It is therefore critical that directors of companies are fully aware of the extent of their duties and understand what they must do to comply.
If you suspect your company is or may be facing impending insolvency, McCabe Curwood is here to help you navigate the opportunities available to you to save your company and limit personal liability, particularly through the safe harbour provisions.
Directors owe a myriad of duties and obligations to the company arising under the Corporations Act
and common law. One of these duties is the statutory duty to prevent insolvent trading, pursuant to s 588G of the Corporations Act
This duty is enlivened when a company is:
- insolvent at the time that a debt is incurred;
- the company will become insolvent by incurring the debt contemplated; or
- the company will become insolvent by incurring debts, including the contemplated debt.
A director will be in breach of this provision if, at the time that the debt is incurred, there are reasonable grounds for suspecting that the company is insolvent or is likely to become insolvent.
Definition of insolvency
A company will be considered solvent if it can pay all of its debts as and when they become due and payable. If a company cannot meet this test, it will be deemed insolvent.
Common indicators of insolvency include:
- suffering continuing losses;
- the company's liquidity ratio falling below 1;
- outstanding tax liabilities;
- the inability to access additional finance;
- outstanding liabilities to suppliers that have extended past the usual trading terms; and
- having to enter into special arrangements with creditors.
Importantly, there is also a statutory presumption that a company will be insolvent if it has failed to keep financial records in accordance with the legislative requirements (see s 286 of the Corporations Act 2001
What happens if I breach my duty to prevent insolvent trading?
The duty to prevent insolvent trading is a civil penalty provision. This means that a director may be fined up to the greater of $1.05 million or three times the value of the benefit derived or detriment avoided for breaching this duty.
The court also has discretion to order that a director pay the company an amount of compensation equal to the amount of loss or damage suffered by the company as a result of the director failing to prevent the company from trading whilst insolvent.
The court may also order that a director be disqualified from managing corporations for a period of time.
Shields at the ready
There are however, a number of defences available to directors who are alleged to have breached their duty to prevent insolvent trading.
A director may have a defence to insolvent trading if:
- they expected that the company was and would remain solvent if it incurred the debt, and that expectation was based on reasonable grounds;
- they believed the company to be solvent based on information provided by a competent and reliable person responsible for providing that information to the company;
- they did not participate in the management of the company at the time the debt was incurred due to illness or some other good reason; or
- they took all reasonable steps to prevent the company incurring the debt.
Deep Seas and Safe Harbours
In September 2017, safe harbour provisions were introduced into the Corporations Act
through the new section 588GA.
Pursuant to this section, a director will not be liable for insolvent trading if, after suspecting that the company may be or become insolvent, they incur debts in connection with a course of action that is reasonably likely to lead to a better outcome for the company.
Put another way, the safe harbour protections will become available to directors if they:
- suspect that the company is (or may become) insolvent; and
- start developing a course of action that is reasonably likely to lead to a better outcome for the company; and
- incur a debt that is either directly or indirectly connected with that course of action.
The threshold of achieving a "better outcome for the company" simply means achieving an outcome that is more beneficial than the immediate appointment of an administrator or liquidator.
Section 588GA acknowledges that it may be necessary to incur debts in the short term to assist the company's overall financial position in the long term, and effectively allows directors to try to trade the company out of financial difficulty without facing persecution for insolvent trading.
In this way, the provision provides an additional layer of protection for directors while allowing them to remain in control of the company.
If you find yourself in a position where you must seek the protection of the safe harbour provisions, we recommend that you consider the following steps:
- Properly inform yourself of the company's financial position. Regularly monitor the financial position and take active measures to inform yourself of any changes.
- Seek advice from an appropriately qualified professional. Though you cannot only rely upon professional advice, it will demonstrate that you have taken active steps to inform yourself and accurately assess the company’s financial position. To ensure the advice is reliable though, it is critical that the professional is provided with adequate information to make informed conclusions.
- Act promptly to invoke the safe harbour provisions. Action should be taken as soon as you begin suspecting that the company is, or may, become insolvent. If you fail to act within a reasonable time period, the delay may preclude you from being entitled to rely on safe harbour provisions.
- Keep proper records documenting financial transactions and director decisions. This includes documenting any advice you have received and relied upon, and documenting any steps taken to inform yourself of the company's financial position. The extent and nature of the record keeping necessary will depend on the size and nature of the company.
- Act honestly. A director will not be able to rely on the safe harbour provisions if they have acted dishonestly in failing to prevent the company from incurring debt.
- Develop and implement a plan to restructure the company in order to improve its financial position.
- Importantly, if you begin to suspect that the actions taken pursuant to the safe harbour are not improving the solvency of the company, act quickly to appoint an administrator or liquidator to limit your risk of personal liability for debts incurred by the company.
Given the large degree of uncertainty plaguing the current economic climate, it is understandable that business owners and directors may feel uneasy.
McCabe Curwood has extensive experience in advising directors about their duties and obligations under the law and can work with you to provide tailored strategies to ensure compliance. If you have any questions or concerns regarding your duty to prevent insolvent trading, or your director duties generally, we encourage you to contact McCabe Curwood's Litigation and Dispute Resolution group today.