Australia: The Director’s Duty To Prevent Insolvent Trading

Last Updated: 12 October 2009
Article by Melanie Bird

The current state of the world's economy is unfortunately taking its toll on many businesses. We hear about these hardships almost on a daily basis.

In 2008, there were over 12,000 corporate insolvencies Australia-wide. That figure is sure to increase significantly in 2009. This in turn will inevitably lead to an increased focus on, and number of, insolvent trading claims against directors.

The collapse of high profile companies earlier this decade, such as HIH Insurance Group, One-tel, Harris Scarfe and Ansett, saw a significant shift in the public opinion and debate on the director's position within the company. The popular view was (and perhaps still is) that the wealth generated by directors via a company was generally untouched by the company's collapse. Such a position, while in accordance with the principle that the company is a separate entity to its directors, does not sit well with creditors and public company shareholders. Accordingly, accountability of directors is increasingly under focus, in particular the duty of a director not to permit a company to continue to trade whilst insolvent.

Take for example, the successful insolvent trading claim against John Elliott in relation to the company Water Wheel Ltd. Justice Mandie in that case made comment that he thought that Mr Elliott "had turned a blind eye to the details of Water Wheel's liquidity crisis in the hope that something would turn up to rescue the company and his own associated financial interests".


Section 588G of the Act provides the basis for insolvent trading claims against directors. In summary, a director will breach this section if;

  1. The person is a director at the time when the Company incurs the debt; and
  2. The company is insolvent at that time, or becomes insolvent by incurring that debt or other debts including that debt; and
  3. At that time, there are reasonable grounds for suspecting that the company is insolvent or would so become insolvent;
  4. The director fails to prevent the company from incurring the debt in circumstances where he or she is aware at that time that there are grounds for suspecting as set out above, or a reasonable person in the director's position would in the circumstances be so aware.

This section of the Act is designed to provide compensation for creditors that have suffered a loss at the hands of a director's actions or inaction.

A director found to be in breach of this section could also see him/ herself being the subject of a civil penalty application by ASIC with a potential penalty of over $200,000 being imposed. ASIC may in such an application also seek to obtain compensation orders on behalf of creditors.

In exceptional circumstances, a director may also be found criminally liable for insolvent trading and potentially face jail time. The Supreme Court of Tasmania case of Kotek Pty Ltd heard in 2004, saw its director Timothy Williams, sentenced to 15 months jail for 38 charges of insolvent trading.

Insolvent trading claims are normally brought by a liquidator on behalf of all creditors.

However, individual creditors can make their own claim if the liquidator decides against making such a claim. If the action is taken by the liquidator, the compensation will be paid to the liquidator for the benefit of all creditors of the company. On the other hand, if a creditor takes the action the recovery will benefit that creditor solely.

As we know, trading a company always has commercial risks. The success or failure of a company can often be subject to risks beyond the control of the company itself and its directors, including risks caused by the economic changes we are currently experiencing.

The best way to ensure that an insolvent trading claim is not brought against a director is for the director to seek early accounting and legal advice if the company is finding it difficult to pay its debts as and when they fall due. While even the most prudent and well advised director can still be at risk of insolvent trading, dealing with the issue "head on" will certainly minimise the risks faced.

Directors also should be aware of ASIC's National Insolvent Trading Program, which was established in June 2003 and has the principal objective of identifying possible insolvent trading before it occurs.

This program involves a review of a company's affairs, with a focus on compliance by directors with their duty to prevent insolvent trading.

Companies are selected for review by ASIC based on a number of sources. On completion of a review by ASIC, it may identify to the company any concerns held by it in relation to the solvency of the company and ask that the company approach an insolvency practitioner for advice.

However, in certain cases ASIC may also prosecute insolvent trading claims against directors as a result of information obtained by a review.

Closing the doors of a business is obviously a very difficult decision for any director to make. However, other options are available, including the appointment of an administrator to assess the financial position of the company and options available to it.

The assessment of a company's financial viability can be a day-to-day process. However, if the relevant steps are taken by the director to ensure the availability and assessment of up to date financial data, it will place the director in the best possible position to determine at what point the company is potentially trading insolvent and therefore to take steps to minimise the risk of any insolvent trading claim being made by a liquidator.

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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