Insolvent Trading

Find out what you need to know about Insolvent Trading from NR Consulting, your partners in Insolvency, Liquidation and Bankruptcy. Our friendly and professional team based in Brisbane, Ipswich, Gold Coast and Sunshine Coast can work with you to achieve things you thought might not be possible. With more than 30 years experience in the financial services industry, we strive to give you quality advice at affordable prices Australia wide. Please take a moment to read our frequently asked questions regarding Insolvent Trading.

What is insolvent trading?

This is a claim for compensation made against a director of a company that is in liquidation. It originates from the director allowing an insolvent company incur debts, and leaving those debts unpaid when the company is wound up. The directors may be liable to compensate creditors for the amount of those unpaid debts.

Why take these claims?

Directors should not allow a company to incur a debt that it is not able to pay. Allowing an insolvent company to incur those debts is a breach of the director’s duty. Directors may have to pay compensation to the company for losses creditors have incurred due to that breach of duty. This is essentially a damages claim made against the director.

Who takes insolvent trading claims?

Liquidators have the first opportunity to take these claims for debts owed to all creditors. If the liquidator decides not to take action individual or groups of creditors may commence their own actions, but are limited to claiming for their own debts only.

What are the factors in an insolvent trading claim?

Apart from the company being in liquidation:

  1. the people must have been directors of the company at the time that the debts were incurred; Guilty 1
  2. the company must have been insolvent when the debts were incurred; and
  3. the debts must remain unpaid at the time of the winding up.

Who are the directors?

Director are not only those people who are appointed directors. People who act as directors even, if not formally appointed, may be defined as directors. Shadow or de facto directors, or other parties that controlled the company at the relevant time may be exposed to an insolvent trading claim. The section 9 definition of director is:

(a) a person who: (i) is appointed to the position of a director; or (ii) is appointed to the position of an alternate director and is acting in that capacity; regardless of the name that is given to their position; and

(b) unless the contrary intention appears, a person who is not validly appointed as a director if: (i) they act in the position of a director; or (ii) the directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes.

The definition excludes people who give advice as part of their normal professional role. This exclusion will include accountants, managers and other paid consultants. The exclusion reads:

Subparagraph (b)(ii) does not apply merely because the directors act on advice given by the person in the proper performance of functions attaching to the person’s professional capacity, or the person’s business relationship with the directors or the company or body.

When is the company insolvent?

A company is insolvent when it cannot pay its debts as and when they become due and payable. The test is an inability of paying debts when they need to be paid. The legislation defines solvency and insolvency in the following terms:

Section 95A – Solvency and Insolvency (1) A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable. (2) A person who is not solvent is insolvent.

Why must the company have been insolvent?

The company must have either been insolvent at the time of incurring the debt, or become insolvent because of incurring the debt, for the claim to exist. A solvent company has the capability of paying all of its debts as they fall due and, hence, the directors should be able to reasonably believe that any debt incurred would be paid when due, even if it had not been paid when the company was liquidated.

The claim against the director is based on a breach of the Act, and that breach contemplates a director knowing that the company cannot pay the debt and still allowing the company to incur it.

What are debts incurred and debts accrued?

The debt must be incurred, not just accrued, when the company is insolvent. There is a distinction between the two. Incurring a debt is the legal creation of a debt that did not previously exist.

Accrued debts usually relate to ongoing contractual agreements. They are incurred at the time of entering into the original agreement and only become payable (or accrue) at the later time. As long as the original agreement was entered into when the company was solvent, and the later amounts only accrue because of that original contract, they will not form part of an insolvent trading claim. For example, lease payments that become due from time to time under a contract entered into prior to the insolvency will not form part of the claim.

How are directors liable?

Section 588G sets out the director’s duty to prevent insolvent trading by the company and starts the process for making a claim under sections 588J and 588M of the Act.

A claim is possible if: (a) the person was a director when the company incurred the debt; (b) the company was insolvent or became insolvent because of incurring that debt; and (c) there are reasonable grounds for the director to suspect that the company is insolvent at the time.

The director contravenes this section by allowing the company to incur the debt when they are aware that there were grounds for suspecting that the company was insolvent; or a reasonable person in the position of the company would have been aware of such grounds.

Once a director has breached the duty set out in section 588G, the provisions of section 588M will allow a recovery from that director. A claim is possible where (a) the director has contravened section 588G; (b) the creditor has suffered loss or damage because of the company’s insolvency; (c) the debt was wholly or partly unsecured; and (d) the company is being wound up;

What defences are available?

The Corporations Act provides some statutory defences to directors. They can be summarized as:

  1. The director had reasonable grounds to expect (not just suspect) that the company was solvent;
  2. A reasonable and competent person was producing information that would reasonably lead to a belief that the company was solvent;
  3. The director had a good reason for not taking part in the management of the company at the relevant time (not whether he did or not, but whether he had a good reason not to); or
  4. The director took all reasonable steps to stop the company from incurring the debt, including attempting to appoint a voluntary administrator to the company.

The burden of proving the defences is placed upon directors. Case law has removed the ‘silent director’ defence. The courts have made it clear that the position of director carries certain responsibilities which cannot be avoided, including the duty to keep informed about the company’s solvency and the debts being incurred.

Is insolvent trading an offence under the Corporations Act?

Yes, insolvent trading may be considered an offense and may be referred to the Australian Securities & Investments Commission for further investigation and possible prosecution. These matters are best dealt with by directors by seeking legal advice. Section 588G – Director’s duty to prevent insolvent trading by company

(3) A person commits an offense if: (a) the person is a director of the company when it incurs a debt; and (b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and (c) the person suspected at the time when the company incurred the debt that the company was insolvent or would become insolvent as a result of incurring that debt or other debts (as in paragraph (1)(b)); and (d) the person’s failure to prevent the company incurring the debt was dishonest.

Can creditors take insolvent trading actions?

Yes. If a liquidator does not or can not make a claim, the creditors of the company (individually or in a group) may make a claim themselves. The creditors may commence an action at any time with the written consent of the liquidator. Creditors may apply to the liquidator for consent 6 months after the liquidation.

Creditors can only take actions for their own debt. Unlike liquidators, they cannot group all creditors debts into their claim. Under certain circumstances, the Corporations Act will stop the creditor from commencing action. These circumstances are limited to situations where the liquidator has has begun proceedings or has intervened in an application for a civil penalty order.

In summary, a restriction is placed on an action where the liquidator has already started an action.

How long do liquidators have to take an insolvent trading action?

The Act allows liquidators six years from the beginning of the liquidation to commence an action for insolvent trading. The liquidator must commence proceedings within that six year period. It is not sufficient just to issue a demand.