Insolvent Trading and Directors Personal Liability for it

Posted by Byron Cannon on September 26, 2011

InsolvencyI have had many clients in this current economic climate approach me, who are concerned about whether their company is trading insolvent, and their personal liability that may arise from this.

What is Insolvent Trading?

Broadly speaking, insolvent trading occurs when a company cannot pay its debts as and when they fall due.

Directors of companies have a duty to take timely action to prevent their company from trading:

  1. While it is insolvent; or
  2. Where there are reasonable grounds for suspecting a company may become insolvent if a particular debt is incurred, or a particular transaction is entered into

Personal Liability for Directors

Directors may be personally liable for a company’s debt if:

  1. They are a director at the time the company incurs a debt;
  2. The company is insolvent at that time, or becomes insolvent by incurring that debt or other debts at that time;
  3. There are reasonable grounds for expecting that the company is, or will become, insolvent;
  4. They are aware, or ought reasonably be aware, that there are grounds for expecting insolvency in the company’s circumstances;
  5. They fail to prevent the company from incurring the debt

Defences

There are four defences for directors accused of personal liability for insolvent trading:

  1. There were reasonable grounds to believe the company was solvent;
  2. The director reasonably believed a competent person provided sufficient and adequate information and, on that basis, reasonably believed the company was solvent;
  3. Through illness or some other good reason, the director did not take part in the management of the company when the relevant debt was incurred;
  4. The director took all reasonable steps to prevent the company from incurring the debt.

Ignorance is no defence, nor is not having an active involvement in the company.  As a director you have specific responsibilities to make enquiries about the financial position of a company and ensure it is not trading whilst insolvent.

Warning Signs for Insolvent Trading

Chartered Secretaries Australia have produced a booklet outlining directors duties. I have taken some of the information in this post from that booklet, which includes some common indicators of insolvency as identified in ASIC v Plymin (The Water Wheel Case):

  1. Continuing losses
  2. Liquidity problems caused by frequent cash shortages;
  3. Unreliable or inadequate management forecasts and budgets;
  4. Breach of key liquidity ratios and other covenants with banks;
  5. Overdue taxes;
  6. A poor relationship with primary banks including a freeze on funding;
  7. No access to alternative finance;
  8. Inability to raise further equity capital;
  9. Suppliers requiring cash on demand terms;
  10. Court proceedings or letters of demand being issued against the company

It is very important to get specific advice if you are concerned that your company is trading insolvent.  Immediate action is needed to prevent personal liability as a director.  Please contact me if you need assistance in this regard.

Insolvent Trading

Posted by Tony Pattinson on March 28, 2011

Many businesses are currently facing financial pressure, either directly or indirectly because of the credit crunch. This can lead to concerns about solvency.

Directors, or persons who could be deemed to be directors, can be held personal liable for debts of the Company where:

  • the Company incurs a debt; and
  • the Company is insolvent at that time or becomes insolvent by incurring that debt; or
  • when that debt is incurred, there are reasonable grounds for suspecting that the company is insolvent or would become insolvent.

Insolvency is the position of being unable to pay debts as and when they become due and payable. This requires a cash flow test as opposed to a balance sheet test. The balance sheet together with a number of other factors will, however, be relevant to determining whether or not a company is insolvent on the cash flow test.

Other indications of insolvency include:

  • continuing losses
  • overdue taxes
  • poor relationship with the bank
  • no access to alternative finance or further equity
  • cash on delivery terms
  • payment of creditors in rounded amounts (as opposed to the invoiced amount)
  • unmet demands
  • dishonoured cheques.

Whilst the presence of only a few of these factors may not necessarily mean a company is insolvent, a number of them would tend to suggest insolvency.

The global financial crisis and subsequently the credit crunch means that it has become difficult for a company to find alternative sources of finance. It has also led to a company's debtors being unable to pay the company, affecting the company's cash flow and therefore its solvency.

A director breaches their duty to prevent insolvent trading by the company if there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, and they incur a debt. This is an objective test. Whether the director actually suspected the insolvency will be less relevant than whether or not a director of ordinary competence would have had that suspicion.

The defences to an insolvent trading claim by a liquidator or ASIC are notoriously difficult to establish. It is therefore important for directors or for persons at risk of being deemed to be directors to ensure that there are no objective grounds for them to suspect that the company is insolvent.

Should the suspicion of insolvency arise at a time when the company is in fact insolvent, directors are at risk of being personally liable for the debts which the company incurs. In those circumstances, it is important to obtain professional accounting and legal advice as to the possibilities of a restructure or, if necessary, to consider the appointment of either a liquidator or voluntary administrator to prevent the incurring of further debts and the possible breach of directors' duties.