With the recent economic downturn, many companies have found themselves facing financial difficulty, teetering on the brink of becoming insolvent.
But if you’re a director of an Australian company, it’s your duty to ensure that all trading activity occurs while solvent. Otherwise, you could face severe consequences.
So, in this article, we will discuss what insolvent trading is, the risks directors face when trading insolvent, and how you can avoid it. We’ll also delve into the Safe Harbour laws extended as part of the COVID-19 provisions.
- 1 What Does It Mean If a Company Is Trading Insolvent?
- 2 What are the Consequences of Breaching Director Duties?
- 3 How Can Company Directors Avoid Insolvent Trading?
- 4 Key Takeaways
- 5 Frequently Asked Questions (FAQs)
What Does It Mean If a Company Is Trading Insolvent?
Insolvent trading occurs when a company’s assets are insufficient to cover its liabilities, but continues trading and incurring further debt. Directors have a positive duty to ensure that the company remains solvent before incurring more debt.
Directors Duties Regarding a Company’s Financial Position
Under the Corporations Act, directors have a legal obligation to prevent trading while insolvent. A director will be in breach of their duties if:
- They were the directors at the time the company incurred debt
- The company is insolvent at the time of incurring debt or becomes insolvent due to the additional debt incurred
- There are reasonable grounds to believe that the company is insolvent or is likely to become insolvent
- The director is reasonably aware (or should be reasonably aware) that these grounds exist
- The director needs to take steps to prevent the company from incurring debt.
Reasonable grounds that may indicate suspicion of insolvency include the following:
- Company liabilities exceed the company assets
- Cash flow shortages
- Assets that can’t be liquidated
- Overdue taxes and superannuation liabilities
- Legal demands for unpaid debts
- Debt collection issues
- Declined debt facilities
These are just a few instances that may indicate insolvency. However, you should seek advice from an accountant or insolvency practitioner to help you establish whether your company is insolvent or will become insolvent.
If there are reasonable grounds for suspecting insolvency, a director must ensure they do the following:
Act With Care and Diligence
Company directors can avoid personal liability if they prove that they took proper care to manage business affairs, stayed informed about the company, didn’t act dishonestly, and acted in the company’s best interests.
Ensure that They’re Aware of the Company’s Financial Affairs
To act in the company’s best interests, a director must always stay on top of the company’s financial affairs so that they can make informed decisions on how to proceed with trading activities.
Ensure the Company Takes Steps to Prevent Insolvent Trading
If, after assessing the company’s financial affairs, there’s reason to believe the company may be insolvent, the director must ensure the company stops trading to avoid an insolvent trading claim.
What are the Consequences of Breaching Director Duties?
According to the Corporations Act,iff directors are in breach of the duty to prevent a company from trading while insolvent, they may face serious penalties and consequences, including the following:
- Civil penalties: Directors who continue to trade while insolvent may face civil penalties of up to $200,000.
- Compensation proceedings: Any interested party, including the Australian Securities and Investments Commission (ASIC), a company liquidator, or a creditor, can institute insolvent trading claims against the director. If found liable, the director may have to pay compensation and be personally responsible for the debts.
- Criminal charges: Where a company director has misled creditors regarding its insolvent trading, they may face criminal charges, leading to a $220,000 fine or a five-year prison sentence.
Defence To Trading While Insolvent: Safe Harbour Regime
In 2017, the Australian Federal Government introduced safe harbour laws to protect directors from being held personally liable for debts incurred during insolvent trading action.
Essentially, the laws allow directors to argue that insolvent trading was a more favourable option than entering into voluntary administration or liquidation.
Specifically, they would not be in breach of their duty to prevent insolvent trading if:
- They begin developing a course of action that is reasonably likely to lead to a better outcome for the company (compared to administration or liquidation); and
- The debt incurred is connected to the development of this course of action.
To help companies who were struggling during the height of COVID-19, the Federal Government extended the scope the of the safe harbour laws to allow directors to continue trading, paying their bills and retaining staff without the fear of having to possibly enter into administration or liquidation if there is a change of insolvency.
If a director was found to be trading while insolvent between 25 March 2020 and 31 December 2020, they will not be personally liable for any debt incurred in the ordinary course of their business.
In other words, if the company incurring debt was necessary to facilitate the continuation of business operations, such as to pay employees or move the operations online, then the director won’t be found to be in breach of their duties.
How Can Company Directors Avoid Insolvent Trading?
Despite the safe harbour laws and the temporary COVID-19 relief, directors must stay on top of their duties to avoid trading insolvent.
Company directors should always stay informed about the company’s financial position so that, if necessary, they can act swiftly in seeking assistance to avoid insolvency issues.
Investigating your solvency status can be complex, so you should immediately seek professional advice from an accountant or insolvency practitioner.
They can assist with identifying the root cause of a negative financial position and help you take the necessary steps to resolve the issues. And if the issues are unresolvable, they’ll guide you through the process of administration or liquidation.
It’s in a director’s best interest to stay on top of their duties to avoid being held personally liable for company debts.
Many risks come with trading insolvent, including director liability, civil penalties and jail time.
At Box Advisory Services, our team of experts can help review your current financial situation and provide recommendations for avoiding insolvency-related problems..
Contact us today for an obligation-free consultation on what steps you should take now so that we can work together with you to ensure that you never trade insolvent again.
Frequently Asked Questions (FAQs)
What is Insolvent Trading?
Insolvent trading is when a company continues to operate and incurs debts despite not having sufficient assets to cover its liabilities.
What is Trading Insolvent?
Trading insolvent is the act of continuing business operations when a company can’t meet its financial obligations.
What is a Trade Creditor?
A trade creditor is an entity to whom a company owes money for goods or services that have been delivered but have yet to be paid.
When is a Company Insolvent?
A company is deemed insolvent when it’s unable to meet its financial obligations or settle its debts as they fall due. This doesn’t merely imply a temporary cash flow issue; instead, it signifies a deeper financial challenge where the company’s liabilities exceed its assets, and it can’t generate sufficient funds to cover its outstanding debts.
Insolvency can arise from prolonged operational losses, high levels of debt, inadequate cash flow management, or unforeseen large expenses. Recognising the early signs of insolvency is crucial for businesses to seek appropriate remedies and avert potential legal consequences.”
What Does Trading Insolvent Mean?
Trading insolvent means continuing to operate a business when it can’t meet its financial obligations, putting the company at risk of legal consequences.