How does a liquidator decide whether to commence an insolvent trading claim?

In a New Zealand case last year, 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.

But what if you are the director of a small to medium-sized enterprise (SME)? What are the chances that a liquidator will bring an insolvent trading claim against you? And if they do, what is the process?  In this article, we set out:

• What an insolvent trading claim is;
• The likelihood of a liquidator pursuing such a claim;
• Factors that the liquidator may consider before pursuing this type of claim;
• The effect of safe harbours;
• How the insolvent trading claim process might unfold;
• How to prepare for an insolvent trading claim; and
• The importance of briefing a specialist insolvency lawyer early on.

What is an insolvent trading claim?

Sometimes people talk about a director being liable for trading while insolvent. But this is not strictly speaking correct. Only a company, not a director, can trade while insolvent. The duty of directors is to prevent that insolvent trading from occurring.  The elements of an insolvent trading claim are set out in section 588G of the Corporations Act 2001. A director may be liable if:

• The company is insolvent. That is, it is unable to pay its debts as they fall due and payable. Note that this requires more than just a suspicion of insolvency, or a temporary lack of cash. What is required is an endemic shortage of working capital;
• The company incurs a debt while insolvent; and
• There were reasonable grounds to suspect insolvency.

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.

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 debtors. 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.

Which factors may affect the liquidator’s decision?

In deciding whether or not to bring an insolvent trading claim, what sort of things will the liquidator take into account?

• Funding. Barristers and instructing solicitors don’t come cheap. Compounding this is the fact that most liquidations are assetless: there aren’t piles of cash lying around to pursue an insolvent trading claim;
• Evidence. Is there proof that will stand scrutiny in court? An important factor here will be what the books say about insolvency;
• What is the defendant’s ability to pay, if successful? Liquidators will be particularly interested in whether there is in any real property owned by directors that might be recovered;
• Workload. As most liquidations are assetless, the business of being a liquidator itself relies on volume. With so many liquidations on their schedule, running an insolvent trading claim will rarely be a priority.

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 debtors;
  • Consider a claim for unfair preference, or other uncommercial transactions.

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;
• When examination begins in order to collect documentary evidence and oral admissions , you should engage your lawyer to appear in court and assess the weight of the You might consider an out-of-court settlement, depending on the weight of evidence and asset position that you are in;
• 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. You should make sure you only seek out experienced insolvent lawyers who can develop the strategy with the best prospects of success.

Key Takeaways

• It is usually liquidators who bring insolvent trading claims against directors. If the claim is successful, the consequences can be serious for directors;
• 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;
• 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.