The responsibilities of directors when a company is in financial trouble
As many would be aware becoming a director of a company comes with a significant amount of responsibility, risk, and a variety of challenges that can impact both the director personally and the company they manage.
Those pressures increase significantly when a company is facing insolvency as the risk of personal liability is at its greatest. This article explores some key issues directors should be aware of if insolvency looms.
Insolvent trading
A company director has an obligation to prevent insolvent trading under section 588G of the Corporations Act 2001 (Cth).
Insolvent trading occurs if, when incurring debts:
the company is or will become insolvent by incurring the debts; and
there are reasonable grounds for suspecting that the company is insolvent or would become insolvent by incurring the debts.
When is a company insolvent?
A company is insolvent when it is unable to pay all of its debts, as and when they become due and payable. A company’s solvency is determined by reference to all of the company’s circumstances and the commercial realities surrounding it.
Some indicators include:
persistent losses
increasing reliance on debt
overdue bills and pressure from creditors
payment arrangements with creditors
declining asset values
a working capital ratio below one¹
Consequences of insolvent trading
A director will be liable for insolvent trading if the director was aware or suspected that the company was or would become insolvent when it incurred the debts or a reasonable person standing in the director’s shoes would have been so aware.
A breach of the duty to avoid insolvent trading can lead to the director being liable for:
A financial claim equal to the amount of the creditors' loss arising from the insolvent trading. This is recoverable as a debt due to the company or as a compensation order;
Civil penalties including pecuniary penalty orders arising from proceedings brought by the Australian Investments and Securities Commission; and
In appropriate cases, criminal actions.
Whilst the Corporations Act provides statutory defences for insolvent trading claims, the burden of proving these defences is on directors.
As an aside, not only are directors (and shadow directors) at risk of a claim for insolvent trading, but so too are holding companies (section 588V of the Corporations Act).
Conclusion
As custodians of their businesses and to protect themselves from potential personal liability, directors should be taking pro-active steps by:
Having systems in place to enable directors to monitor the Company’s financial position
Investigate financial issues; and
Seek and act on advice in a timely manner from a qualified professional (if circumstances warrant it)
Further reading
ASIC Regulatory Guide for Directors: RG 217 Duty to prevent insolvent trading: Guide for directors | ASIC
What is insolvent trading? | Worrells
Reference
¹ Working Capital Ratio = Current Liabilities / Current Assets
