Insolvent Trading

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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. Please don’t hesitate to contact me if you have any questions.

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