Insolvent Trading

Estimated reading time: 29 minutes

The prohibition against insolvent trading is a duty of all company directors to prevent their company from trading (i.e. incurring debts) while insolvent. It is illegal for a director of a company to allow an insolvent company to continue to trade, while having reasonable grounds for suspecting insolvency. The consequences can be serious: read our guide to find out more.

Insolvent trading picture

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.

Sometimes people talk about a director being liable for trading while insolvent. But this is not technically correct. Only a company, not a director, can trade while insolvent. The duty of directors is to prevent that insolvent trading from occurring. 

Breaching this duty makes a director liable for a civil penalty for insolvent trading. If, in addition to satisfying the criteria set out above, the director was also dishonest, under section 588G(3) that director may be prosecuted for a criminal offence. ‘Director’ here refers to de facto and shadow directors, as well as de jure directors.

Before the safe harbour protection was introduced in September of 2017, and temporarily modified and extended in 2020 due to COVID-19, 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).

Explanatory video on insolvent trading (2020)

Insolvent Trading
Watch Ben Sewell (Principal) break down the prohibition on insolvent trading in his own words in this brief explanatory video.

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 set out in section 588G of the Corporations Act 2001.

  • 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 investigation and prosecution by ASIC

Essentially, it is illegal for a director of a company to allow an insolvent company to continue to trade, while having reasonable grounds for suspecting insolvency. The consequences can be serious.  In a New Zealand case in 2019, Dame Jenny Shipley, former Prime Minister of New Zealand, was ordered to pay $6 million for allowing the construction company Mainzeal to continue trading while insolvent.

What is the difference between civil and criminal insolvent trading?

As discussed above, there are three possible penalties for insolvent trading. Directors may receive, one, two or all three penalties, depending on the nature and scale of the insolvent trading and the discretionary decisions of the investigators.

Civil proceedings (bearing the penalties of fines and compensation) are always pursued first and more commonly in insolvent trading cases, as they deal with recovery of money. However, where an element of dishonesty is involved and can be proved, criminal charges may be pursued. It is more likely that a criminal case will be made out where the insolvent trading is especially serious, sustained, relates to high values of money, or is accompanied by other wrongdoing (i.e. accounting fraud, phoenix activity or breaches of other directors’ duties). The ASIC is the body in charge of pursuing criminal charges against directors.

Where criminal charges can be made out by ASIC, directors can be fined up to 2,000 penalty units or be imprisoned for up to five years, or both. If a director is found guilty of criminal insolvent trading, they will be permanently disqualified as a director.

When is a debt incurred?

It is important to understand what exactly is meant by ‘incurring a debt’ in the legislation. The term debt has been interpreted widely for insolvent trading and can include contingent debts. Transactions which give rise to a debt may include supplying goods and services, issuing a loan, entering a lease or guarantee and certain transactions which incur tax obligations (e.g. hiring new staff leads to payroll tax liability). The legislation states that a company has incurred debt when they pay a divided, make a capital reduction, redeem preference shares, assist an individual to acquire shares or enter into an uncommercial transaction. Broadly speaking, a debt is incurred if a company through its conduct subjects itself to a conditional but inevitable obligation to pay money. ‘Incurring a debt’ is considered in a logical way by courts with regard to commercial reality and the overall purpose of the prohibition on insolvent trading.

Directors of small-to-medium enterprises act differently to large corporations

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 against an SME that goes into liquidation. Having said that, they may choose to do so 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.

What does 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 a 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 run these proceedings to judgment. There is no empirical research into how many letters of demand 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, giving SMEs and advisors little tangible evidence of how best to approach these issues outside of personal experience.

Empirical research conducted by James, Ramsay and Siva (in a collaboration between the University of Melbourne and Clayton Utz) found only 103 cases of insolvent trading brought to court between the introduction of the prohibition in the 1960s and 2004. 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. It is very unlikely that a director of an SME (up to 200 employees) would face an insolvent trading action. 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 unless the debts incurred are significant or they go hand in hand with other wrongdoing.

The following tables from the University of Melbourne and Clayton Utz study reveal important information about insolvent trading cases that proceeded to judgment in Australia.

Table 2

Section/RegimeNumber of CasesPercentage
303(3) and related sections of the Companies Act54.9%
374C and related sections of the Companies Act1514.6%
556 and related sections of the Companies Code3534.0%
592 and related sections of the Corporations Law2524.3%
588G and related sections of the Corporations Law1716.5%
588G and related sections of the Corporations Act21.9%
592 and 588G of the Corporations Law 32.9%
556 of the Companies Code and 592 of the Corporations Law11.0%
Total103100.0%
Table 2: Distribution of cases according to which section of which regime they were brought under (please note that the Corporations Act is the current law).

Table 3

Type of ProceedingNumberPercentage
Civil8885.4%
Criminal1514.6%
Total103100.0%
Table 3: Distribution of cases according to the nature of the proceeding (i.e. civil or criminal).

Table 4

JurisdictionNo. of CasesPercentage
State courts8380.6%
Federal courts2019.4%
Total103100.0%
Table 4: Distribution of cases between state and federal courts.

Table 7

Finding of CourtNo. of CasesPercentage
Liable7774.8%
No liable2525.2%
Total103100.0%
Table 7: Distribution of cases according to whether directors were found liable or not liable for insolvent trading.

Table 8

Range of CompensationNo. of CasesPercentage
$1 – $20,0001116.7%
$20,001 – $50,000812.1%
$50,001 – $100,0001218.2%
$100,001 – $200,0001116.7%
$200,001 – $500,001725.8%
$500,001 – $1,000,00034.6%
$1,000,001 – 46.1%
Total66100.0%
Table: Distribution of cases according to the amount of compensation ordered.

Table 10

Year of JudgmentNo. of DecisionsPercentage
1970 – 79109.7%
1980 – 891615.5%
1990 – 996260.2%
2000 – 1514.6%
Total103100.0%
Table 10: Distribution of judgments across the years. Please note this study was published in 2004 and only accounts for cases up to and including that year.

Table 12

Industry Division/sNo. of CasesPercentage
Agriculture, Forestry & Fishing21.9%
Mining21.9%
Manufacturing1716.5%
Construction2322.3%
Wholesale Trade1110.7%
Retail Trade1716.5%
Accommodation, Cafes & Restaurants21.9%
Transport and Storage54.9%
Finance and Insurance43.9%
Property and Business Services54.9%
Education11.0%
Cultural and Recreational Services54.9%
Personal and Other Services11.0%
Manufacturing, Wholesale and Retail11.0%
Retail and Construction11.0%
Property and Business Services and Construction11.0%
Finance and Insurance and Transport and Storage11.0%
Unclear43.9%
Total103100.%
Table 12: Distribution of cases according to industry.

Table 18

PlaintiffNo. of CasesPercentage
Creditor/s6260.2%
Corporate Regulator1716.5%
Crown / DPP76.8%
Liquidator / Company1615.5%
Other11.0%
Total103100.0%
Table 18: Distribution of cases according to the nature of the plaintiff (i.e. who initiated the insolvent trading claim).

The above data gives useful insights into the nature of insolvent trading claims, but leaves many questions about how this may have changed or evolved over the last 16 years to 2020. From what the data suggests about trends, and what we have observed within the practice space, we know this: an insolvent trading claim is like a lightning strike: they are rare, but they can be very dangerous if you’re unlucky enough to receive one.

What is the rationale behind the prohibition on insolvent trading?

The prohibition on insolvent trading exists to discourage directors from mismanaging funds. It aims to stop creditor losses from occurring, and to prevent the diversion of economic resources away from the most profitable businesses and operations. Essentially, it operates to stop businesses from incurring further debt when they are already insolvent and will likely cease trading, thus protecting commercial players.

Historically, Australian law has included some form of liability in relation to insolvency since the 1930s (initially focused on fraudulent trading). The first incarnation of the prohibition on insolvent trading was introduced in the 1960s. The positive duty on directors to avoid trading while insolvent was first established in 1993, following a comprehensive review of Australia’s corporate and personal insolvency regime. The review was prompted by the changing social and economic environment in light of Australia’s tenuous economic situation in the early 80s, simplified access to credit, high levels of unemployment and fluctuating interest rates, all of which were perceived to be having an impact on the increase in insolvency proceedings.

Knowing what prompted the review and thus the reforms can help us understand why Australia has some of the strictest insolvent trading provisions in the world, which many refer to as ‘draconian’ and ‘anti-business’. The provision was interestingly not intended to be a punishment for directors, but to provide more opportunities for recourse for unsecured creditors where directors had been reckless.

Below are some of the economic risks that the prohibition attempts to address.

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 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 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 the 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. Barristers and instructing solicitors don’t come cheap.

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, where debts incurred amount in the tens of millions.

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: Workload of an 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 [2018] 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).

Background

  • 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 a 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)

Key facts

  • 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 at 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.

Decision

  • 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 the 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

Case Study: Re Balmz Pty Ltd (In Liquidation) [2020] VSC 652

In the recent case of Re Balmz Pty Ltd (In Liquidation) [2020] VSC 652 the Court heard an application by the liquidator against the director defendants for not preventing the company from trading while insolvent. Prior to winding up, the company owned two local cafes, which owed monies in excess of $100,000 to creditors, the largest of which was the directors themselves – the company had been insolvent for several years and had begun to seriously struggle when a technological malfunction affected their bookkeeping, so the directors sold personal assets and withdrew from their superannuation to pay suppliers and keep the business afloat.

The Court rejected the directors’ assertions that they continued to trade under the protection of the safe harbour from insolvent trading, on the basis that the company had outstanding tax lodgements, had not paid employee entitlements and the directors had failed to point to what action they had taken that was reasonably likely to lead to a better outcome for the company.

The directors (first and second defendants) were ordered to pay compensation to the company for failure to prevent insolvent trading. This case is a good illustration of why the safe harbour is not a suitable solution for SMEs – the hurdles implicit in the legislation in terms of obtaining advice from an “appropriately qualified entity” and developing a course of action that is “reasonably likely to lead to a better outcome” can be difficult to navigate for SMEs. In this case, the company engaged a business advisory firm and believed that this, coupled with their personal contributions to the business were satisfying these requirements, while the Court ultimately decided otherwise. It is therefore very important for SMEs to seek quality restructuring advice should they begin to experience or suspect insolvency – read our article on pre-insolvency advisers to find out more.

Case Study: Kleenmaid

Kleenmaid is an Australian domestic appliances brand. In 2008, the company began to suffer from rumours that it was experiencing serious financial instability. In April 2009, the company announced it was going into voluntary administration with debts of almost $70 million, immediately firing 150 employees. In May 2009, the administrators reported that they had suspicions the company had been trading while insolvent since June 2007. The company was then liquidated, and the true debt was revealed to be more than $100 million.

In 2015, former director of Kleenmaid, Gary Collyer Armstrong was sentenced to seven years in prison for fraud and trading while insolvent, and in 2016, another former director Bradley Wendell Young was sentenced to nine years in prison for fraud by dishonesty and criminal insolvent trading. In both cases, dishonesty was the critical element establishing criminality.

The Kleenmaid case is an example at the extreme end of the spectrum of what can happen to directors who engage in insolvent trading and should serve as a warning to directors to consider the consequences of their actions.

Case Study: Re Swan Services Pty Ltd (in liq)

Swan Services Pty Ltd operated a large cleaning business in Australia. Liquidators brought an insolvent trading claim against the director (and his wife as a de facto director). The claim was ultimately upheld against the director alone. The judgment of this case illustrated that a Court will not simply determine the quantum for an insolvent trading claim based on the amount of unsecured debt incurred while insolvent. The important decision outlined three key things the Court will look at in determining an amount for an insolvent trading claim:

  • A secured creditor whose debts become unsecured by operation of the PPSA upon the commencement of the winding up may be considered unsecured for the purposes of an insolvent trading action;
  • Credits to a running account ought to be taken into account when determining the loss or damage sustained with respect to debts incurred during a period of insolvent trading;
  • The estimated distributions to creditors in the winding up should be factored in when determining the loss or damage sustained with respect to debts incurred.

Case Study: Seafolly and Australian retail

Many Australian retailers (such as Bardot, Tigerlily, Jeanswest, etc.) have experienced failure in the last year as a result of the consumer base’s increased movement towards online shopping, exacerbated by the COVID-19 pandemic which saw household incomes, consumer confidence and shopping habits impacted. Questions have arisen as to whether any of these businesses continued to trade while insolvent.

Iconic Australian swimwear brand Seafolly had voluntary administrators appointed in late June 2020 after COVID-19 decimated sales ahead of the typically slow winter sales period. The administrators, KordaMentha Restructuring, stated that Seafolly may have traded while insolvent from early April to the date of their appointment.

So will insolvent trading claims be brought against Seafolly, or any of these other retailers? It is unlikely that insolvent trading claims will be brought against any businesses experiencing hardship because of the pandemic, due to the extension of the safe harbour (which can now be gained automatically), an influx of insolvencies and a rise in general pro-business sentiment, particularly for important and historic Australian labels. The Seafolly case, and others like it, suggest that the pandemic may have the positive impact of destigmatising insolvent trading where it is short-lived and conducted in a genuine attempt to save the business and evaluate options before considering formal solutions.

Case Study: Sargon

Sargon Capital (in liq) is a company providing financial technology and infrastructure solutions for investment and superannuation. The liquidation commenced in April 2020, and a month later, liquidators announced a potential $3.5 million insolvent trading claim for debts incurred from 1 October 2019 against the company’s directors, including Phil Kingston, Stephen Conroy and Rob Rankin, all well-known business and political figures.

However, liquidators also stressed that there was a likelihood that defences may be available to the directors, including if they held reasonable expectations about the company’s ability to remain solvent. This could include their expectations about their ability to raise funds or defer key repayments to creditors.

At the time of writing, the investigation remains ongoing, and it remains to be seen whether the directors will be able to successfully raise a defence.

Case Study: Not-for-profit (Mansfield v Townend)

In this case, a liquidator brought a claim against a director to recover unsecured company debts totalling around $190,000. The liquidator was unsuccessful, despite being able to prove a breach of all the elements in s 588G(1) of the Corporations Act.

Ms Townend was a social director (voluntary unpaid) of Camperdown Bowling and Recreation Club and had limited education and understanding of her responsibilities. There was no evidence she was aware of the club’s solvency issues in her time there from 2008-12 when the business was liquidated.

Despite Ms Townend’s lack of understanding of her role and other evidence to suggest she had little to do with the finances, she was found to be a de jure director.

Importantly, the limited information about the company’s debts that Ms Townend was privy to was held to be inadequate to create a level of suspicion required for the purposes of s 588G(2)(a). It was affirmed that the requisite suspicion must be more than a mere inkling. Adopting a blended objective/subjective test for s 588G(2)(b) Ms Townend was found not to be involved in financial decisions and it was held that a reasonable person in her position would not be aware of any reasonable grounds for suspecting insolvency.

Ultimately, while unsecured creditors suffered loss due to the Club’s insolvent trading, Ms Townend was not held liable because the liquidator failed to discharge the onus of establishing that she contravened s 588G(2) in relation to incurring company debts. The liquidator was held liable for Ms Townend’s costs.

The judgment noted that the entire situation in relation to Ms Townend and her position was “unusual and extremely unfortunate”.

The key takeaway should be that directorship is likely to be recognised more often than not, even if the director did not carry out many directorial functions, receive pay, or have an awareness of their responsibilities. Moreover, where a reasonable director’s suspicion of insolvency would be aroused, directors should make active inquiries to ascertain the truth.

This case also demonstrates why insolvent trading claims are rare – liquidators risk their money and their reputation in pursuing them. 

What is the likelihood of an insolvent trading claim being brought against you?

So far, so scary. As the director of a SME, what you probably want to know is what the likelihood is of such a claim being pursued against you. The good news is that it’s relatively low.

A claim for insolvent trading is not usually one of the first matters that a liquidator turns their mind to. Their key focus in recovering value is on collecting debts. It is usually at the end of the liquidation process where the possibility of an insolvent trading claim might be considered.

There are no firm statistics on this, but in our estimation, only a handful of insolvent trading claims have been successfully pursued against SME directors in the last fifty years. It is worth noting, however:

  • It is not only liquidators who can bring such a claim. It is possible for a creditor to bring a claim for insolvent trading where a liquidator chooses not to. The likelihood of this may depend on how well-heeled your creditors are.
  • The Australian Securities & Investments Commission (‘ASIC’) does have the ability to fund a claim where a liquidator refuses. It is unlikely to use this power though, except in the cases of the most egregious director behaviour.

Note also that a liquidator has six years from the beginning of the liquidation to commence an action for insolvent trading. It is not sufficient for the liquidator to have issued a letter of demand within the six-year period; proceedings must have been commenced. This means that even if a liquidation has been finalised, there is still a significant period of time in which the liquidator may decide to commence a claim.

Defences to insolvent trading

There are several defences available to directors against an insolvent trading claim.

  • At the time the debt was incurred, the director had reasonable grounds to expect (and expected) that the company was solvent and would remain solvent even if it incurred that debt; note that this ‘expectation’ must be deemed to be reasonable on the facts
  • The director expected that the company was solvent at the time the debt was incurred, and that expectation came as a result of relying on information provided by a competent and reliable person who was responsible for providing information as to the solvency of the company (i.e. false information was relied on by no fault of the director)
  • Because of illness or a similar ‘good reason’ the director did not take part in the management of the company at that time (complete ignorance or the fact that a director was a non-executive director will not satisfy this)
  • The director took all reasonable steps to prevent the company from incurring the debt. This can include appointing a voluntary administrator at the appropriate time
  • The debt was incurred on or after 19 September 2017 and the safe harbour can be claimed
  • The COVID-19 safe harbour applies (24 March 2020)

What is the effect of safe harbours?

A liquidator cannot pursue a claim for insolvent trading if the director’s activity is under the protection of a ‘safe harbour’. There are currently two types of safe harbour in Australian law:

  • Standard safe harbour. The standard safe harbour in section 588G(2) of the Corporations Act 2001 means that a director is not liable for allowing insolvent trading while they are developing a course of action reasonably likely to result in a better outcome for the company, and incur debts in the process;
  • COVID-19 safe harbour. A temporary safe harbour is in place which means that, for the next several months at least, a director is not liable for allowing insolvent trading where a debt was incurred in the ordinary course of business.

Liquidators are risk averse – they want strong evidence to support a claim before they will run it in court. At the end of the day, they are accountants on an hourly rate. If there is a real prospect that your behaviour was protected by a safe harbour, they are unlikely to risk bringing an insolvent trading claim in court.

How long does it take to run an insolvent trading claim?

If a liquidator does decide to run an insolvent trading claim, it is important for you to know what the likely timeframe is for this. While we can’t give exact timeframes, we can describe the usual steps in bringing such a claim:

  • Initial appointment of liquidator. This will begin a long investigation period into the assets of the business.
  • The liquidator begins to recover assets. This usually occurs in the following order:
    • Sell plant and equipment;
    • Collect debts;

If the liquidator has decided to pursue an insolvent trading claim, it is likely that the liquidator will begin with examination proceedings to acquire information and develop their ‘theory of the case’.

How to prepare for an insolvent trading claim

Just as when dealing with the police, you have the right to remain silent. While there are statutory obligations to provide a range of materials to liquidators, as a director you need to be careful not to say anything else that incriminates you. For example, if you have not been keeping adequate financial records and you admit this to the liquidator, this admission could be used as part of the case against you.

Once you are being interviewed, with the prospect of a criminal prosecution, the best advice, as stated above, is to exercise your right to remain silent. As this can be difficult in a liquidator’s examination, you should seek legal advice before this occurs. Important things to consider include:

  • As soon as the letter of demand is received, talk to a lawyer. Make no admissions;
  • In order to collect documentary evidence and oral admissions, you should engage your lawyer to appear in court and assess the weight of the evidence and asset position that you are in (you might consider an out of court settlement);
  • A common flaw of directors is pursuing the ostrich strategy – sticking their head in the sand until it is too late. It is important to seek legal advice early and try to make sensible decisions without overreacting.

What should you think about when briefing a lawyer?

The possibility of an insolvent trading claim on the horizon is a key reason why you may need to seek legal advice prior to, or in the process of liquidation.  Lawyers are the only ones that fully understand litigation and the risks you face. In addition, your discussion is protected by legal professional privilege. By contrast, your discussion about possible insolvent trading claims with an accountant is not and if discovered, can be used against you. You should ask for an initial discussion with a lawyer to begin assessing your risk, and make sure you only seek out experienced insolvency lawyers who can develop a tailored strategy with the best prospects of success.

Key Takeaways

  • While it is usually just liquidators who commence insolvent trading cases, creditors are also able to do so.
  • 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 underfunding of both is the reason.
  • It is relatively unlikely that a liquidator will pursue an insolvent trading claim against a director of a SME. But watch out if you have been reckless or dishonest.
  • If the claim is successful, the consequences can be serious for directors.
  • There are a range of factors that make liquidators reluctant to bring these claims, including a lack of funding, and the difficulty in proving that a director is liable.
  • An insolvent trading claim is a long and involved process. Once one has been pursued against you, you need to seek advice from a specialist insolvency lawyer.

Others

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The safe harbour is a carve-out to the duty of company directors to cease trading when a company is insolvent. It is a pro-business mechanism that helps companies stay afloat by giving directors protection from prosecution for insolvent trading while they work on a restructure. Read our guide to the safe harbour to find out more about this potential lifeline for insolvent companies.

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