Insolvent Trading and Directors Personal Liability for it

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I 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.

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