Insolvent trading is a serious form of director misconduct in Australian corporate law. It arises when a company incurs debts while it is insolvent and its directors fail to prevent those debts from being incurred.
Under section 588G of the Corporations Act 2001 (Cth), directors have a duty to prevent insolvent trading. If they breach this duty, they can be held personally liable to compensate for the debts pursuant to section 588M.
While liquidators typically bring these claims, section 588M(3) creates an unusual exception: it allows individual creditors to sue directors directly, provided the company is in liquidation and the liquidator consents. These cases are rare. However, it is important that creditors are aware that if they are dissatisfied with a liquidator not pursuing a claim, they have the power to pursue it in their own right.
What is insolvent trading?
A company is insolvent when it is unable to pay its debts as they become due. Section 588G of the Corporations Act imposes a duty on directors to prevent the company from incurring further debt while insolvent. If they breach this duty, and the company later goes into liquidation, section 588M allows a recovery action.
For a creditor to succeed in a claim, they must prove:
The company was insolvent at the time the debt was incurred.
The director knew, or a reasonable person in their position would have suspected, that the company was insolvent; and
The creditor suffered a loss because of that debt being unpaid.
Section 588H offers directors limited defences, such as reasonable reliance on others or illness, but these are difficult to establish and rarely succeed in court.
Why Liquidators often don’t pursue claims
Although liquidators are best positioned to pursue insolvent trading claims, they often choose not to. The reasons are mostly practical:
Funding constraints: Companies that are insolvent often lack the funds/assets to pay for litigation. Without creditor funding or litigation finance, the liquidator may not be able to proceed.
Cost of pursuit: Prior to pursuing a claim, a liquidator may choose to gather additional information via a public examination and may also need to obtain a solvency report. Both exercises are expensive, on top of an already expensive legal action.
Director’s asset position: If the director has no assets or is already bankrupt, a claim may not be commercially worthwhile.
Alternative priorities: Liquidators must prioritise actions that maximise return to the company and its creditors. Pursuing insolvent trading may not be viable if there are stronger recovery avenues.
Speculative action: Any litigation has an inherent risk of not being successful. A liquidator may judge that an action is too risky to pursue – they have a fiduciary duty to creditors and may make a judgement that the risk outweighs the potential return. Where there are funds, creditors may also express a preference to see a return now, rather than pay for expensive litigation that may result in a greater return year down the track.
Adverse cost orders: In a worst-case scenario, the liquidator may lose, and the director may successfully obtain an Adverse Cost Order. If such an order was made and there were insufficient assets in the Company to pay an order, the liquidator may have to personally pay it.
In some cases, liquidators may prefer to grant consent for a creditor to bring the action instead, under s588M(3).
Why creditors choose to pursue claims
While rare, some creditors do decide to sue directors directly under section 588M(3). Common motivations include:
Inaction by the Liquidator: If the liquidator refuses to act or delays too long, creditors may feel they have no alternative.
High value of debt: A creditor with a large unpaid debt has more at stake and may decide that it’s commercial to pursue a claim. Or may have non-financial motivations.
Belief in strong case: Where the creditor has access to compelling evidence (e.g., insider knowledge or strong documentation), they may feel confident enough to proceed.
Recoverability from Director: If the director has assets or insurance, the creditor may see a genuine chance of recovery.
Barriers faced by creditors
Despite the right to sue, several barriers deter creditors:
Liquidator consent requirement: Creditors must obtain written consent from the liquidator or apply to the court for leave to proceed. This can delay action. See Zappia V Grant Baines Transport Pty Limited [2010] NSWSC 98) which emphasises the need for Consent; the creditor cannot bring the action.
Cost and risk: Legal costs are high, and creditors bear them alone. An unsuccessful case may lead to an adverse costs order.
Burden of proof: Creditors must prove insolvency at the time the debt was incurred, the director’s awareness, and loss. This often requires expert evidence and access to company records.
Information access: Unlike liquidators, creditors do not have automatic access to company books or examination powers, making evidence-gathering difficult.
Director’s financial position: Even a successful judgment is only valuable if the director has assets. Otherwise, the claim may be a hollow victory.
Why Liquidators are better placed to pursue claims
From a practical and policy perspective, liquidators are generally better suited to bring insolvent trading claims:
Access to information: Liquidators can compel the production of books and conduct public examinations.
Economies of scale: They can recover for all creditors, not just one, making claims more impactful.
Neutrality: As independent officers, liquidators may be perceived as more impartial, which can assist in settlement negotiations.
Cost sharing: Creditors can pool funds to support a liquidator’s action, reducing individual exposure.
Creditors can purchase the right to pursue a claim
In some circumstances, creditors may negotiate with the liquidator to purchase or take assignment of an insolvent trading claim. This can be an effective way for a creditor to obtain standing without relying on the liquidator’s consent under s588M(3).
Under section 477(2B) of the Corporations Act, a liquidator may sell or assign a chose in action (i.e. the right to litigate) with the approval of the committee of inspection, creditors, or the court. Once assigned, the creditor (or assignee) can pursue the action in their own name as if they stood in the shoes of the liquidator.
This approach has several advantages:
No need to prove personal loss: Unlike s588M(3) claims, an assignee can pursue the full quantum of the insolvent trading claim.
Procedural control: The assignee has full conduct of the litigation, independent of the liquidator.
Potential for recovery beyond one’s own debt: If successful, the assignee may recover a larger judgment, subject to any sharing arrangement with the liquidator/insolvent company.
However, the court will scrutinise such arrangements for fairness and compliance with statutory requirements, particularly if the purchaser is a creditor with competing interests.
Case study:
Tremco Pty Ltd v Thomson [2018] QDC 101
In this case, a creditor was successful in their insolvent trading claim, but made the claim against the director’s wife, whom the Court found was a de facto director. The District Court of Queensland held Mrs Thomson liable under section 588M of the Corporations Act 2001 (Cth) for debts incurred by Kadoe Pty Ltd (In Liquidation) while insolvent. Although not formally appointed as a director, Mrs Thomson was found to be a de facto director due to her extensive involvement in the company’s operations, including managing finances, negotiating with suppliers and the ATO, and overseeing staff. Her role was substantiated by internal correspondence, third-party testimony, and her own identification as “General Manager” in documents.
The Court determined that Kadoe was insolvent from March 2010, unable to meet its GST obligations or pay its principal supplier, Tremco Pty Ltd. Despite attempts to negotiate payment plans, the company’s financial position deteriorated, and it was ultimately wound up in April 2015. Mrs Thomson’s defence, that she relied on financial statements and advice from others, was rejected. The Court found she had reasonable grounds to suspect insolvency and failed to prevent the company from incurring further debts, breaching her duty under section 588G(2).
Tremco was awarded $372,016.10, comprising the unpaid debt, legal costs incurred in obtaining the original judgment, and interest.
Conclusion
While insolvent trading claims are more commonly pursued by liquidators, creditors do have a statutory right to step in where the liquidator does not act. The process can be complex, costly, and rarely undertaken, but not impossible.
The key to success is strong evidence, liquidator cooperation, and a director who has the capacity to pay out any such claim. The case of Tremco Pty Ltd v Thomson demonstrates that creditors can use s588M(3) to recover losses personally from directors and de facto directors who trade insolvently.
That said, in most situations, the best approach remains for creditors to collaborate with liquidators, either to support them in pursuing the claim or to provide funding, ensuring a more efficient, cost-effective, and collective recovery effort for all affected parties.
