Written by Bruce Huynh in July, 2010

Pursuant to Section 588G of the Corporations Act 2001 (“the Act”), Director’s have a duty to prevent insolvent trading by the Company. If the Director incurs a debt without reasonable prospect for being able to repay the debt, the Director can become liable to compensate the Company/Creditors for those further debts.

It is noted that an Insolvent Trading Action can only be taken once the Company has been placed into Liquidation, and the action can be commenced by the Liquidator, or a Creditor.

There are a number of factors which need to be established before any insolvent trading action is taken against the Director. These factors include:-

• Whether the debt was incurred at a time when the Company was insolvent or caused it to be insolvent
• The Director knew, or a reasonable person in his/her position should have suspected the Company was insolvent and failed to prevent the Company from incurring further debts,
• Who were the Directors at the time, and are there any Shadow Directors or other Consultants/Advisers who may also be liable to be held accountable.
• The commerciality of taking any action against the Director or persons involved.

Time Limits

The above point will be briefly described below:-

Timing

The Director will only be held to be liable for those debts which were incurred post the determination of insolvency.  Debts incurred prior to this time which remain unpaid at the commencement of the Liquidation will not be awarded by the Court.

Section 588G(1A) of the Act sets out the transactions which could lead to claims in insolvent trading.

Director knew or should have suspected the Company was insolvent

The Liquidator will need to establish this before any further action can be pursued. The Liquidator is required to examine whether the Director had taken reasonable steps to prevent the Company from incurring debt which could not be paid when they fell due.

Further to the above, the Court will consider whether a reasonable person in the Directors position should have suspected the insolvency of the Company.

Directors, Shadow Directors and Consultant/Adviser

If it can be proven that a person has acted as a Shadow Director, this person can be held to be just as accountable as a party who is listed with ASIC as being the Director.

Commerciality of taking action against the Director or persons involved

Once it is established that the Director or relevant persons involved did engage in insolvent trading action, the Liquidator will have to establish whether it is commercial to pursue.

The Liquidator will need to examine whether the Director and other parties have sufficient resources to meet any amounts awarded against them by the Court.

Timing

Pursuant to Section 588M of the Act, the Liquidator has a time limit of six (6) years from the date of Liquidation to take action in relation to insolvent trading.

As we know every case has two sides, and in this case in Section 588H of the Act makes available certain defences for Directors. Some of the defences available to a Director in defending an insolvent trading action are as follows:-

• The Director had reasonable grounds to believe or suspect that the Company was solvent at the time
• The director had reasonable grounds to expect the company would remain solvent if it incurred the debt and other debts at the time the debt or debts were incurred
• From the information available to the Director, the Director or a reasonable person would have concluded the Company was solvent at the time
• The Director took positive action to stop the Company from incurring further debt
• If the Director can prove he/she had reasonable grounds not to part take in the management of the Company (e.g. illness, death in the family, mentally unstable or sound)\

• The Director can reply on the advice of professionals who have advised them. However the Director must establish he/she had reasonable grounds to believe that:-

(a)                the person who advise them was competent and reliable

(b)               the person knew and was fulfilling their role and responsibility

(c)                with the information provided they believe the company was solvent at the time and would remain solvent if the debt was incurred.

• The director took reasonable steps to prevent the company from incurring further debt. To establish this, the Director needs to prove:-

(a)                the Director took action to consider or appoint an administrator to the company;

(b)               provide a date when the appointment took place;

(c)                the resolution to appoint an administrator; and

(d)               any other information which would establish that the director was taking steps to prevent further debt.

The onus is on the Director to prove that they had reasonable grounds to believe the Company was solvent and they did in fact believe the Company was solvent. To prove that the Director did believe the Company was solvent at the time, evidence needs to be produced to show the Director made enquires into the matter and advice was sort from an adviser or consultant.

The reliance on information produced by a professional adviser or consultant is a major stepping stone in establishing that the Director did in fact believe in the solvency of the company before incurring debt, which led to insolvency.

In seeking to commence an insolvent trading action, a Liquidator will need to assess whether he/she can prove to the Court that the company was insolvent, the Directors allowed the company to continue to trade and that further debt where incurred which ultimately were not repaid.  As taking such an action can prove to be a costly exercise, the Liquidator will also need to consider if the Director has funds or assets to warrant taking the action in the first instance.

If there are no resources available to the Director to satisfy any judgement for insolvent trading, then there is little point in taking an insolvent trading action, if no recoveries will be made from same.