Directors Personal Liability for the Company’s Insolvent Trading?

When the Titanic hit that iceberg, there were no night-vision goggles, no sonar detection, no radar. Just sailors with binoculars on the lookout. That gave them about ten minutes warning of disaster. These days they would have known hours ahead.

So how quickly does a company director need to act when the tip of the iceberg appears, and the company owes money but is unable to make payment when due, has no apparent recoverable assets, and appears to be trading insolvent? When does a company director become personally liable for the company’s debts?

These days company directors are also expected to see disaster looming as early as possible. One of the big no-nos for a company director is allowing the company to ‘trade while insolvent’. Section 588G (1) of the Corporations Act 2001 lays out what that means. Essentially, it is continuing to do business and incur debt when you know, or should know, that the company cannot pay the debt.

Although there is no legal duty for third parties like suppliers and customers to know about a company’s solvency, it obviously makes sense for you to be very wary if you suspect that a company you are doing business with is heading for insolvency. If a sinking company owes you money, you could easily lose out in the wash-up. ‘Secured creditors’ like the banks and the Australian Tax Office (ATO), and the preference given to payment of employee entitlements, could well take all the company’s remaining funds and leave you without a lifeboat.

When is a company trading whilst insolvent?

Assessing a company’s solvency involves having an up-to-date knowledge of the company’s financial position, including the cashflow position. ASIC guidelines to company directors, on avoiding insolvent trading, is something we have discussed in a previous Blog article.

So let’s just take a look at the main points of this complicated topic. Section 588G (1) of the Corporations Act defines trading while insolvent as entering into a debt which the company is unable to pay, when a ‘reasonable person’ would have known that the company could not pay the debt. It also lists actions taken by companies regarding their shares, like paying dividends, which are the same as entering into a debt for legal purposes.

When is a Director personally liable for the company’s debts?

As we’ve seen all the way down the line with directors’ duties, as a company director you can’t argue that you are lazy or stupid and thus didn’t know that the iceberg was there and the company was insolvent. You can try and persuade the court that you were too sick at the time, if indeed there is evidence of that. However, presuming that the court does not accept that type of defence is available, what do you need to prove to not be held personally liable for the debts incurred by the company trading while insolvent? The defences which the Act allows are-

  1. You had reasonable grounds to believe that the company was solvent at the time it entered into the debt. Looking at court cases up to now, it’s clear that the more complicated a company’s finances are, the more a director has to pay careful attention to them. Looking at annual or even biannual financials may not be enough. In some cases, directors need to look at financials, including cashflow information, monthly or even weekly. Otherwise, the court may decide you didn’t have reasonable grounds for believing the company was solvent.
  2. You had reasonable grounds to believe that financial information given you, by ‘a competent and reliable person’ whose job it was to keep you financially updated, was correct and was showing solvency.
  3. You did everything you reasonably could to stop the company entering into the debt which made it insolvent.
  4. You started developing one or more courses of action that are reasonably likely to lead to a better outcome for the company – than if you immediately wound up or liquidated the company – therefore qualifying you for the Safe Harbour under section 588 GA (1) of the Corporations Act. The actions reasonably likely to achieve a “better outcome” could include appointing an administrator to restructure debt.

Director liability- How bad can the punishment get?

It can be very hard on your wallet! Even where you were not found personally responsible for the company’s insolvent trading, you may also be held personally liable for other debts incurred by the company. As a director, you could be held personally liable by the Australian Tax Office for any unpaid employee Superannuation Guarantee Contributions (SGC) or Pay As You Go (PAYG) income tax payments.

A director also risks criminal prosecution by ASIC if he dishonestly allows an insolvent company to incur debts. For each offence, a court can impose a fine of up to $220,000 or up to 5 years’ imprisonment (or both) under section 588G(3) of the Corporations Act.

So there are clearly lots of good reasons why a company director needs to keep a very close eye on all financial information. If the company is heading for insolvency, as a director you need to act quickly and decisively, whether you go with restructuring debt or a winding-up of the company through voluntary administration or liquidation.

If your company is heading for insolvency, you should also get legal advice immediately.

What if you are owed superannuation by a company?

The directors at the time the liability arose can be liable for superannuation guarantee obligations of the company, when the company fails to pay and the ATO sends out a Director Penalty Notice to which the director has no defence (of illness, non-participation, or reasonable steps) and the winding up of the company is not commenced within 21 days.

What if you are doing business with a sinking company?

No doubt if you suspect a company is heading downwards, and the company owes you money, you would insist on immediate payment or supply or whatever is owed to you for every transaction, just as a practical business matter. The cold hard fact is that otherwise you might be left without payment, because if the company goes under, the ‘secured creditors’ like banks and the ATO have first go at its remaining funds and might take all the money.

However, if you do have a debt owed to you by a company which you now realise is sinking, there are a few other legal options available to you, like:

  • Commencing debt recovery proceedings against the company in the Local Court or the District Court and obtaining default judgement, assuming the matter is undefended. [NB: Once a company is in liquidation, you cannot sue the company without court permission, and as a creditor you would need to have a good reason as to why you did not act sooner to collect the debt.]
  • Issuing a Creditor’s Statutory Demand for Debt against the company and then getting a winding-up order, which might improve your position in the queue of unsecured creditors of the dead company.

You also should get immediate legal advice on your position before others start dividing up the company’s carcass.

Contact us now for an initial obligation-free confidential discussion about your situation.