Against a backdrop of the highest levels of corporate collapses and insolvency for 12 months, the Australian Securities and Investments Commission (ASIC) has issued a new Regulatory Guide on the duty for directors to prevent insolvent trading.
The economic conditions over the past two years have seen an increasing number of insolvencies and recent data has shown a sharp rise in corporate collapses, with 914 companies being placed into administration during May and 848 in June 2010. The prevalence of insolvencies has also increased the focus on directors' obligations to prevent insolvent trading and monitor the financial position of the company. Several high profile company collapses including Allco Finance, Babcock & Brown and ABC Learning are now being examined for potential breaches of insolvent trading laws.
Against this landscape, ASIC has now released Regulatory Guide 217 - Duty to prevent insolvent trading: Guide for directors, which reminds directors of their legal duty to prevent insolvent trading and outlines:
- the key principles that ASIC considers that directors need to take into account to prevent insolvent trading;
- and the factors ASIC will consider in determining whether directors have breached that duty.
The duty to prevent insolvent trading
A director has a positive duty to prevent insolvent trading under section 588G of the Corporations Act 2001 (Cth) (Corporations Act), which provides that a director must prevent the company from incurring a debt if:
- the company is already insolvent at the time, or would become insolvent by incurring the debt; and
- there are reasonable grounds for suspecting that the company is already insolvent at the time, or would become insolvent by incurring the debt.
Consequences of breach of duty to prevent insolvent trading
A company is insolvent if it is unable to pay all of its debts when they fall due. A director who breaches his duty to prevent insolvent trading risks incurring serious civil and criminal penalties.
Proceedings may be brought by ASIC, liquidators or creditors of the company and the Court ultimately determines whether a director is in breach of the duty to prevent insolvent trading.
Civil consequences of a breach of the insolvent trading provisions include potential disqualification from managing a corporation, a fine of up to $200,000 and proceedings to recover compensation for loss as a result of incurring debts whilst trading insolvently. Criminal provisions may also apply in circumstances where the director has acted dishonestly, with penalties including a fine of up to $220,000 and imprisonment for up to five years.
Whilst there are a number of defences available to a civil claim, such as that the director expected (on reasonable grounds) that the company was solvent and would remain so after incurring the debt, there is no general defence available to protect directors who wish to assist a company to attempt to trade out of insolvency as is the case in certain other jurisdictions.
Key principles for directors
ASIC has set out four key principles that directors should consider in performing their role and which ASIC will take into account when assessing whether a director has breached his duty to prevent insolvent trading as follows:
- Remain informed
- Investigate financial difficulties
- Obtain advice
- Act in a timely manner
It is important to note that these duties apply to both executive and non-executive directors, each of whom must actively monitor the financial position of the company.
Key principle 1: Remain informed
A director must remain informed about the financial position of the company. A director is never excused or relieved from the duty to monitor and remain informed of the financial position of the company unless there is a good reason, such as serious illness or where the director is overseas for a prolonged period and has appointed an alternate director to act in his absence.
This means a director must continually:
- ensure that the company maintains proper financial records and keep all relevant financial information; and
- make relevant enquiries so as to have an understanding of the financial and cashflow position of the company at all times, such as through overseeing the preparation of budgets and management accounts and reviewing the company's ability to meet its obligations.
Where a director is not involved directly in the daily operation of the company or relies upon a third party for information, the director will need to ensure that the relevant person, such as an executive director or Chief Financial Officer, is suitably qualified, competent and reliable, and that appropriate systems are in place for the director to remain informed of the financial position of the company and to verify the reliability of the information being provided to him.
Key principle 2: Investigate financial difficulties
As soon as a director suspects that the company is in financial difficulties or may be insolvent, he should take positive steps to confirm the company's financial position and the options available to resolve the difficulties, and realistically consider the company's solvency before incurring any new debts.
Key principle 3: Obtain advice
As soon as a director has reasonable grounds to suspect that the company is in financial difficulties, he should consider obtaining advice from lawyers, accountants or other insolvency specialists regarding:
- the solvency of the company and whether it is at risk of trading while insolvent; and
- how the company may address its financial issues and whether it can realistically continue to trade out of the financial difficulties to return the company to long-term financial health.
Key principle 4: Act in a timely manner
If there are reasonable grounds to suspect a deterioration of the company's financial position, a director is at risk of breaching his duty to prevent insolvent trading if he does not take immediate steps to prevent the company incurring further debts.
If a director knows, or has reasonable grounds to suspect, that the company is insolvent he should take appropriate steps such as:
- persuading other directors in writing not to incur further debts;
- convening a board meeting resolving to prevent a debt from being incurred; and
- obtaining advice as to how to deal with the company's financial difficulties.
If the Board is advised that the company cannot pay its debts as they fall due, the directors should consider appointing an external administrator immediately. If, however, after taking advice the directors determine that the company is not currently insolvent and formulate a restructuring plan, they should continuously monitor the company's financial position throughout the implementation of the plan to ensure that they are not at risk of trading insolvently at any time.
In the absence of reform to insolvency laws to provide a degree of leniency for directors to facilitate corporate restructuring without the risk of personal liability, Australian insolvent trading rules remain some of the strictest in the world. Accordingly, it is very important that directors understand the scope of their duty to prevent insolvent trading and seek advice as soon as the company falls into financial difficulties to assist in determining whether options are available to prevent insolvency and to ensure that their personal position is protected.
© DLA Phillips Fox
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This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances.