A Director’s Duty to Prevent Insolvent Trading
Introduction
This article aims to educate the reader on the laws governing company directors on insolvent trading in Australia. Whilst this article will primarily focus its discussion on the pertinent sections of the Corporations Act 2001 (Cth) (“CA”) regulating a director’s duty to prevent insolvent trading by his/her company and the statutory defences available to a director in breach of the duty, it will be beyond the scope of this article to examine the specific area of insolvency and its related issues.
The Duty
The duty of company directors to prevent insolvent trading is governed by s588G of the CA.
s588G comes into effect if:
- The person is a director of a company at the time the company incurs a debt; and
- The company is insolvent at that time of incurring the debt or becomes insolvent by incurring that debt; and
- At the time of incurring the debt, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent because it incurs the debt; and
- The director is aware at the time the debt is incurred, that there are reasonable grounds for suspecting the company is insolvent; or a reasonable person in a like position in a company in the company’s circumstance would be so aware.
The Key Elements that make up s588G
“Director”
s9 of the CA defines a director to mean a person who is appointed to the position of a director; or is appointed to the position of an alternate director and is acting in that capacity, regardless of the name that is given to his/her position. The definition is broad and it is clear that s588G will be applicable to both shadow and de facto directors.
“When the company incurs a debt”
Apart from regular transactions, s588G(1A) provides the following list of events “deemed” to be an incurrence of debt by a company.
When debts are incurred
| Action of company | When debt is incurred | |
|---|---|---|
| 1 | paying a dividend | when the dividend is paid or, if the companyhas a constitutionthat providesfor the declaration of dividends, when the dividend is declared |
| 2 | making a reduction of share capital to which Division 1 of Part 2J.1 applies (other than a reduction that consists only of the cancellationof a share or shares for no consideration) |
when the reduction takes effect |
| 3 | buying back shares (even if the consideration is not a sum certain in money) | when the buy-back agreement is entered into |
| 4 | redeeming redeemable preference shares that are redeemable at its option | when the companyexercises the option |
| 5 | issuing redeemable preference shares that are redeemable otherwise than at its option | when the shares are issued |
| 6 | financially assisting a personto acquireshares (or unitsof shares) in itself or a holding company | when the agreementto providethe assistance is entered into or, if there is no agreement, when the assistance is provided |
| 7 | entering into an uncommercial transaction (within the meaning of section 588FB)other than one that a courtorders, or a prescribedagencydirects, the companyto enter into | when the transactionis entered into |
“The Company is Insolvent”
s95A of the CA defines insolvency. A company is defined to be insolvent if it is unable to pay all its debts, as and when they become due and payable.
It may be worthwhile to note that s588E of the CA contains certain presumptions that may assist one to determine if a company is insolvent. For instance, s588(4) of the CA states that where a company has failed to keep financial records in relation to a periods as required by s286(1) or has failed to retain financial records in relation to a period for the 7 years required by s286(2), the company is to be presumed to have been insolvent throughout the period.
“Reasonable Grounds for Suspecting Insolvency”
Directors will only breach s588G if there are reasonable grounds for suspecting insolvency.
In Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266 at 303, the High Court of Australia held that the respective director must have “positive feeling of actual apprehension or mistrust, amounting to a slight opinion, but without sufficient evidence”. This implies that mere speculation will not suffice to be a reasonable ground for suspecting insolvency.
“A Director’s Awareness”
The case is straightforward if a director knew that there were reasonable grounds for suspecting the company is insolvent.
“A Reasonable Person in the Director’s Shoes”
A director may still be in breach of s588G if a reasonable person in his/her position would have been aware that there were reasonable grounds for suspecting insolvency. A “reasonable person” in this context would mean a director of ordinary competence.
Consequences of breaching s588G
Should all elements of s588G crystalise, the respective director may be liable to civil penalties under s588G(2). The director also commits a criminal offence under s588G(3) if, aside from satisfying the elements in s588G(1), the director had acted dishonestly in failing to prevent the company incurring the debt. Should a director be found guilty of both civil and criminal provisions under the CA, he or she may face a fine penalty, be barred from being a company director within a certain timeframe to be determined by the relevant court and or face imprisonment.
Defences Available to Directors
Should a director find himself/ herself in breach of s588G of the CA, he or she may rely on the statutory defences available under s588H, in so far as it may be applicable.
Under s588H, a director may have a valid defence if it can be proven on the balance of probabilities that:
- The director had reasonable grounds to expect that the company was solvent and would remain solvent if the company had incurred that debt; or
- The director had reasonably relied on information provided by others; or
- The director had because of illness or some other good reason, failed to participate in the management of the company; or
- The director had taken all reasonable steps to prevent the company from incurring the debt.
Conclusion
It is clear that s588G of the CA is designed primarily with the aim of protecting the interests of creditors. Whilst it may appear that the rigid nature of s588G may discourage competent professionals from accepting director roles, it can be argued that the harshness of breaching s588G is perhaps balanced out with the availability of s588H, which serves to protect the interests of directors who have under equitable circumstances, failed to prevent their companies from insolvent trading.
Written by a previous solicitor of Lovegrove Solicitors
