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Insolvent Trading

Author: Arul Niles

Insolvent trading occurs when a company incurs a debt when it is unable to pay its debts as and when they fall due.

The law imposed on the directors, a duty to prevent the company from engaging in insolvent trading under Section 588G, at the same time implementing new statutory defences.

The Corporations Act

Section 588G places a duty on directors of an insolvent company to prevent the company incurring debts where a director has grounds for suspecting that it is insolvent.  The duty contains five elements:

• The person is a director at the time when the company incurs that debt [588G(1)(a)]
• The company was insolvent at the time or became insolvent by incurring that debt, or by incurring at that time or became insolvent by incurring that debt, or by incurring at that time debts including that debt [588G(1)(b)]
• At that time there were reasonable grounds for suspecting the company was insolvent or would become insolvent [588G(1)(c)]
• The debt was incurred after 23 June 1993, being the commencement of Part 5.7B of the Act [588G(1)(d)]
• By failing to prevent incurring the debt, the director contravenes Section 588G(2) where, at the time the director was aware that there are such grounds for suspecting, or a reasonable person in a like position in the company, would have been aware that the company was insolvent.

Definition of Director

The new definition of Director was introduced in s 9 and duties and powers are set out in Chap 2 D.

The Proof

Even if a company is insolvent, before a director becomes liable it must be established that there were reasonable grounds to suspect that the company was insolvent or would become insolvent, to successfully invoke Section 588G.  Under Section 588G the test requires that whatever is "suspected" must be based on reasonable grounds and imports into this section an objective test for suspicion.

The three methods used in court to prove insolvency are:

• Statutory presumption
• Direct evidence
• Opinion evidence by use of an expert report.

Presumption of Insolvency (Section 588G)

The presumptions contained in 588G operate to facilitate liquidators, creditors or the ASIC in establishing solvency at a particular time.  Insolvency of a company can be presumed at a relation back date prior to the winding up or in the circumstances where accounting documents have not been kept or concealment or removal of records.  The presumption does not operate in criminal proceedings.

Civil Penalties

Contravention of Section 588G gives rise to civil consequences under Part 9.4B.  The civil penalty orders include the power of the court to disquality a person from managing a corporation or imposing a pecuniary penalty order up to $200,000.00.  However, a court may not order civil penalties disqualification if it is satisfied that despite the contravention, the person is fit and proper to manage a corporation nor order a pecuniary penalty where is considers a contravention not to be a serious one.

Only ASIC, a commission delegate or some other persons authorised in writing by the Minister can apply for a civil penalty order.  Applications for civil penalty orders are determined in accordance with the Rules of Evidence and procedure applicable to civil proceedings and must be taken within 6 years.

Criminal Consequences

A director may be liable to criminal proceedings by ASIC through the Commonwealth Director of Public Prosecutions if they contravene a civil penalty provision (Section 588G).  A director will be convicted of such an offence where it is proven that the contravention was carried out in circumstances which established the following:

1. Knowingly, intentionally or recklessly, and
2. either:
   1. dishonestly and intending to gain, whether directly or indirectly, an advantage for that or any other person; or
   2. intending to deceive or defraud someone.

If a court finds a guilty of an offence, that person is liable to a find of $200,000.00 or 5 years jail.

Criminal proceedings for an offence constituted by contravention of a civil penalty provision cannot begin if the ASIC or its delegate has already applied for a civil penalty order in relation to the same contravention, even if the application has been finally determined or disposed of.  However, although it is possible for ASIC to initiate civil proceedings after the commencement of criminal proceedings in relation to the same contravention, such an application would be stayed.

Where the criminal proceedings have been determined or disposed of by conviction, any civil proceedings stayed in relation to the same contravention must be dismissed.  Alternatively, if a director is not convicted, civil proceedings may proceed.  It is most unlikely that the ASIC or the DPP will issue both civil and criminal proceedings in relation to the same civil penalty contravention.  It is likely that the criminal provisions will be used where a director acts dishonestly and deceitfully for a personal advantage from a subject transaction.

Defences

A director can avail themselves of one of four statutory defences contained in Section 588H and can be absolved from liability if:

1. There were reasonable grounds to expect the company was solvent
2. There were reasonable grounds to rely on the information provided by another person
3. If at the time debts were incurred the director can establish illness or other good reason
4. The director took all reasonable steps to prevent incurring the debt.

Alternatively, further relief from liability from contravention of civil penalty may be provided to a director by a court in circumstances where the director has acted honestly or ought fairly to be excused from the contravention.

Compensation Against Directors

An application initiated by the ASIC/DPP to pay compensation to the court made in those circumstances may be enforced as though it were a judgment of the court.  However, a liquidator does not have to wait for ASIC/DPP to commence proceedings.  They may take recovery of compensation actions resulting from insolvent trading in circumstances where a creditor has suffered loss or damage and the company is being wound up (Section 588M).

Please note, however, proceedings under this section may only be begun within 6 years after the beginning of the winding up.

Liability of Holding Company

A holding company is liable for the debts of a subsidiary if a holding company has permitted the subsidiary to trade whilst insolvent (Section 588V).  The provision only applies to the relationship between the holding company and the subsidiary.  It does not apply to related companies generally.

A holding company is liable in circumstances equivalent to those contained in Section 588G.  However, the provision requires the court to consider, at the relevant time of incurring the debt, the grounds of awareness of the corporation or its directors to suspect insolvency and objectively consider, in the contest of the nature and extend of the corporation's control over the subsidiary, where a holding company or its directors in a like position would be aware of the subsidiary's insolvency.  There is no criminal liability for contravention by a holding company and a holding company and its directors have statutory defences comparable to those discussed in Section 588H.

Chatswood Lawyers