Corporate insolvency is becoming more and more of a reality in these financially turbulent times. Insolvent trading is an extremely serious issue for a company and the civil and criminal consequences can be devastating for the company directors.

What is insolvent trading?

In order to avoid insolvent trading, company directors should have an understanding of when a company becomes insolvent.

According to Australian law, a company is insolvent if it is unable to pay its debts as, and when, they fall due. The simplest way of determining whether or not a company is trading whilst insolvent is to ask the question: Am I concerned about the company’s capacity to service its debts? If the answer is ‘yes’, then something needs to be done.

The Australian Securities and Investment Commission (ASIC) is the corporate watchdog regulating corporate behaviour. They list the danger signs of when a company may be at risk of insolvent trading which include the following:

•  poor cash flow;

•  absence of a business plan;

•  incomplete financial records or disorganised internal accounting procedures;

•  lack of cash-flow forecasts and other budgets;

•  increasing debt (liabilities greater than assets);

•  problems selling stock or collecting debts;

•  unrecoverable loans to associated parties;

•  creditors unpaid outside usual terms; and

•  solicitors’ letters, demands, summonses, judgments or warrants issued against your company.

What are the risks of insolvent trading?

The risks of insolvent trading, particularly towards individual directors, are quite extreme. Personal fines can be as high as $200,000 and directors can face 5 years in gaol for any criminal aspect related to the insolvent trading.

In addition, ASIC may initiate on behalf of the creditors civil claims against directors for compensation. Directors are also vulnerable to similar claims brought personally by liquidators or creditors.

Civil penalties are but one form of financial penalty imposed on directors who trade with company money whilst insolvent – compensation orders can also apply against directors. It is important to note that there is technically no limit placed on compensation payments. A large claim made against a director of a company could potentially result in the director’s bankruptcy. This personal bankruptcy means that the director is disqualified from managing as a director or continuing in his or her current position.

Things to consider in order to minimise exposure to insolvent trading

ASIC have created a guide which sets out four key principles that directors of struggling entities should follow to avoid a breach of duty if they are in control of an insolvent company. The four key principles are as follows:

  • Stay informed

Directors must do a number of things to stay informed about the financial position of the company, including:

o   Keeping all financial records and any other information that may be relevant to the finances of the company; and

o   Gaining an understanding of the cash flow of the company.

  • Investigate

If the company is looking like it is not in a strong financial position, directors should be quick to do the following:

o   Take steps to understand where exactly the company stands financially;

o   Look at what can be done to manage the financial instability; and

o   Make sure the company has systems to investigate whether or not the company will remain solvent upon taking any new debts.

The take away here is that directors must be the most involved in their company and should know exactly where the company’s money is being spent.

  • Get advice

When it comes to getting the right advice, don’t wait! Find the right financial adviser and get advice about the financial stability of the company and how these obstacles can be overcome. By seeking advice, directors are able to rely on this advice as a defence to any potential claim that may arise out of the company’s insolvency. The availability of this defence, however, hinges on whether you have given your accountant full, complete and up-to-date instructions.

  • Act quickly

When ASIC investigate the company over insolvent trading, they will examine:

o   The minutes of board meetings, and any other materials (e.g. email correspondence) that may illustrate to the Commission that the directors were aware that the company was unable to service its debt obligations as a company; and

o   Any internal documents that would give a better picture of the company’s financial position (balance sheets, etc.).

ASIC is looking to see that directors have been active, efficient and honest in the steps they have taken to avoid incurring additional debt.

ASIC’s warnings are clear: directors must become heavily involved in the company’s affairs once there is any concern that a company is struggling to pay its debts when they fall due.

Importantly, following ASIC’s guide does not:

  • provide immunity from prosecution; or
  • limit the action creditors or a liquidator may take against directors who traded while insolvent – that is a decision for the courts.

Conclusion

As a director, you are required to become involved in the company’s affairs to whatever extent is necessary to ascertain the true financial position of the company. If you are a director worried about the financial position of your company and wish to have a lawyer or financial adviser advise you on your position, please contact LegalVision on 1300 544 755.

Jill McKnight

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