Australia: Is It Time To Indemnify Directors For Civil Penalty Orders For Insolvent Trading?

Last Updated: 30 July 2003
Article by Danielle Hauer

One could be forgiven for labelling 2003 as the 'year of corporate insolvencies'. Since the start of this year the Australia Securities and Investments Commission (ASIC) has conducted solvency reviews of 169 companies and 56 directors, including a number of large corporate groups. Recent corporate insolvencies such as HIH, One.Tel and Waterwheel have placed insolvency law at the forefront of press attention.

Flowing from this ASIC has increased the number of civil proceedings against directors for insolvent trading. Directors found liable for insolvent trading may face civil pecuniary penalties of up to $200,000. For instance Waterwheel Holdings Pty Limited in ASIC v Plymin [2003] VSC 123 received plenty of press attention when the directors John Elliott, Bernard Plymin and William Harrison all faced civil pecuniary penalties for insolvent trading.

This then begs the question, which this article examines, whether directors and officers insurance policies (D&O insurance) can indemnify directors against civil penalties, or if not, whether they should do so.

What is insolvent trading?
Section 588G of the Corporations Act (the Act) states that where a director fails to prevent a company incurring a debt when the company is insolvent, that director will be guilty of an offence known as insolvent trading. A breach of this provision can attract both criminal and civil penalties, including pecuniary penalties of up to $200,000 and imprisonment for up to five years, or both.

Where a director allows a company to trade whilst insolvent and this is done knowingly, intentionally or recklessly and was dishonest (with a view to gaining an advantage or was intended to deceive or defraud someone) then the director is guilty of a criminal offence: section 588G(3).

Alternatively where the element of dishonesty is absent ASIC may seek a pecuniary penalty under section 1317G against a director if at the time the debt was incurred he or she was actually aware of the existence of reasonable grounds to suspect insolvency or a reasonable person in a similar position within a similar company would have been so aware (section 588G(2)).

Directors' and Officers' insurance policies
Legislative restrictions on indemnity
Sections 199B and 199C of the Act prohibit a company (and a related body corporate) from paying, or agreeing to pay, the premium for insurance of an officer (including a director) or an auditor of the company against a liability (other than for legal costs) arising out of:

  • conduct involving a wilful breach of duty in relation to the company, or
  • a contravention of section 182 or 183 (which relate to directors' misuse of position and information).

Provided that these matters are excluded from the cover under the D&O policy, which they usually are, there are no restrictions on the ability of a company to pay for an insurance premium for their directors and officers. The question that then remains is whether a director who is found guilty of insolvent trading is guilty of conduct involving a wilful breach of duty in relation to the company?

Insolvent trading as a criminal offence
A company is prohibited from paying the premium for D&O insurance against criminal liability for insolvent trading. This is because a criminal offence is committed as a result of a wilful breach of duty, or wilful deceit and by virtue of s199B of the Act any policy that indemnifies this conduct is void.

Irrespective of who is paying the insurance premium, whether the director or the company, a D&O policy will not indemnify a director or officer for who is criminally liable for insolvent trading. Public policy dictates that a criminal should not be protected for acts, the very nature of which the State is trying to deter and punish.

Insolvent trading as a civil contravention
D&O policies could cover directors or officers for liability incurred under a civil penalty provision.

Criminal insolvent trading cases involve complex evidentiary issues that make them challenging for ASIC and liquidators to pursue. It is often difficult and costly to prove that the director's failure to prevent the company incurring the debt that ultimately led the company to insolvency was in fact dishonest. Consequently it is preferable to pursue civil sanctions against the director for insolvent trading rather than attempting to enforce a criminal sanction.

Typically insolvent trading actions are claims for compensation by a liquidator or creditor. If the element of dishonesty and wilful deceit is not at issue, a director may, subject to any other limitations in the policy, be covered under the direct component of a D&O policy. D&O insurance may therefore potentially provide liquidators with a source of recovery in insolvent trading claims particularly where the relevant directors may not themselves have sufficient assets to satisfy a judgment. It is clear how in law and why as a matter of public policy this cover should and indeed does exist.

Can D&O insurance indemnify a director for liability for Civil penalty orders?
It is less certain whether D&O policies can indemnify a director or officer against civil pecuniary penalties for insolvent trading. By virtue of section 588G(2) of the Act the elements of civil liability for insolvent trading do not require ASIC to prove wilful deceit or dishonesty. Therefore sections 199B and 199C of the Act do not apply to prohibit D&O policies from indemnifying a director or officer for civil penalty orders.

However such an indemnity may be prohibited under the common law for reasons of public policy. This is because the policy reasons for a civil penalty order are deterrent and punishment: civil penalties are in the nature of fines. To permit indemnification against a penalty order for insolvent trading can only frustrate the efficacy of the deterrent: if directors can offload liability for these 'fines' onto insurers there will be little disincentive to civil insolvent trading.

Corporate form makes it difficult to determine which individual is morally responsible and therefore who should be held accountable. The use of civil penalty orders allow ASIC to apply for punitive orders against individuals who have breached legislative provisions, without the need to proceed through the normal criminal process.

It is well settled law and policy that an express promise of indemnity to an individual for the commission of unlawful conduct, whether a civil wrong or a criminal act, is void: Burrowes v Rhodes [1899] 1 QB 816. The well publicised Waterwheel case exemplifies how civil penalty orders provide ASIC with an effective means of ensuring directors' accountability for insolvent trading and (hopefully) deterring other directors from breaching insolvent trading laws. In an address to the IPAA Conference in Adelaide on 28 May 2003 Professor Berna Collier, the ASIC Commissioner, describes how:

'The Waterwheel success is a psychological victory in the market even though no criminal charges were laid, and we hope, a financial victory for creditors.'

If one of the policy reasons for ASIC enforcing civil penalty orders against directors for insolvent trading is to deter other directors from this conduct then as a matter of public policy insurance companies should not cover directors for such orders. If D&O insurance policies indemnify directors for civil penalty orders, the efficacy of the penalty as a deterrent is lost.

In conclusion, the Act, in its terms, does not prohibit a D&O insurance policy indemnifying a director against civil penalty orders incurred for insolvent trading. Even so, irrespective of whether the wording of the policy is wide enough to provide such cover, public policy does not allow indemnity against civil pecuniary penalties.

In the meantime ASIC's enhanced regulatory focus in the area of insolvency highlights the growing importance for corporate awareness and guidance in this aspect of commercial law.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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