Summary: What is an insolvent trading claim?
An insolvent trading claim is an action for breach of a director’s duties. The prohibition against insolvent trading is a duty of all company directors that is set out in section 588G of the Corporations Act. It is a cause of action that liquidators have against company directors after a company is placed in liquidation to compensate creditors.
Before the safe harbour protection was introduced in September of 2017, Australia had one of the strictest insolvent trading prohibitions in the world for company directors. The law effectively mandated directors to move to external administration as soon as their company was insolvent to avoid risk of personal liability (i.e. being sued by a subsequently appointed liquidator).
What are the elements of an insolvent trading claim?
The basic elements that a liquidator needs to satisfy to successfully sue a former director are:
- A person is a director of a company;
- The company is insolvent (actual not suspected – endemic shortage of working capital, not temporary illiquidity);
- The company incurs a debt (at that time); and
- There are reasonable grounds to suspect insolvency (i.e. the directors should have known better than to incur a debt whilst insolvent).
What are the penalties for insolvent trading?
- Civil penalties up to $200,000
- Liability to compensate the company or relevant creditors for the amount of the debt incurred as a result of the breach
- Potential criminal prosecution
Insolvent trading claims by liquidators: Real threat or bluff?
An insolvent trading claim is like a lightning strike: they are rare, but they can be dangerous if you’re unlucky enough to receive one.
It is very unlikely that a director of an SME (up to 200 employees) would face an insolvent trading action. There are no statistics on how many demands have been issued by liquidators or what proportion of liquidations involve insolvent trading claims. However, one empirical study found that there were only 63 insolvent trading judgments in Australia between the 1960s and 2004. It is a demanding and expensive exercise for a liquidator to run an insolvent trading claim, so they are usually averse to this course of action.
The new safe harbor from insolvent trading prohibition
As a result of insolvency reform (National Science and Innovation Agenda), policy makers decided that the prohibition on insolvent trading discouraged company directors from taking sensible risks when considering an informal workout as an alternative to voluntary administration. The result was that the parliament enacted a new safe harbour from insolvent trading that, in effect, allows company directors to legally trade whilst insolvent. To get safe harbour protection to trade whilst insolvent, company directors need to carefully consider the criteria for the carve-out from the insolvent trading prohibition.
The duty to prevent insolvent trading does not apply when:
- At a particular time after the director suspects insolvency the director starts to develop a course of action that is reasonably likely to lead to a better outcome for the company; and
- The debt is incurred in connection with the course of action.
For the purposes of finding that a course of action is likely to lead to a better outcome for the company regard is had to whether the director:
- Informs themselves about the company’s financial position
- Takes steps to prevent misconduct by officers or employees
- Keeps appropriate books and records
- Obtains advice from appropriately qualified entity
- Develops or implements a plan for restructuring the company
Compared to the insolvent trading regime that it reforms the new safe harbour is designed to reward thoughtful company directors who take sensible records and also document their actions.
What are the elements of the safe harbour?
- “Better outcome” for the company, means an outcome that is better for the company than the immediate appointment of an administrator, or liquidator, over the company.
- Director is to be active not passive in the process
- No strict requirement to engage an “appropriately qualified entity”
- Directors are required to “develop” one or more courses of action that are “reasonably likely to lead to a better outcome for the company” (not the creditors, employees or the ATO)
- No essential requirement to have either a written plan or a plan that is actually executed
For more information on the safe harbour from insolvent trading, listen to our podcast.
Directors of small-to-medium enterprises
To launch an insolvent trading claim, the liquidator needs to be well funded and have a potential defendant who is also well funded. The empirical evidence is astounding because it shows that very few cases are actually run and disgruntled creditors can’t do much about it (unless they want to put up the money for legal fees). It is very unlikely that a liquidator will commence an action for an SME that goes into liquidation. Having said that, they may choose to in the worst cases of insolvent trading. Directors should consider using the new safe harbour from insolvent trading as a mechanism to protect themselves, and also because it is a good idea that may help a turnaround have a chance at success. The case study deals with a recent example where a creditor succeeded in an insolvent trading claim that was funded and run by the creditor themselves. This blog post does not deal with criminal cases of insolvent trading.
What does the empirical research tell us about insolvent trading claims?
Academic commentary isn’t very useful overall for directors because the academic articles that seek to critically analyse insolvent trading want to change director behaviour through policy. Empirical research, which makes direct observation about insolvent trading in Australia would be very useful. Unfortunately in Australia there is very sparse empirical research into SME insolvency.
What empirical research is available, however, tells us that liquidators very rarely actually commence insolvent trading claims and runs these proceedings to judgment. There is no empirical research into how many letters of demands are sent out by liquidators to company directors. This means that we also have no idea what proportion of potential claims are settled out of Court.
Empirical research does reveal that between the 1960s and 2004 that there were only 63 cases that were run to judgment in Australia on insolvent trading. This is an extraordinary statistic when you consider the number of companies that would have been placed into insolvent liquidation. The chances are not quite one in a million but the chances of being sued for insolvent trading in Australia must be close to negligible.
What is the rationale behind the prohibition on insolvent trading?
Risk one: Premature liquidation
Those who oppose the prohibition on insolvent trading argue that it results in directors putting companies into liquidation too quickly rather than trying to turn around the business. The actual risk of an insolvent trading claim is low but the prohibition itself has a salutary effect, simply because most people want to follow the law.
The downside is that all the goodwill value in a business is lost in a liquidation and it is also unlikely that there would be a significant return to creditors.
Risk two: Flogging a dead horse
A business must be sustainable and this means that whatever it produces must be sold for a higher price than it costs to produce. If it can’t do this then there is no hope for it and the economic resources it utilises should be passed on to more efficient enterprises.
The entire rationale for a prohibition on insolvent trading is to protect creditors. If a company is a “dead horse” then wasting assets through continued trading (that would be available in a liquidation to pay creditor claims) should be prohibited.
Risk three: Prognostication and procrastination
Directors of insolvent SMEs usually have imperfect information systems and limited or no access to high quality advisers. That creates a perfect storm for procrastination. They could be stuck at a point of indecision because there is no readily accepted template for how they should behave when faced with insolvency. If they don’t have up-to-date financial information how can they make a good decision? Who is going to help? Their accountant and solicitor probably don’t have the inclination or expertise to assist. They may be worried about getting paid for providing services when their client is potentially unable to pay for their fees.
What are the elements of the liquidator’s decision to commence an insolvent trading claim?
Key element 1: Cash at bank or a funder
Liquidators run a business and therefore their principal objective is getting paid. Most liquidations are assetless and therefore there are no funds available to pay legal or accounting fees to move ahead with insolvent trading claims. A liquidator cannot be directed by creditors to run an insolvent trading claim if they aren’t going to be paid for it.
The alternative if a liquidator is assetless is to seek funding from a creditor or a litigation funder. The game changer in the insolvency industry is that in the last decade the Australian Tax Office, Department of Employment (FEG) and litigation funders have been more active. Having said that, they aren’t likely to be interested in claims that aren’t significant. What “significant” means is changing over time but it is likely to be in the multiples of millions. However, the ATO and FEG have strong policy reasons to go after the worst cases of insolvent trading and phoenix activity.
Key element 2: Availability of books and records
There is a positive obligation upon a liquidator to prove that the company was insolvent at the relevant times. Alternatively, a director may also prove through books and records that the company was solvent. This means that access to books and records is likely to be critical or the liquidator may not be confident enough to commence the case. It sounds trite, but lawyers always say that proving insolvency “turns on the facts”. The person most likely to be able to explain the solvency of the company will be the director(s). A company may also be presumed to be insolvent if the directors do not maintain books and records (see section 588E of the Corporations Act).
Key element 3: Quantum of the claim
Liquidators charge high hourly rates and if they run litigation, they usually won’t start a case for a low quantum (i.e. the compensation claim amount). There isn’t much by way of research to explain the chances of a case being run but a liquidator would be more likely to run a case that runs in the millions rather than the thousands of dollars.
Key element 4: Defendant’s capacity to pay a judgment
Before anyone commences litigation they will want to know if the potential defendant has the capacity to pay a judgment in full. The liquidator won’t have access to private information that may be useful such as ownership of ASX shares, investment account balances or bank balances but they will have access to RP data. The liquidator will undertake a property search to see if the director owns real property and if so, where. This will heavily influence the decision to commence litigation by a liquidator.
Key element 5: Work load of insolvency practitioner
A liquidator’s work on an individual company is a bit like a garden. If they don’t have the time, it won’t be taken care of and over time doing anything may become unmanageable. The result is that often, good claims sit on the shelf and are never commenced. If a liquidator has a bigger appointment or a large litigation matter they may never start a case.
Key element 6: Evidence of safe harbour protection
The new safe harbour is a carve-out to insolvent trading claims. It means that if a director has a turnaround plan that is likely to result in a better return for creditors, they are exempt from the insolvent trading prohibition in practice. It’s not quite as simple but what is important is that directors have evidence of a plan and the steps that they took to execute it to present to any future liquidator.
Case study: Inner West Demolition (NSW) Pty Ltd v Silk  NSWDC 136 (30 May 2018)
This is an interesting case study because it is an example of where a creditor has run their own insolvent trading case. The creditor succeeded and the director had a judgment (plus legal costs) against them.
There isn’t any information in the case about why the creditor and not the liquidator ran the case against the sole director of the company in liquidation (a Mr Silk). The liquidator has the first option to commence an insolvent trading case but a creditor can take up the challenge (s588R) if the liquidator either consents (s588s) or a certain time period elapses (s588T).
- Plaintiff was Inner West Demolition (NSW) Pty Ltd
- Defendant was Mr Silk, the director of One Build Pty Ltd
- Plaintiff contracted with One Build Pty Ltd to provide demolition services on a building project for fixed price of $345,000 on 30 August 2013
- Demolition services were provided and a debt incurred by One Build Pty Ltd between September and November of 2013, therefore, the debt was incurred in full before the company was placed in liquidation.
- One Build Pty Ltd (In Liquidation) was placed in voluntary administration on 26 November 2013 and in liquidation on 13 December 2013
- The claim for insolvent trading against Mr Silk was commenced in the NSW District Court on 9 June 2017 by the creditor (Inner West Demolition (NSW) Pty Ltd)
- To succeed in the claim the Plaintiff was required to prove that the company in liquidation traded whilst insolvent and that the director (Mr Silk) knew or had reasonable grounds to suspect that the company was insolvent (and therefore has no defence)
- Each party relied upon experts to prove (or bring into question) the actual insolvency of the company as at the date of the contract (30 August 2013)
- The company failed each indicator of insolvency
- The company at the date of liquidation had $3.1 million in unpresented cheques
- Mr Silk had an in-house accountant and he gave evidence that he relied upon this person.
- For a creditor to make an insolvent trading claim they are required to comply with section 588M of the Corporations Act and this may include obtaining consent of the liquidator – the Court found that this was complied with
- Taking into account all the expert evidence and materials the Court found that the company was insolvent from 30 June 2013
- The director had not proven any defence because he did not show he had reasonable grounds to expect that the company was solvent
- Verdict for the Plaintiff for compensation for insolvent trading in the amount of $327,332
- It isn’t just liquidators that can commence insolvent trading cases but also creditors
- Only a brave and well-funded creditor would start an insolvent trading action because they need to prove the company in liquidation was insolvent and also deal with any defence raised
- Where was ASIC and why didn’t the liquidator run this? No explanation is given but it may be that under funding of both is the reason
A good starting point for further reading is the following articles on the topic:
Brotchie, J & Morrison, D. “Insolvent trading and voluntary administration in Australia: Economic winners and losers”  Accounting and Finance, p 1-26.
Herzberg, A, “Is Section 588G a paper tiger?” .
Herzberg, A. “Why are there so few insolvent trading cases?” , Company Directors Liability for Insolvent Trading, Chapter 6, p 148-166.
James, P. Ramsay, I. & Siva, P. “Research Report, Insolvent trading – An empirical study” .
Whincop, M. J. “The economic and strategic structure of insolvent trading” , Company Directors Liability for Insolvent Trading, Chapter 3, p 43-70.