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What You Need to Know About Insolvent Trading

What You Need to Know About Insolvent Trading

Challenging economic conditions in the post-Covid world have caused a rash of insolvencies in certain parts of the Australian economy, in particular the construction industry. As such it’s important for company directors dealing with the possibility – or the reality – of insolvency to remember their legal responsibilities under Australia’s Corporations Act 2001 (‘the Act’). In particular, directors need to be aware of the potentially serious consequences of continuing to trade while insolvent. This article takes a closer look at what constitutes breaches of the law by company directors and the penalties they may face for trading while insolvent.

Insolvency under the Corporations Act

Under section 95A of the Act, a person is considered insolvent if they are unable to pay all their debts as and when they become due and payable. Directors have a duty to prevent insolvent trading and protect the interests of creditors.

This duty requires due diligence on the part of company directors to remain vigilant about the financial health and status of the company, regularly assessing its financial position, identifying potential insolvency risks, and implementing strategies to address them.

Maintaining accurate and up-to-date financial records is essential for directors to assess the company’s solvency. Failure to keep proper records may indicate a lack of oversight and can contribute to allegations of insolvent trading. Taking professional advice from an accountant or insolvency practitioner to recognise and address a perilous financial position is highly advisable for company directors facing insolvency. Experts will also help clarify the issues involved in undertaking the process of administration or liquidation, perhaps in preference to insolvency.

What is considered a breach of the laws relating to insolvency?

A company director may breach their fiduciary duty to remain vigilant about the financial health of the company if:

  • they held a position as a director when the company incurred debt;
  • the company is insolvent at the time of incurring debt or becomes insolvent due to the additional debt incurred;
  • there are ‘reasonable grounds’ to believe that the company is insolvent or is likely to become insolvent;
  • the director is reasonably aware – or should be reasonably aware – that these grounds exist;
  • the director is required to act to prevent the company from incurring debt.

What are some of the factors that comprise reasonable grounds for a director to suspect the company is, or is at risk of, insolvency? Examples include when the company’s liabilities exceed its assets, cash flow is limited, lines of credit are declined, legal demands for payment of debt start to arrive, and taxes and employee superannuation liabilities become overdue.

A director’s duty includes the consideration of whether there are reasonable grounds to suspect the company is insolvent or will become insolvent before incurring a new debt.

Penalties for insolvent trading

Civil penalties, compensation proceedings and criminal charges can apply to company directors who continue to trade while insolvent.

Civil penalties in the form of substantial fines vary depending on the severity of the breach, but can range up to $200,000 for an individual.

Directors may be ordered to compensate the company or its creditors for the losses incurred due to insolvent trading. This can involve personal liability for the debts the company accumulated while insolvent in proceedings initiated by ASIC, a liquidator or a creditor. A compensation order can be made in addition to civil penalties. Again depending on the severity of the breach, these pay-outs are potentially unlimited and could result in the bankruptcy of an individual director, disqualifying them from continuing as a director or managing a company.

In the most severe instances of insolvent trading, where the conduct of a director or directors was dishonest, deliberate and egregious, directors may face criminal charges leading to a large fine or up to five years’ imprisonment, and disqualification from further serving as a company director.

Statutory defences for directors exist within the Act, such as a director having reasonable grounds to expect the company was solvent, or that a reasonable, competent person produced information that would reasonably lead to a belief that the company was solvent – but these will be ineffective if the director failed to take steps to stay informed about the company’s financial position.

In 2017 the introduction of ‘safe harbour’ laws served to protect directors from personal liability for debts incurred during insolvent trading action where the director can show insolvent trading was a more favourable option than entering into voluntary administration or liquidation.

Seek professional advice to avoid trading while insolvent

Insolvent trading is a fraught issue for company directors in tight economic times, requiring them to maintain high and constant awareness of their company’s financial position and their responsibilities under the law. Breaches can result in life and career-changing consequences, including criminal charges. Directors must take prompt, appropriate action to address insolvency risks.

If you need more information about how to address concerns about insolvency, including your obligations under the Act, speak with our corporate law experts at PD Law as soon as possible for direct, relevant advice to help you take the right steps.