Insolvent Trading: Odds Stacked Against Directors

• In this article, we discuss some of the key findings of an empirical study into insolvent trading. While there have not been many insolvent trading actions that have gone all the way in Australia, directors lose in three out of four cases that do.

An empirical published jointly by Clayton Utz and the Centre for Corporate Law and Securities Regulation (The University of Melbourne) has made various interesting findings. Despite insolvent trading provisions having been in existence in Australia for over 40 years, there have only been 103 cases that have gone to judgment (many cases are of course settled). Perhaps most significantly, 75 per cent of insolvent trading cases against directors end up in a loss for the director. This shows why insolvent trading has become such a bogeyman for company directors.

The duty to prevent insolvent trading is the most controversial of the duties imposed upon company directors. Those who support the duty argue that it provides appropriate protection for the unsecured creditors of companies. Those who oppose the duty argue that it has the effect of making directors unduly risk adverse which can result in directors too quickly putting companies into voluntary administration or liquidation for fear of personal liability (which may have a negative financial impact on unsecured creditors).

The duty to prevent insolvent trading (as currently formulated) is contained in section 588G of the Corporations Act. This section applies to impose liability upon a person if:

• the person is a director of the company when the company incurs a debt;
• the company is insolvent when it incurs the debt or becomes insolvent because it incurs the debt;
• when it incurs the debt there are reasonable grounds for suspecting that the company is insolvent or would become insolvent if it incurs the debt; and
• the director is aware at the time the debt is incurred that there are reasonable grounds for suspecting that the company is insolvent or would so become insolvent (as the case may be) or a reasonable person in a similar position in a company in the company’s circumstances would be so aware.

Even if a director has breached section 588G, there might be a defence for the director. Section 588H contains four defences. These are:

• reasonable grounds on which to expect solvency;
• reasonable reliance on information provided by others;
• absence from management; or
• taking reasonable steps to prevent the incurring of a debt.

The project involves an empirical study of insolvent trading cases based on court judgments. Insolvent trading provisions were first introduced by each of the States and Territories in their Companies Acts in 1961. Research was undertaken to obtain relevant cases from the introduction of the insolvent trading provisions until February 2004.

Key findings and implications

The key findings of the study are summarised below.

There has not been a large number of insolvent trading cases in Australia (our research revealed 103 cases in total). Although the insolvent trading provisions were introduced into companies legislation in 1961, we were unable to find any cases from the 1960s. In the 1970s there were ten cases and in the 1980s there were sixteen cases. There was a rapid increase to 62 cases during the 1990s. However, the number of cases decided has since slowed, with only 15 cases decided since the end of the 1990s.

The implementation of the Harmer Report's recommendations in 1993 may have contributed to this fall in the number of insolvent trading cases being brought before the courts. While the drop in the number of cases could be caused by various factors, it may be in part be related to the changes which removed creditors' primary right to initiate insolvent trading proceedings. In this regard, creditors have been plaintiffs in far fewer proceedings relating to post-Harmer provisions than they were before.

Conversely, the Harmer amendments gave liquidators the primary right to initiate insolvent trading proceedings (whereas there was only a limited right under the pre-Harmer provisions). This amendment has resulted in liquidators being involved in significantly more cases post-Harmer, but, as the person with the primary right to initiate proceedings, they do not appear to have been as active post-Harmer as creditors were pre-Harmer.

Accompanying these changes is a drop in the number of cases brought by the authorities (ie. corporate regulators and the DPP) since the implementation of the Harmer's Report's recommendations. With the relatively recent introduction of the National Insolvency Coordination Unit by ASIC and other associated ASIC initiatives, the number and proportion of these cases may increase.

In the vast majority of the insolvent trading cases (75 per cent), the defendant is found liable for insolvent trading. This suggests that only the strongest cases make it to court. Only in about 11 per cent of the cases in which a defence was argued was the director held not liable because a defence applied.

Where the defendant is found liable for insolvent trading, the amount of compensation the court orders the defendant to pay varies significantly. The largest amount of compensation a director was ordered to pay by a court was $96.7 million. The smallest amount of compensation ordered in a case was $517. The median amount of compensation was $110,600. It should be noted that the amount of compensation is directly linked to the amount of the unpaid debts incurred during the period the company trading whilst insolvent.

In addition to ordering the defendant director to pay compensation where the director has engaged in insolvent trading, the court has the power in certain circumstances to impose other orders including pecuniary penalties and orders banning the director from managing companies for a specified period of time. Such orders are relatively rare, being made in only seven cases, with only two of those involving management banning orders.

Once again, given the implementation of recent initiatives by ASIC in relation to insolvent trading (see above), it seems possible that this trend will start to turn around soon.

Ninety-one per cent of the companies alleged to be engaged in insolvent trading are private companies.

Twenty-two per cent of all the cases involved companies engaged in construction, with the next two most common categories of business being retail trade (17 per cent) and manufacturing (17 per cent). These findings may have implications as to where ASIC should be devoting its remedial and enforcement resources.

Excluding those cases where the type of director was unknown, 55 per cent of the cases involved executive directors and 22 per cent involved non-executive directors. Four per cent of the cases were brought against the chairman of the companies.

Most cases of insolvent trading against directors (60 per cent) were brought by creditors of the companies. About 17 per cent of the cases were initiated by the relevant corporate regulator with another 16 per cent being brought by the liquidators of the companies. The relative levels of activity of each of these plaintiffs has however varied over time (see above).

In about 64 per cent of the cases, the debt related to the purchase of goods or services by the company. In about another 8 per cent of the cases the debt was a loan from a bank or another financier. This may reflect the fact that banks will often have taken personal guarantees from directors (especially in the case of small companies), and so can recover directly from the directors without having to make an insolvent trading claim.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.