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Duty to Prevent Insolvent Trading

What is Insolvent Trading?

Insolvent trading occurs when a company incurs a debt that it cannot, and does not pay, within a period which the director knew, or should have known, that the company was in fact insolvent.  By way of section 588G of the Corporations Act, directors have a duty to prevent insolvent trading. If a director is found to be engaged in insolvent trading, a director is liable to pay an amount of compensation, equal to the amount of the company’s debt.

Liquidators are obliged under the Corporations Act to investigate the existence of any insolvent trading claims, and if it is found to have occurred, take the appropriate action. Liquidators are given the first opportunity to pursue an insolvent trading claim, and if they decide not to, creditors may start their own actions, but their claims are limited to the amount of their individual debt. An action may be commenced either with the consent of the liquidator, or if the liquidator fails to provide consent, the creditors can instead seek the leave of the court.

Liquidators have six years from the beginning of the liquidation to commence an action for insolvent trading. Proceedings must be initiated by way of an application to the court within that six-year period, merely issuing a demand for payment is not sufficient.

A claim can be made for compensation for losses resulting from insolvent trading. The amount claimable is equal to that of the debt incurred when the company was insolvent, as long as the debt remained unpaid at the time of liquidation.

A liquidator can make a demand upon a director to compensate the liquidator for the amount of the insolvent trading claim; however, in reality, the liquidator must prove the elements of the claim. The liability will not be enforceable until such time as the court makes an order against the director.

Section 588H of the Corporations Act sets out the available defences. Directors will not be liable if they can establish one of the following:

  • They had reasonable grounds to expect that the company was solvent;
  • They did not participate in management of the company, due to illness or some other good reason; and
  • They took all reasonable steps to prevent the company from incurring the debt.
 

A court may consider the following matters when deciding whether a director took ‘all reasonable steps’:


  1. ‘Any action the person took with a view to appoint an administrator of the company; and
  2. When that action was taken; and
  3. The result of that action.’
 
The appointment of a voluntary administrator or a liquidator will mitigate a director’s exposure to an insolvent trading claim; but, it may not eliminate a claim for debts incurred prior to the appointment.

Members’ Voluntary Winding Up

When a solvent company has reached the end of its useful life and the members no longer wish to retain the company’s structure, a members’ voluntary winding up is the process used. This process is the only way to fully wind up the affairs of a solvent company. All outstanding creditors are paid in full, and any surplus assets are distributed to its members. A members’ voluntary winding up also protects the members’ interests while the company structure is dismantled.

A company is usually considered solvent if it can pay all of its debts as and when they fall due. This strict definition does not apply to members’ voluntary winding up as the appointment lasts for 12 months. If a liquidator forms the view that all creditors will not be paid in full within the 12-month period, the members’ voluntary winding up must convert to a creditors’ voluntary winding up administration.

The process of a members’ voluntary winding up is started by the directors resolving to call a meeting of members to wind up the company. The directors must complete a ‘declaration of solvency’ that states the company is solvent and can pay all its debts within 12 months. The declaration is lodged with the Australian Securities and Investments Commission (ASIC) before the members’ meeting. The solvent company is then wound up on the resolution of its members at the meeting.

The members’ voluntary winding up effects the company as follows:

  • The company structure itself survives the appointment of a liquidator;
  • The control of all assets, conducting any business, and financial affairs are transferred to the liquidator;
  • The directors cease to have any authority;
  • All bank accounts are frozen, any employment can be terminated and the liquidator may engage necessary labour; and
  • At the end of the liquidation, the liquidator applies to ASIC to deregister the company, after which the company ceases to exist.

Investigation Process

A members’ voluntary winding up does not require the same investigations as a creditors voluntary or court liquidation. As the company is solvent and creditors should be paid in full, there is no need for any recovery actions to be initiated. Preferential payments and insolvent trading are recovery actions that require the company to be insolvent at the time of the transaction, or if there is a loss to creditors.

Liquidators may have to verify what assets are available to them. Commonly, some assets are loans made to shareholders and are sometimes either in dispute or insufficiently recorded. In these cases, the liquidator has to reconstruct the loan accounts to determine the amounts and extent of the debts.

A liquidator must ensure a proper distribution is made to members through the capital accounts of the company. This distribution requires some investigation into a company’s balance sheet, particularly capital reserve accounts and franking accounts. A company’s external accountant can provide a current and detailed balance sheet showing all equity accounts and the liquidator then pays the distribution to members in the most tax-advantageous way.

Preferential Payments

Preferences are payments or transfers of assets, that give a creditor an advantage over other creditors.  Payments or transfers made to a creditor before a liquidation, may be recovered by liquidators in certain circumstances.  Preferences are typically monetary payments, yet, a variety of transactions could be deemed ‘preferential’.

Liquidators void preferential payments, as the liquidator’s main role is to distribute a company’s assets between its creditors on an equal basis. It must be determined whether any creditor received treatment prior to the liquidation, which was not equitable compared to the distribution to other creditors in the liquidation.  These payments can be voided by liquidators, to ensure a more equitable distribution to all creditors, including the creditor who received the preference.

The main elements of a preference are:

  1. There must be a debtor-creditor relationship;
  2. There must be a transaction;
  3. The relevant period;
  4. The debt must be unsecured;
  5. Continuing business relationship; and
  6. The creditor must obtain a preference.

Defences Available to Creditors

Section 588FG of the Corporations Act 2001 provides defences that may be available to creditors who received preferential payments. To rely on a defence, a creditor must be able to satisfy all three conditions of the defence. The onus of proving the defences is on the creditor, it is not for the liquidator to disprove them.

The three conditions of the statutory defence are:

  1. The creditor gave valuable consideration for the payment;
  2. The creditor received the payment in good faith;
  3. The creditor had no reason to suspect the insolvency of the company.
 

If a liquidator claims a preferential payment, a creditor should ensure that:


  1. The transaction was entered into within the relevant period;
  2. They are not a secured creditor;
  3. They are (or were) a creditor when the transaction was made, and that it was not a cash on delivery payment;
  4. The liquidator demonstrates they received an advantage over other creditors by virtue of the payment.
 
The creditor also must consider:

  1. Whether the creditor gave extra credit to the company after the payment or transfer was received, whether it is possible that the claim may be reduced or eliminated by the amount of extra credit granted, that is, to determine whether the creditor had a continuing business relationship with the company;
  2. That the liquidator can show insolvency at the time of, or before the payment was received; and
  3. Whether the creditor has a realistic chance of convincing the liquidator that the statutory defences apply.
 
Claims must be commenced within three years after the relation-back day. A liquidator must issue proceedings within three years— not just make a formal demand. A time extension may be granted by the court, but the application must be made within the three year period after the relation-back day, and the liquidator must demonstrate a reasonable cause for the delay in initiating the claim.

Uncommercial Transactions

Liquidators investigate any transactions which they believe were not beneficial to or were detrimental to the company. The Corporations Act allows these uncommercial transactions to be voided and sets out the way the other party to the transaction is to return an asset or make a payment to the liquidator. 

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