The risk of insolvency for companies is currently high as
companies are finding it harder to meet their debt obligations.
This is further compounded by sharp downward asset revaluations
which are causing companies to refinance their debt on less
favourable terms and the ever present possibility that banks may
not renew a credit facility even if there has never been a default.
The unpredictability of the declining economy is also making it
difficult for companies to foresee whether they will be able to pay
their debts as they fall due. However, that is precisely what
directors are required to do under the Corporations Act 2001
(Cth) ("Corporations Act").
Definition of insolvency
A company is insolvent, if and only if, it is unable to pay all
of its debts, as and when they become due and payable. There are a
number of factors that the court will take into consideration in
determining whether a company is able to pay all of its debts.
Among the considerations include the expected availability of cash
and the ability of the company to sell assets in order to pay its
debts. In these uncertain times, these factors can be
extraordinarily difficult to assess.
Director's duty to prevent insolvent trading
Nevertheless, directors have a legal duty under the Corporations
Act to prevent insolvent trading. A director (who occupied that
office at the time the company incurred the debt) breaches this
the company was insolvent when the debt was incurred; or became
insolvent by incurring that debt, or by incurring debts at that
time including that debt; and
at that time, there were reasonable grounds for suspecting that
the company was insolvent or would become insolvent; and
the person was aware at the time that there were such grounds
for so suspecting, or
a reasonable person in a like position in the company's
circumstances would have been aware; and
the person failed to prevent the company incurring the debt. A
director found to have breached his or her duty to prevent
insolvent trading may face civil penalties, including pecuniary
penalties of up to $200,000.
No element of recklessness or dishonesty required
The duty to prevent insolvent trading does not contain an
element of recklessness. Nor does a director need to be negligent
or dishonest to breach his or her duty (dishonesty in insolvent
trading may lead to criminal charges). A director does not even
necessarily have to be aware at the time that there were grounds
for suspecting insolvency. A director will breach his or her duty
under the Corporations Act if a reasonable person in a like
position in the company's circumstances would have been aware
that there were grounds for suspecting insolvency.
It will be for the courts to decide how much weight the current
economic conditions will carry in determining whether a director
should have been aware that the company was insolvent or would
The Corporations Act provides defences for directors that have
contravened the duty to prevent insolvent trading. This E-Alert
does not examine these defences in detail, but the four specific
The person had reasonable grounds to expect the company was
The person had reasonable grounds to rely upon information as
to solvency from another person.
The person did not take part in the management of the
The person took all reasonable steps to prevent the company
from incurring the debt.
In general, these defences will not be available to directors
who have not taken steps to inform themselves about the
company's financial position.
If in doubt, seek legal advice
The economic downturn has undoubtedly increased the risk of
insolvency for companies and in November alone over 1,500
insolvency appointments were made. This places greater pressure on
directors and arguably makes it harder for directors to comply with
the Corporations Act. The risk of liability for directors is real
and directors are subject to a tough legal standard. It is critical
that companies and their directors seek legal advice when assessing
these issues. We can provide advice about your options if you
suspect your company is in financial difficulty. Recent months have
shown that the solvency of once-healthy companies can quickly
deteriorate. Directors should be alert to these dangers.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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When determining if a DOCA is to be terminated, public interest can, and often will, outweigh any benefit to creditors.
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