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 level of responsibility, risk, and a variety of challenges that can impact both the company and the director personally.
Those pressures increase significantly when a company is facing insolvency as the risk to the director of personal liability is at its greatest. This article explores some key issues directors should be aware of when insolvency looms.
What is insolvent trading?
Under Section 588G of the Corporations Act 2001 (Cth) (‘the Act’), directors have a statutory obligation to prevent insolvent trading. Insolvent trading occurs when a company incurs debts under the following circumstances:
The company is, or will become, insolvent as a result of incurring those debts, and
There are reasonable grounds to suspect that the company is insolvent or will become insolvent because of those debts.
In those circumstances, the director must actively prevent the company from trading whilst it is insolvent.
Defining insolvencuy
A company is considered insolvent if it cannot pay its debts as and when they’re due. To determine insolvency, all the circumstances surrounding the company’s financial situation and commercial realities must be taken into account.
Some indicators of insolvency include:
Continuous financial losses
Growing reliance on debt to stay afloat
Overdue bills and pressure from creditors
Payment arrangements with creditors
Decreasing asset values
A working capital ratio below one¹
Consequences of insolvent trading
Directors can be held personally liable for the trading debts incurred by a company whilst it is insolvent if they were aware (or should have reasonably suspected), the company was insolvent at the time it incurred the debt. If a reasonable person in the director's position would have known the company was or would become insolvent, the director could be held responsible.
If a director breaches their duty to prevent insolvent trading, they may face:
A financial claim for the creditors' loss due to insolvent trading, which may be recovered as a debt owed to the company or through an order for compensation.
Civil penalties, brought by the Australian Securities and Investments Commission (ASIC).
In certain circumstances, criminal prosecution.
It is important to note that the burden of proving any of the statutory defences which may be available to an insolvent trading claim lies with the director.
Additionally, pursuant to s.588V of the Act, holding companies and shadow directors may also be at risk of insolvent trading claims.
Taking proactive steps
To safeguard themselves from potential personal liability, directors should take proactive steps, such as:
Implementing systems to monitor the company’s financial position
Investigating any financial issues promptly
Seeking timely professional advice from qualified experts, when necessary
Conclusion
Directors should remain vigilant to avoid the risks of insolvent trading. By being proactive and diligent, they can protect themselves and their company from the risk of an insolvent trading claim.
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
