Insolvent trading claims by liquidators: Real threat or bluff?
This isn’t a blog post written for other lawyers – it’s written for company directors. An insolvent trading claim is like a lightening strike, it is rare but dangerous if you’re unlucky enough to receive one. Recently, Australia’s insolvent trading laws have been significantly watered down by the new safe harbour protection.
What is trading while insolvent?
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).
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.
What are the elements of an insolvent trading claim?
- 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
- Also criminal prosecution potential
How likely is an insolvent trading claim?
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. For a liquidator to run an insolvent trading claim it is a demanding and expensive exercise so they are usually adverse to this course.
The new safe harbour
As a result of insolvency reform (National Science and Innovation Agenda), the 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 frominsolvent 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.
New section 588GA of Corporations Act 2001 (Cth)
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
Do you want to learn more – read the article about trading while insolvent Navigating the safe harbour: The role of solicitors