Directors of companies owe many duties towards their creditors and shareholders. The most serious breach of a directors’ duty is trading while your company is insolvent or is becoming insolvent. A major principle of insolvency law is to legally recover as much property for the benefit of creditors. Therefore, recovering maximum property is achieved by imposing a duty on directors to prevent insolvent trading. This suggests that directors must be aware of what is going on in the company – you must be active and proactive in relation to your trade dealings. The consequences of failing in duties are very serious and you may become personally liable to pay compensation, criminally liable or even disqualified from managing the company for a period of time.

In order to prove that a director has engaged in insolvent trading, these four circumstances must coexist:

  1. The person is a director when the company incurs a debt;
  2. The company is insolvent or becomes insolvent when incurring that debt;
  3. There were reasonable grounds to suspect that the company is insolvent; and
  4. This occurred after 15 July 2001.

When is a person a director of a company?

Essentially, a director can be a natural or articficial person. A director is defined not only in terms of somebody who is appointed a director but indeed regardless of the name or title, that person has acted in the position of the director. This may also include if the directors have acted under the persons’ instructions. Therefore, de facto and shadow directors are also considered directors of the company.

What is a Debt?

A debt is something that is legally owed or due. It can take many forms, including money, goods and services. A debt is incurred when the company subjects itself to an obligation to pay or to do something.

What is Insolvent?

By definition, to be insolvent is the state of being unable to pay all your debts when they are due and payable. Here, insolvency is not necessarily assessed based on your balance sheet because assets and liabilities may not be accurate. For example, some of your assets may not be able to be used or liquidated into money to pay your debts. Therefore, you should examine insolvency in its context – you look at whether the company has the assets or can raise the money in a reasonable time to pay the debts.

When is a debt incurred?

Picture this – if you order material from a factory to be delivered next month, is the debt incurred when you ordered the material or when the material is delivered. Normally, the debt is incurred when you placed the order. In relation to a lease, it is when you signed the lease.

What are the reasonable grounds for suspecting insolvency?

It must be shown that the director should have suspected the company to be insolvent or to become insolvent. To suspect something requires more than just thinking or having a feeling about it. The test is based on whether an ordinary person in the position of the director would have thought that the company was insolvent. The following are indicators that should be a warning that your company is becoming insolvent:

  1. Continuing losses: it does not matter how much the company has, if you are a director and its monthly accounts run at a loss, that should alert you as to how close you are to bankruptcy
  2. Liquidity ratio below 1: involves an assessment of the liquid assets
  3. Overdue commonwealth and state taxes
  4. Poor relationship/s with your current bank including inability to borrow any more money
  5. No more access to alternative finance
  6. Inability to raise equity capital
  7. Suppliers want you to pay cash and no longer want credit
  8. Creditors are paid outside of trading terms
  9. Issuing of post-dated cheques
  10. Dishonoured cheques
  11. Special arrangements with selected creditors
  12. Any evidence of solicitors letters, summons, judgments or warrants of execution
  13. Payments to creditors are in rounded sums, which are not reconcilable with specific invoices
  14. Inability to produce timely and accurate financial information

Conclusion

If the above four factors are satisfied, a director is liable for trading in insolvent circumstances. It is strongly advised that you consult with an Insolvency lawyer to fully understand your best options for your business. If you would like to discuss your situation with one of our specialist Insolvency lawyers, please complete the form or give us a call. We will then assess your needs free of charge and provide a fixed-fee quote if relevant. Just give us a call on 1300 544 755.

Jill McKnight

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