Directors’ statutory duty to prevent insolvent trading

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This topic is within Business Associations.

Contents

Required Reading

Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC, pp. [7.135]-[7-210].

Introduction

Directors have a statutory duty to prevent insolvent trading. The duty is breached when the following four elements are satisfied:

  1. Person is a director: s 588G (1) (a)
    • under s 9, someone not validly appointed but who acts as a director still qualifies for the purposes of this duty.
  2. Company is insolvent: s 588G (1) (b)
  3. The debt was incurred after 23 June 1993: s 588G (1) (d)
  4. There were reasonable grounds for suspecting that the company was insolvent or would become insolvent: s 588G (1) (c)
    • This is satisfied when the director was actually aware of the grounds for suspecting insolvency, or a reasonable person in a company in the company’s circumstances would have been aware: s 588G (2)
  • This duty is a civil penalty provision: s 1317E (1)
  • If person was dishonest in the process of contravening the duty, it also a criminal offence.
  • The director is not liable if they can establish a defence under s 588H - a director bears the burden of establishing one of the defences on the balance of probabilities.

Debts engaging the duty

The company must incur a debt for the duty to arise. The term ‘debt’ signifies an obligation surrounding the payment of a sum of money or money’s worth.

  • Must be an ascertainable debt involving an obligation to pay a liquidated sum as distinct from an obligation to pay unliquidated damages
  • Several capital management transactions such as the payment of a dividend, reduction of share capital and buying back shares are deemed to be incurring of debt within s 588G(1), as is entering into uncommercial transactions within s 588FB: s 588G(1A).
  • Deemed date for incurring debt varies with individual transaction - see Table, s 588G(1A).

The definition of insolvency

Insolvency, as per s 95A of the Act, occurs when a person is no longer solvent, ie, when he is unable to pay all of their payable debts.

  • Company’s ability to pay debts is concerned with the question of the company’s ability to pay debts as and when they fall due.
  • Whether or not debt is “due” is to be determined with reference to legally binding agreement between the parties: Kong v Pilkington (Aust) Ltd (1997).

This was discussed in Southern Cross Interiors Ptd Ltd (in liq) v Deputy Commissioner of Taxation (2001):

  • Whether or not company is insolvent is a question of fact to be ascertained from a consideration of company’s financial position taken as a whole by looking at commercial realities to see what resources are available to co to meet its liabilities as they fall due, and whether resources other than cash are realizable by sale or borrowing upon security.
  • A commercial reality that creditors will normally allow some latitude in time for payment but this does not warrant conclusion debts are not payable at time contractually stipulated and have become debts payable only on demand.
  • Given this, when courts assessing solvency of a company, they will act on the basis that the debt is payable at time stipulated unless there is evidence suggesting there is an express or implied agreement between the company and creditor for extension of time.
  • Course of conduct is sufficient to give rise to an estoppel preventing a creditor from relying upon stipulated time for payment or a well-established and recognised course of conduct whereby debt are payable at other time than that stipulated.

Cases show that solvency is to be determined primarily according to companies’ cash flows rather than strictly in accordance with the balance sheet.

  • Hymax Concrete Pty Ltd v Garrity (1977) distinguish between characterisation of troubled company’s financial position as simply one of a “temporary lack of liquidity” or whether it is part of “an endemic shortage of working capital whereby liquidity can only be restored by a successful outcome of business ventures in which the existing working capital has been deployed”

Indicators of insolvency

Indicators of insolvency include:

  • Continuing losses
  • Overdue taxes
  • Poor relationship with bankers
  • No access to alternative finances
  • Inability to raise further equity capital
  • Special arrangements with selected creditors
  • Solicitor’s letters, summonses, judgements/warrants issued against company
  • Inability to produce timely and accurate financial info to display company’s trading performance and financial position and to make foreseeable forecasts

Presumptions of insolvency

Presumptions of insolvency include:

  • s 588E: a company which fails to keep financial records that correctly records its transactions over previous 7 yrs and its financial position, is presumed to be insolvent throughout this period.
  • s 295 (4)(c): except for small proprietary companies, directors must make declaration as part of the company’s annual financial report that they believe there are reasonable grounds to believe that the company will be able to pay its debts as and when they become due.
  • ss 347A – C: directors of other companies must pass a solvency resolution annually - payment by company of annual review fee is taken to be a representation of solvency by directors unless they have passed a negative solvency resolution and notified ASIC of that resolution within 7 days.

Reasonable grounds for suspecting insolvency: s 588G(1)(c)

This requires a predication of the company’s future financial capacity which may involve an assessment of several contingencies.

  • “Suspicion that something exists is more than a mere idle wondering whether it exists or not; it is a positive feeling of actual apprehension or mistrust, amounting to a slight opinion, but without sufficient evidence… a reason to suspect that a fact exists is more than a reason to consider to look into the possibility of its existence”: Queensland Bacon Pty Ltd v Rees (1966).
  • The test to be applied is objective and the “state of knowledge of a particular director and any assessment which he may have made as to ability of company to pay its debts is irrelevant. The court must make its own judgement on the basis of the facts as they existed at the relevant time and without the benefit of hindsight”: Powell v Fryer (2001)
  • “The establishment of liability is not contingent on elements personal to the respondent”: Metropolitan Fire Systems Pty Ltd v Miller (1997).

The director’s awareness, actual or imputed, of the company’s financial position: s 588G(2)

Awareness requirement is satisfied by either of the two limbs in the section:

  1. Not necessary for the director to be aware that the company is insolvent, merely that there are reasonable grounds for suspecting insolvency
    • Satisfied if the director has actual knowledge of facts or circumstances concerning the company’s financial condition which comprise reasonable grounds, even though the director fails to appreciate their significance
  2. Satisfied even where the director lacks such personal awareness, but if a reasonable person in like positions to director in the company in the companies circumstances would be aware of reasonable grounds for suspicion of insolvency/future insolvency
    • The reasonable person is vested with characteristics specific to the particular director’s office and to the particular circumstances

Subjective character of this requirement in the first limb compliments the objective character of other elements under s 588G(1). A director’s subjective appreciation of a companies’ financial condition is also relevant to defence under s 588H(2) which is expressed in terms of directors’ expectations as to a companies’ solvency.

  • This is a civil penalty provision - in civil proceedings founded upon contravention, directors’ liability needs to be established only on balance of probabilities and to extent that it is “clear and cogent such as to induce, on the balance of probabilities, an actual persuasion of the mind as to the existence of the liability” Refjek v McElroy (1965).

Defences to liability for failure to prevent insolvent trading

Reasonable grounds to expect solvency: s 588H(2)

  • Requires “expectation” rather than “suspecting” as in s 588G(1) - exculpation standard thus higher than that of primary liability
  • “Expect” imports “higher degree of certainty than ‘mere hope/possibility’ or ‘suspecting’. The defence requires an actual expectation that the company was and would continue to be solvent and that the grounds for so expecting are reasonable… cannot rely on a complete ignorance or neglect of duty and cannot hide behind ignorance of the company’s affairs or the director’s own failure to make necessary inquiries”: Tourprint International v Bott (1999)
  • Point at which reasonable grounds are to be established is immediately before debt incurred thus formally eliminating sense of hindsight review: Metro Fire Systems v Miller (1997)
  • See Hall v Poolman (2007) excellent explanation of this defence and reasonable grounds of solvency.

Reliance upon information as to solvency provided by another: s 588H(3)

This defence has two limbs each of which have to be satisfied:

  1. Director must establish belief in the existence of an adequate system for monitoring the companies’ solvency and in its continuing functioning
    • Director’s belief must be founded upon reasonable grounds that compliance was occurring, not proof that a delegate was actually competent or reliable and fulfilling responsibilities
  2. Director must establish an expectation of continuing solvency founded on basis of info provided by delegate

Defence builds upon permitted scope for delegation to and reliance upon company officials conceded to directors under their duties or care and diligence.

  • In Manpac Industries Pty Ltd v Ceccattini [2002], the directors could not rely on statements from a business consultant appointed to assist the company survive threats of its insolvency when those statements were based on info supplied by the directors themselves

Non-participation in management due to illness or other good reason: s 588H(4)

  • If a director establishes that at time debt incurred, he or she did not take part in management of the company due to illness or other good reason, a defence will be established
  • Illness/other good reason MUST preclude participation ie, if the director would not have been any more involved if they had been participating in management, disability does not provide defence.
  • See also below Deputy Commissioner of Taxation v Clark

Reasonable steps to prevent the incurring of the debt: ss 588H(5), (6)

  • Central concept - the reasonableness of steps
  • Explanatory paper to the earlier draft of the section discussed reasonableness requirement as requiring court to have regard to factors such as size and complexity of the company, size of debt which was incurred and nature of grounds which gave rise to suspicion of insolvency etc
  • A director who argues in favour of voluntary administration but does not persuade the majority of fellow directors to this view may well escape liability
  • Burden of advocacy necessary for this defence may be a continuing one, however, not necessarily discharged by single expression that fails to carry on the day

Compensation remedies with respect to insolvent trading

  • Section 588G(2) is a civil penalty provision
  • Company has a right of recovery under Pt 9.4B
  • Part 5.7B Div 4 contains other specific remedies that enable proceedings to be taken for compensation for loss arising from contravention of duty to prevent insolvent trading
    1. These remedies provide for recovery at the suit of the liquidator and in some circumstances of individual creditors
    2. Each of the grounds of recovery under this Part applies ONLY where the debt is wholly/partly unsecured
    3. The incurring of a debt that is wholly secured may contravene the directors duty to prevent insolvent trading but it will not trigger civil remedies under this Part
    4. Contravention through incurring of a wholly secured debt will, however, trigger civil recovery remedies under Pt 9.4
    5. Recovery under Pt 5.7B Div 4 may be awarded in civil proceedings (s 588J), in criminal proceedings where a court finds that the director is guilty of an offence constituted by breach of duty to prevent insolvent trading (s 588K), by direct recovery by liquidator (s 588M) or in limited circumstances, by direct recovery by individual creditor (ss 588R, 588T)

The liability of a holding company for insolvent trading by a subsidiary company

Under Pt 5.7B Div 5 an action for compensation can be brought against a holding company where it allows a subsidiary company to trade while insolvent

  • The subsidiary’s liquidator may sue for compensation for loss suffered by unsecured creditors as result of insolvent trading: s 588W
  • A holding company contravenes the Act, which contravention serves as one of the foundations for compensation proceedings, if each of the following four elements is satisfied:
    1. Company must be holding co of the subsidiary co at time when subsidiary incurs debt: s 588V(1)(a)
    2. Subsidiary company must be insolvent at that time or become insolvent by incurring that debt or by incurring at that time debts that include that debt: s 588V(1)(b)
    3. At time when subsidiary company incurs debt there must be reasonable grounds for suspecting that company is insolvent or would become insolvent or by incurring that debt or incurring at that time debts including that debt as case may be: s 588V(1)(c)
    4. Either:
      • If holding company, or 1+ of its directors, is aware when debt is incurred that there are reasonable grounds for suspecting such insolvency: s 588V(1)(d)(i)
      • If, having regard to the nature and extent of the holding company’s control over the subsidiary’s affairs and to any other relevant circumstances, it is reasonable to expect either that a holding company in the company’s circumstances would be so aware, or that 1+ directors of such holding company would be so aware: s 588V(1)(d)(ii)
  • If the subsidiary co goes broke, you can look to the holding company and sue it:
    • Liquidator of subsidiary may recover compensation from holding company for loss resulting from insolvent trading by subsidiary where EACH of the 4 conditions are satisfied:
      • Holding company must have contravened s 588V in relation to incurring of a debt by subsidiary
      • Person to whom debt is owed must have suffered loss/damage in relation to debt because of company’s insolvency
      • Debt must have been wholly/partly unsecured when loss/damage was suffered
      • Subsidiary company is being wound up

Where each is satisfied, liquidator of subsidiary may recover from holding company, as debt due to subsidiary, an amount equal to amount of loss/damage it has suffered: s 588W(1)

  • Proceedings by liquidator must be begun within 6 years after beginning of winding up: s 588W(2)
  • Company’s unsecured debts must first be paid in full before secured debt can be paid to company: s 588Y(1)
  • If aggrieved party knew company was insolvent/would become insolvent and loaned anyway, debt may be postponed until insolvent company has paid unsecured debts in full first: s 588Y(2)

Defences to liability:

  • It is a defence if it is proved that, at the time when the debt was incurred, the corporation and each relevant director had reasonable grounds to expect, and did expect, that the company was solvent at that time, and would remain solvent even if it incurred that debt: s 588X(2)
  • Reasonableness is assessed with regard to factors such as the size and complexity of the company concerned, the size of debt incurred, and nature of the grounds which gave rise to the suspicion of insolvency

Cases

Hall v Poolman :[1]

  • Looks specifically at s 588H(2) defence of reasonable ground for expecting solvency within definition of s 96A re being able to pay debts as they fall due for payment
  • Not appropriate to base such expectation of solvency on prospect that the company might trade profitably in the future so as to restore its financial position à question is whether the company at the relevant time is able to pay its debt as they become due
  • Whilst easy enough to tell the difference between solvency and insolvency in hindsight, often difficult from point of directors in situation – there is no clear dividing line between the 2 state of affairs
  • Critical question = how soon will the proceeds of realisation be available whilst bearing in mind the commercial realities that creditors would usually prefer to wait a reasonable time to have their debts paid in full rather than insisting on putting company into insolvency if it fails to pay at strict deadline
  • Very broad general rule that a director would be justified in “expecting solvency” if an asset could be realised to pay accrued and future creditors in full within about 90 days but the position becomes murkier the less certain the outcomes ie, the market value of asset may not be ascertainable until market tests, state of market, complexity of transaction
  • Comes time when the director must inform himself as fully as possible on all relevant facts and then ask “how sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, with 3 months (90 days)?” Honest and reasonable answers could then be:
    • A1: “certain/probable” - reasonable expectation of solvency
    • A2: “possible/no way of knowing” - NO reasonable expectation of solvency
    • A3: “more likely than not” - director runs risk that a Court will hold to contrary in insolvent trading claim
    • A4: “no way of knowing yet, we need more info”
  • Director must then ask “how long before we have the info so that we can give a final answer?” Honest and reasonable answers could then be:
    • A.4.1: “by a definite date which will not extend the realisation period (if there is to be one) beyond 3 months” - Director may reasonable say “Let’s wait until then before deciding
    • A.4.1: “there is no way of knowing yet when we will have the info to make a decision” - Director must then say “then there is no way we can now have a reasonable expectation of solvency and there is no way we can reasonably justify continuing to trade without knowing when we will know whether co is insolvent. Call the administrators.”
  • Notes that above formulations are NOT some ‘pro forma test’ but each case depends on its particular facts - merely serve to illustrate that when co struggling, directors must face up to issue directly and with brutal honesty

Deputy Commissioner of Taxation v Clark:[2]

  • Facts: Mrs C was director of SCI, the vehicle for her husband’s carpentry business and he was the other director. Company wound up and liquidator obtained order against Dep Comm for recovery of payments made by SCI by way of group tax on ground that it was by way of an unfair preference
    • Mr C was ordered to indemnify the DCT for that amount but Mrs C established the defence pursuant to s 588H(4) - special reason was reliance on the husband
    • Argued that any reason that is good enough in the common law should be good enough to constitute a ‘good reason’ - look to other areas of the law to see what other excuses have been available for people to not honour their contracts
    • Includes - undue influence, special equity of wives (Garcia v NAB), unconscionable dealing (e.g. language barrier prevented them from understanding what they were signing, see Amadio), misrepresentation, mistake - unilateral requires some misrepresentation. DCT appealed against this judgment
  • Held (Spigleman CJ): Held that a wife’s total reliance on husband in the management of the company was not a good reason constituting the defence of non-participation. Statutory provision which has been added to the law which doesn’t follow contract and equity. Held liable under statute for debts which are not even their own.
    • It is a protective provision to protect creditors of company’s which doesn’t depend on fault
    • Development of the common law duty of care (Daniels v Anderson area has imposed greater burden on non-executive directors) do not allow excuses of not paying attention - cannot allow those types of excuses to exonerate a director of the company
    • Mrs Clark should have resigned or not taken position if she didn’t want to be in control (when taking the positive duties of a director)
    • Reasons have to be more akin to illness that incapacitated you

End

This is the end of this topic. Click here to go back to the main subject page for Business Associations.

References

Textbook refers to Redmond, Paul Corporations and Financial Markets Law 6th ed, 2013, LBC.

  1. (2007) 65 ACSR 123.
  2. [2003] NSWCA 91.
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