– By Brendan Pitman, Lawyer

shutterstock_137977967

The Corporations Act imposes a positive duty on directors to prevent insolvent trading. This duty seeks to balance two often competing interests: the protection of creditors and the liability of directors.

If a company continues trading while insolvent, whether in an attempt to rescue the company or otherwise, its director/s walk down a precarious path paved with personal liability, civil and criminal fines, and disqualification.

Section 588G of the Corporations Act provides that a person breaches the duty to prevent insolvent trading if:

  • The person is a director of a company at the time when the company incurs a debt; and
  • The company is insolvent when it incurs the debt or becomes insolvent because it incurs the debt; and
  • When the company incurs the debt, there are reasonable ground for suspecting that the company is insolvent or would become insolvent by incurring that debt; and
  • The person is aware that at the time of incurring the debt, there are reasonable grounds for suspecting the company is insolvent (or would become insolvent) or a reasonable person would be so aware.

Defences and relief

Section 588H of the Corporations Act provides that it is a defence to a breach of insolvent trading if a director can prove:

  • There were reasonable grounds to believe the company was solvent, and would remain solvent, at the time of incurring the debt; or
  • There were reasonable grounds to believe that a competent and reliable person was responsible for providing adequate information about the company’s solvency; or
  • That the director did not take part in the management of the company at the time the debt was incurred due to illness or some other good reason; or
  • All reasonable steps were taken to prevent the company from incurring the debt.

If a director is unsuccessful in relying on these defences, sections 1317S and 1318 of the Corporations Act provides that a court may relieve a director of a breach of the duty to prevent insolvent trading if the court is satisfied that the director acted honestly and that the person ought to be relieved. These relief provisions are purely discretionary. It is important to understand that relief under these sections does not remove the breach but just excuses the contravention of the duty.

There is a concern that the current defences and relief provisions available to directors do not support informal workouts and can lead to the reduction in a company’s value. An option to overcome this concern is to extend the reach of the current statutory business judgment to act as a safe harbour for directors when their company is nearing insolvency.

Extending the business judgment rule

Whether the current insolvency regime strikes the appropriate balance between creditors and directors is uncertain.

Some say that the current insolvency provisions necessarily favour creditors and that an extension of the statutory business judgement rule would unnecessarily weaken the current protection afforded to unsecured creditors.

By way of example, the recent decision in Stake Man makes it clear that successful reliance on the defence in section 588H(3) of the Corporations Act requires a director to prove that a person was engaged for the purpose of supplying information regarding the company’s state of solvency and not merely advice of a general nature.

The general relief provisions compliment the statutory defences in providing a reasonable fall-back position and catching those directors that failed to satisfy the criteria clearly established by the defences in s588H.

Others say the current business judgment rule should be extended as this would further incentive directors to work through issues faced by a company and thereby give the best chance of maintaining the value of the company. Directors are under strict obligations and the current regime requires flexibility to allow directors to operate effectively in times of tough financial circumstances.

Regardless of the above views, it is probably the uncertainty surrounding when a company is actually deemed to be insolvent that is the cause for directors’ inconsistent behaviour when a company is in tough financial circumstances.

Where to from here?

The current law surrounding insolvent trading imposes strict obligations on directors. It is important to obtain professional legal advice as soon as possible so that a director can understand the best way forward and avoid the significant consequences of trading a company while insolvent.

At MBA Lawyers, we are experienced in insolvency law and can assist both creditors and directors in forming a strategy to deal with their current situation.