• If the company is at risk of becoming insolvent in the near future, the Director should take immediate steps. This may include obtaining further advice and preventing the company from incurring further debts.

• The Director should continue to monitor the financial position of the company closely and be prepared to take further action as soon as they suspect the company’s ability to meet its debts as they fall due is deteriorating.

• If the Director knows, or has reasonable grounds to suspect, that the company is insolvent, they should take all reasonable steps to prevent incurring further debts. These steps must be clear, positive and unequivocal.

By following the key principles, Directors are more likely to be able to demonstrate that they took reasonable steps to comply with their duty. However, following these four principles does not provide the Director of a collapsed company immunity from further prosecution.

Commissioner Dwyer said that the Regulatory Guide “in no way affects any action that may be taken by Creditors or a Liquidator against Directors who may have traded while insolvent. The Courts ultimately determine whether a Director has breached their duty to prevent the company from incurring debts when insolvent…”

Nonetheless, the Regulatory Guide will be a valuable guidance for the less than informed Directors regarding their duty to prevent insolvent trading.

PLEASE NOTE: All information contained in the articles below was correct at time of publishing.