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Insolvent trading – why it matters, how to identify it, and what to do if it happens to you?

In Australia, company directors have a number of duties and obligations. One of those obligations is the duty to prevent a company from trading whilst insolvent. Accordingly, it is important for company directors to understand how to establish whether a company is, or about to become insolvent.

Whilst it might seem obvious, in order for a director to establish whether or not their company is, or is about to become, insolvent, they first need to understand the concept of insolvency.

When is a Company Insolvent?

A company is insolvent when it cannot pay its debts as and when they fall due.

This should be determined by actual circumstances and can be relatively easily established by conducting a cash flow test. Directors need to ask “will the company’s anticipated current and future cash flows be sufficient to enable current and future liabilities to be paid as and when they fall due for payment”.

Insolvent Trading in Australia

It may also be appropriate to apply the balance sheet test to assess the company’s financial position as a whole. As part of a balance sheet test, directors should, in particular, note:-

  • The company’s ability to collect debts owing to it;
  • Whether arrangements have been negotiated with creditors to defer payment of outstanding debts;
  • Whether the liquid assets or working capital of the company is sufficient to pay current liabilities when they fall due;
  • Whether additional funds can be raised in a timely manner (eg: by issuing additional shareholdings, or by increasing future borrowings); and
  • Any surplus assets available that can be sold to help pay debts without damaging the company’s ability to continue to trade and pay its ongoing debts as and when they fall due.

Directors need to take into account all relevant information about the company’s financial position when considering solvency issues and if there are any concerns, they should consider seeking appropriate advice. It is not enough for the director to merely receive the relevant advice, but they must then consider and act appropriately in a timely manner.

Further, the Judge in ASIC v Plymin & Ors (2003) 46 ASCR 126 (commonly referred to as the “Water Wheel case”) detailed 14 factors that should be taken into account when assessing the solvency of an entity as detailed below:-

  1. Continuing losses
  2. Liquidity ratio below 1.0
  3. Overdue Commonwealth & State taxes, and statutory obligations
  4. Poor relationship with present bank, including inability to borrow additional funds
  5. No access to alternative finance
  6. Inability to raise further equity capital
  7. Supplier placing the debtor on ‘cash on delivery’ (COD) terms, or otherwise demanding special payments before resuming supply
  8. Creditors unpaid outside trading terms
  9. Issuing of post-dated cheques
  10. Dishonouring cheques
  11. Special arrangements with selected creditors
  12. Payments to creditors of rounded sums, which are not reconcilable to specific invoices
  13. Solicitors’ letters, summonses, judgements or warrants issued against the company
  14. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

It is not necessary for all of these factors to be present for a company to be deemed to be insolvent, rather these are indicators, and can also be thought of as “Red Flags” or “Warning Signs”. If any of these are present in your business you should seek immediate advice from your lawyer, accountant or specialist Insolvency and Restructuring Advisor.

Not all of the factors are fatal, but, as with most things, if you are able to get on top of the issue early in the piece, the more likely you are to be able to deal with it most effectively.

So what is a director’s Duty to Prevent Insolvent Trading?

It means just that.

Directors are required to prevent a company from incurring a debt:

  • If the company is already insolvent at the time the debt was incurred; or
  • Would become insolvent as a result of incurring that debt (or a range of debts of which that debt forms part); and
  • At the time there would be reasonable grounds for a reasonable person to suspect the insolvency of the company either prior to or due to the debt being incurred.

A Director’s duty to prevent insolvent trading is governed by Section 588G of the Corporations Act 2001 and any claim against a director for insolvent trading must be determined by the Court.

The Courts have said that the statutory purpose of Section 588G (Directors’ duty to prevent insolvent trading) is to discourage and provide a remedy for a particular type of commercial dishonesty or irresponsibility.

Insolvent Trading in Australia

A director’s primary duty is to shareholders however the duty extends to creditors when the company is or becomes insolvent.

This duty applies not only to appointed directors but also to those persons who, although not formally appointed, may act in the role of director or pursuant to whose instructions and wishes the company’s directors act.

What are the Penalties for Insolvent Trading?

Penalties for Insolvent Trading can include:

  • Civil penalties up to $200K, and/or
  • Compensation proceedings that could lead to bankruptcy; and/or
  • Criminal Charges lead to fines of up to $200K and/or imprisonment of up to five years. (NB for a criminal charge to apply, the director’s failure to prevent the company from incurring debt whilst insolvent must have been dishonest).

The Court may also disqualify the director from managing a corporation for a period of time.

How can Directors Prevent Insolvent Trading?

In order to avoid Insolvent Trading, directors need to understand the financial position of the company at all times. This includes being properly informed about the financial circumstances of the company and ensuring that it does not trade whilst insolvent. This can be done by taking the following measures:-

  • Being involved with or supervising the preparation of management accounts and budgets and the ongoing comparison of same;
  • Reviewing the collectability of debtors;
  • Understanding when creditors are due to be paid; and
  • Being familiar with the extent of lending facilities and the ability to access additional funding if required.
Insolvent Trading in Australia

An understanding of the financial position of the company only at the time year-end reports are signed is insufficient. It is more appropriate to be considering the same on at least a monthly basis.

It is a requirement for a company to keep adequate financial records.

If these records are not appropriately maintained the company will generally be presumed to have been insolvent throughout the period where it can be shown to have failed to keep adequate financial records.

There is no “one-size-fits-all” approach here, instead, the appropriate steps taken by a director to comply with their duty to prevent insolvent trading will partially depend on:-

  • The size and complexity of the Company’s business; and
  • The skills and experience of Company Management and Staff.
  • Directors can rely on an external adviser in relation to a company’s solvency, however, in order to comply with their duties, Directors must ensure that: –
  • Those people relied upon have the necessary level of knowledge, skill and experience given the company’s business circumstances;
  • Appropriate systems are operating effectively to provide the requisite information to the director;
  • Directors make the proper inquiries to remain informed about the financial position of the company; and
  • If directors are repeatedly not receiving the information on how or when they have requested it, they need to revise the systems they have in place (including potentially replacing the external adviser).

Are There Defences Available to Directors if a Claim has been Made?

There are a number of defences upon which a director against whom an insolvent trading claim has been made can rely, including: –

  • Reasonable expectation of solvency.
  • Reliance on a suitably qualified and competent person who had provided the director with advice that the company was solvent and would remain so with the incurring of relevant debts.
  • Not being involved in the management of the company during the relevant time due to illness or some other good reason.
  • The taking of all reasonable steps to prevent the debts being incurred by the company (including any action taken to appoint an administrator to the company where appropriate).

It is important to note, however, that the above defences do not apply to a criminal insolvent trading claim.

If you have queries with respect to Insolvent Trading or External Administrations in general, please feel free to contact me at aruhe@smbadvisory.com.au

This article is intended to provide general information only in summary format on relevant issues. It does not constitute legal or financial advice, and should not be relied on as such.

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