With the recent economic downturn, many companies have struggled to keep their heads above water and stay afloat.
But, if you’re a director of an Australian company, then it is your duty to make sure that all trading activity occurs while solvent. Otherwise, you could face some serious consequences.
So, in this article, we will discuss what insolvent trading is, the risks directors face if a company is training insolvent and how you can avoid it.
As part of the COVID-19 provisions, the Federal Government has also extended the Safe Harbour laws, so we will discuss what this means for your company.
Here’s what you need to know.
- 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
What Does It Mean If a Company Is Trading Insolvent?
Insolvent trading is when a company has insufficient assets to pay its liabilities but nonetheless continues trading and incurring debts.
Directors have a positive duty to ensure that the company remains solvent before incurring more debt.
What Are Directors Duties Regarding a Company’s Financial Position?
It is the director’s legal obligation to ensure that a company doesn’t trade while insolvent. A director will be in breach of their positive duty to prevent insolvent trading if:
- they were the director 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 and
- the director fails to take any steps to prevent the company from incurring debt.
Reasonable grounds that may indicate suspicion of insolvency include:
- 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, and
- 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:
- Act with care and diligence: company directors can avoid personal liability if they can 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 that the company stops 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, If directors are in breach of the duty to prevent a company from trading while insolvent, they may face serious penalties and consequences, including:
- 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, who will be personally liable for the debts.
- Criminal charges: where a company director has misled creditors regarding its insolvent trading, they may face criminal charges, which could lead to a $220,000 fine or a five-year prison sentence.
Defence To Trading While a Company is Insolvent: Safe Harbour Regime
In 2017, the Australian Federal Government introduced safe harbour laws to provide some protection to 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 the COVID-19, the Federal Government extended the scope of the of the safe harbour laws to allow directors to continue trading, paying their bills and retain 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 will not be found to be in breach of their duties.
How Can Company Directors Avoid Insolvent Trading
Despite the existence of the safe harbour laws and the temporary COVID-19 relief, it’s important that directors 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 directors best interests to stay on top of their duties to avoid being held personally liable for company debts.
Whether your company is insolvent or not, it’s important to understand what trading is while insolvent entails.
There are many risks that come with this practice including the risk of director liability, civil penalties and jail time.
Regardless of the safe harbour laws and COVID-19 extended relief, which aim to protect directors in reasonable circumstances, it’s important that you try to avoid trading insolvent to minimise the risk and consequences.
At Box Advisory Services, our team of experts can help review your current financial situation and provide recommendations for how to avoid insolvency-related problems down the road.
Contact us today for an obligation free consultation on what steps you should take now so that we can work together with you towards making sure that you never trade insolvent again.
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.