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A guide against Insolvent trading

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. Company directors must know how to determine if a company is insolvent or on the verge of insolvency.

Directors must understand insolvency to determine if their company is or will become insolvent.

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”.

You can use the balance sheet test to evaluate the overall financial position of the company. As part of a balance sheet test, directors should, take note of the following:

  • The company’s ability to collect debts owing to it;
  • Whether we have negotiated arrangements with creditors to defer payment of outstanding debts;
  • Does the company have enough money to pay its debts when they are due?
  • Can we raise more money quickly (e.g. by selling more shares or borrowing more in the future)?
  • 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 must consider all relevant financial information about the company’s position when thinking about solvency. If they have concerns, they should seek advice. The director needs to listen to advice and then act quickly to make the right decisions.

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

  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. This can rather be considered as indicators, and can also be thought of as “Red Flags” or “Warning Signs”. If you have any of these in your business, seek advice immediately from a lawyer, accountant, or insolvency and restructuring advisor.

It is important to consult with professionals who can provide guidance in these matters. Do not delay in seeking their assistance. They can help you navigate through any challenges or issues that may arise.

Not all factors are deadly, but if you address the problem early, you can handle it better.

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

It means just that.

Directors must prevent a company from incurring a debt,

  • If the company is already insolvent at the time the debt was incurred; or
  • If it would become insolvent as a result of incurring that debt (or a range of debts of which that debt forms part); and
  • If there were valid reasons to suspect the company’s insolvency before or because of the debt.

Directors must prevent insolvent trading according to Section 588G of the Corporations Act 2001. The Court decides any claims against directors for insolvent trading.

Courts said that Section 588G aims to discourage and fix a specific kind of dishonesty or irresponsibility in business.

A director must prioritize shareholders, but also consider creditors when the company is insolvent or in financial trouble.

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.

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How can Directors Prevent Insolvent Trading?

Directors must understand the financial position of the company to prevent insolvent trading. They can assist by handling financial reports and budgets.

They can also check if customers will pay their debts. Additionally, they need to know when to pay suppliers. Lastly, they should be aware of loans and ways to obtain money.

It is important for directors to regularly assess the financial position of the company, not just at year-end. Adequate financial records must be maintained to demonstrate solvency.

Directors prevent insolvent trading based on business size, complexity, and management team skills and experience. Directors can seek assistance from external advisors.

However, it is crucial for them to ensure that these advisors are knowledgeable and equipped with the appropriate systems. This is necessary to provide accurate financial information. If directors are not receiving the information they need, they should revise their systems or consider replacing the external advisor.

Director's defence in case of claims

Directors facing an insolvent trading claim have several defences they can use to protect themselves. Here’s a few examples:

  • Reasonable expectation of solvency.
  • The director relied on a qualified person’s advice. The advice stated that the company was financially stable. The advice also stated that the company would remain financially stable even with new debts.
  • Not being able to manage the company at that time because of illness or a valid reason.
  • Taking necessary actions to avoid company debts, including appointing an administrator if needed.

Important to note, however, the above defences do not apply to a criminal insolvent trading claim.

This article intends 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.

About the Author

Farrah Motley
Director of Prosper Law. Farrah founded Prosper online law firm in 2021. She wanted to create a better way of doing legal work and a better experience for customers of legal services.

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