The risk of falling into insolvency

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 duty where:

  1. 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
  2. at that time, there were reasonable grounds for suspecting that the company was insolvent or would become insolvent; and
  1. the person was aware at the time that there were such grounds for so suspecting, or
  2. a reasonable person in a like position in the company's circumstances would have been aware; and
  1. 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 become insolvent.

Available defences

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 defences are:

  1. The person had reasonable grounds to expect the company was solvent.
  2. The person had reasonable grounds to rely upon information as to solvency from another person.
  3. The person did not take part in the management of the company.
  4. 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.