Directors’ Liability for Insolvent Trading

There are six sections of the Corporations Act 2001 which I propose to address. The first two are relevant to whether the company is insolvent. The other sections are concerned with the liability of directors for insolvent trading and the defences which may be available to them.

ASIC has produced a Regulatory Guide entitled ‘Duty to Prevent Insolvent Trading: Guide for Directors’. This Guide provides important information for directors.

Definition of Insolvency

Section 95A of the Corporations Act 2001 provides:

(1) A person is solvent if, and only if, the person is able to pay all the person ‘s debts, as and when they become due and payable.

(2) A person who is not solvent is insolvent .

Section 459D is also relevant. It deals with contingent or prospective liabilities.

(1) In determining, for the purposes of an application of a kind referred to in subsection 459C(1), whether or not the company is solvent , the Court may take into account a contingent or prospective liability of the company .

(2) Subsection (1) does not limit the matters that may be taken into account in determining, for a particular purpose, whether or not a company is solvent.

Applications referred to in s 459C(1) include applications to wind up the company.

Tests of insolvency

The test of insolvency is a question of fact and the Court approaches that question as a matter of commercial reality.

Usually, insolvency is established (other than by way of a statutory demand) by showing that a company has current liabilities which it is unable to meet from currently realisable assets or other available sources of funding. However, the question is not resolved “merely by looking at the accounts and making a mechanical comparison of assets and liabilities.”1

Although the question of solvency is principally a question of whether adequate cash flows exist to satisfy the company’s debts as and when they become due, the current consolidated balance sheet position of the company or group of companies may also be relevant.

There is a difference between temporary illiquidity and “an endemic shortage of working capital whereby liquidity can only restored by a successful outcome of business ventures in which the existing working capital has been deployed”.2

Palmer J in Reynolds Wines (a case discussed in more detail later) observed: ‘It is easy enough to tell the difference in hindsight, when the company has either weathered the storm or foundered with all hands; sometimes it is not so easy when the company is still contending with the waves. Lack of liquidity is not conclusive of insolvency, neither is availability of assets conclusive of solvency’.3

Whether or not a company is insolvent is a question of fact to be ascertained from a consideration of the company’s financial position taken as a whole.

An examination of all of the company’s resources, including terms of credit available to a debtor is required to be undertaken.

In considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable.

Arrangements with creditors

Forbearance on the part of major creditors is a matter which often arises for consideration in the context of determining whether or not a company is insolvent.

In Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation, one of the questions addressed was whether the commercial reality that creditors will normally allow some latitude in time for the payment of their debts should be taken into account.

As observed by Palmer J in Southern Cross, ‘practical experience teaches that creditors will often allow a debtor some indulgence before insisting on payment. Where a company is suffering a temporary liquidity shortage, the hypothetical director of ordinary competence may reasonably expect that a discreet reliance upon such indulgences, paying those creditors who are becoming insistent and delaying payment to those who have not yet become insistent, may well enable the company to trade successfully through its difficult period.’

Palmer J undertook an analysis of authority on this point and identified the following four principles:

(i) In assessing whether a company’s position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality that, in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade but that does not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency.

(ii) The commercial reality that creditors will normally allow some latitude in time for payment of their debts does not, in itself, warrant a conclusion that the debts are not payable at the times contractually stipulated.

(iii) It is assumed that a contract debt is payable at the time stipulated for payment in the contract, unless:

• there is evidence of an agreement with the creditor for an extension of time;
• the creditor is estopped by its conduct from insisting on timely payment; or
• there is a course of conduct in the industry whereby debts are payable other than when stipulated by the creditor.4

(iv) It is for the party asserting that a company’s contract debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence.

Taxation debts

Taxation debts call for specific mention, particularly the question of when a disputed tax assessment is payable.

The following propositions are well established:

• First, the issue and service of a Notice of Assessment creates, upon expiry of the prescribed period for payment, a debt which is immediately due and payable to the Commonwealth.
• Secondly, while the correctness of the assessment and the amount of the debt can be challenged by statutory review procedures (but not in proceedings in which the Commissioner seeks to enforce payment of the debt created by the assessment), the fact that objection has been taken to an assessment and a review of the assessment is does not, in itself, demonstrate the existence of a “genuine dispute”.
• Thirdly, a company served with a statutory demand founded upon a Notice of Assessment may demonstrate a “genuine dispute” as to the existence of the debt under s.459H(1)(a) of the Corporations Act only if it demonstrates that one or other of the prerequisites for the creation of liability under the Notice of Assessment has not been met: this is limited to the Commissioner having not actually assessed the amount of taxable income and the tax payable, or notice of the assessment has not been served on the taxpayer, or the prescribed period for payment of the tax assessment has not expired.5

Future debts

The Court will look at debts which will become due and payable at a future time from assets which the company currently owns, or from any other sources which might come into existence within the relevant time frame.

The expression “when they become due and payable” in s 95A includes debts which have not yet fallen due for payment but will or will probably fall due for payment.

This was a central question in The Public Trustee v Octaviar Limited (formerly MFS). Another question that arose in that case was the question of solvency of companies which are part of a group of related entities.

Octaviar Investment Notes Limited, a subsidiary of Octaviar Limited, was a special purpose vehicle established to borrow money for the Octaviar Group. It borrowed $348m from members of the public and institutional investors in late 2006 and early 2007. In return it issued debentures in the form of unsecured notes which matured in December 2011.

Octaviar Investment Bonds Limited was another such subsidiary. It borrowed $93m from Challenger Managed Investments Limited in late 2007, and issued in return unsecured interest-bearing bonds maturing in December 2011.

Octaviar Limited guaranteed the obligations of its subsidiaries. The question of Octaviar’s solvency arose in 2008, before maturity of the notes and bonds.

The relevant principle in respect of future liabilities may be summarised as follows: a company is solvent only if the circumstances presently existing disclose that it will be, or will be likely to be, able to pay those debts when they fall due in the future, either from cash resources, by selling assets, by raising funds from debt or equity markets, or from any other source that is likely to be available to the company when the obligation to make payment arises. In making that assessment, again regard is to be had to commercial realities.6

Groups

Where there is a group of related companies, if one member of a group has, as a matter of commercial reality, ready recourse to the assets of another member of the group for payment of the first company’s debts as they fall due, and that recourse will not result in the insolvency of the second company or in merely delaying the insolvency of the first, then the Court may have regard to that fact in assessing whether the first company is able to pay its debts as they fall due.7

Director’s duty to prevent insolvent trading by a company

The next section I would like to discuss is s.588G. This section is quite impenetrable, so I will endeavor to break it down to some essential elements.

Section 588G essentially provides that:

• where the company is insolvent at that time it incurs a debt, or becomes insolvent by incurring that debt; and
• at that time, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent,

a person who is a director at that time will contravene s. 588G by failing to prevent the company from incurring the debt if:

• that director is aware at that time that there are grounds for suspecting that the company is insolvent, or would become insolvent; or
• a reasonable person position of the director would suspect that the company is insolvent, or would become insolvent.

The contravention of s. 588G:

(a) exposes the director to a civil penalty under s. 1317E;

(b) will constitute an offence if the director suspected the company was insolvent or would become insolvent and his or her failure to prevent the company incurring the debt was dishonest.

(c) can give rise to an order that the director to pay compensation to the company equal to the amount of loss or damage suffered by the person who is owed the debt if the debt incurred was unsecured (ss. 588J and 588K).

(d) can give rise to an order that the director to pay compensation to the unsecured creditor (s.588M).

These sanctions are in addition to any other liability the director may have for breaches of duty.

It is also relevant to note that the expression ‘director’ extends to include alternate directors and persons who may not be formally called ‘director’ but act in that position or are in a position where the directors of the company customarily act in accordance with that person’s instructions or wishes.

It is instructive to look at a recent example where the Court has considered s. 588G. One such case is Hall v Poolman8, a decision of Palmer J in the NSW Supreme Court. The case is better known as ‘Reynolds Wines’.

Reynolds Wines involved the Reynolds Group of companies, which owned vineyards and a winery near Orange in New South Wales. The Group went into liquidation in November 2003, owing secured and unsecured creditors a total of approximately $130M.

Mr Poolman was the Deputy Chairman of directors of Reynolds Wines Limited (referred to in the judgment as ‘Wines’) and a director of Reynolds Vineyards Pty Ltd (referred to in the judgment as ‘Vineyards’).

Mr Irving was the Chairman of Directors of both Wines and Vineyards. He held a Bachelor of Commerce degree and had commenced his professional life as an accountant. He was a very experienced director with a long and distinguished career as a director of many substantial companies, including Australian Industry Development Corporation, Australian Medical Insurance Ltd, FAI Life Ltd, Willis Australia Ltd Group, Anxiom Funds Management Corporation and David Jones Superannuation Fund Pty Ltd. He had been Managing Director of CIBC Australia Ltd and a director of companies such as Caltex Australia Ltd and Telstra Corporation. He had also been a member of many government and non-government advisory boards, and had been awarded the Australia Medal.

Mr Irving was appointed a non-executive director of Wines and Vineyards on 10 September 1999 and had held the position of Chairman of the Boards of both companies until the appointment of the administrators on 4 August 2003.

The claim against Mr Poolman and Mr Irving was for loss and damage suffered by creditors as a result of Wines and Vineyards trading while insolvent.

In the course of his reasons for judgment, Palmer J made a number of observations about the requirement of s.588G. The principal points can be summarized as follows:

(i) the test as to whether there are reasonable grounds for suspecting that the company is insolvent is an objective one.

In other words, it is sufficient that a reasonable person in a like position in a company in the company’s circumstances would suspect.

(ii) Regard is to be had to the facts and circumstances that the director ought to have known, as well as to the facts and circumstances that were actually known to him.

(iii) Suspicion of insolvency falls somewhere between a belief that insolvency exists, on the one hand, and a mere wondering whether it exists, on the other. Suspicion is a positive feeling of apprehension, an admittedly tentative belief, without sufficient evidence to form a concluded and supportable opinion.

In Reynolds Wines, ‘Wines’ had not procured an agreement from the Commissioner of Taxation to defer a tax payment nor had it obtained a stay of enforcement proceedings. Because of the dependency of Vineyards on financial support from its related entity, ‘Wines’, Palmer J concluded that a reasonable director of Vineyards could not refuse to think about the consequences to Vineyards if Wines had to be wound up because it was insolvent.

His Honour said: ‘It would have been the duty of a director of Wines and of Vineyards to obtain legal advice as to whether the tax assessed against Wines was due and payable, and then to consider the impact of that advice directly on the solvency of Wines and, indirectly, on the solvency of Vineyards.’

Defences

There is a defence to directors provided by s.588H(2) and (3). Again, these provisions are something of a ‘mouthful’. They provide:

“(2) It is a defence if it is proved that, at the time when the debt was incurred, the person had reasonable grounds to expect, and did expect, that the company was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time.

(3) Without limiting the generality of subsection (2), it is a defence if it is proved that, at the time when the debt was incurred, the person:

(a) had reasonable grounds to believe, and did believe:

(i) that a competent and reliable person (the other person) was responsible for providing to the first-mentioned person adequate information about whether the company was solvent; and

(ii) that the other person was fulfilling that responsibility; and

(b) expected, on the basis of information provided to the first-mentioned person by the other person, that the company was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time.”

An “expectation” of solvency, as required by the section, means a higher degree of certainty than ‘mere hope or possibility’ or ‘suspecting’. The defence requires an actual expectation that the company was and would continue to be solvent, and that the grounds for so expecting are reasonable.

A director cannot rely on a complete ignorance of or neglect of duty and cannot hide behind ignorance of the company’s affairs which is of their own making or, if not entirely of their own making, has been contributed to by their own failure to make further necessary inquiries.9

It is a defence under s.588H(4) if the director, at the time when the debt was incurred, because of illness or for some other good reason, did not take part at that time in the management of the company.

It is also a defence under s.588H(5) if the director took all reasonable steps to prevent the company from incurring the debt.

In Reynolds Wines, Palmer J formulated the following propositions:

1. In order for the defence to succeed, there must be an expectation, held on reasonable grounds, that recourse to assets will enable debts to be paid, not at some indefinite time in the future, but so as to keep the companies solvent according to the definition in s. 95A namely, as the debts fall due for payment.

2. It is not appropriate to base an expectation of solvency: “… upon the prospect that [the company] might trade profitably in the future thereby restoring its financial position. … The question is whether the company at the relevant time is able to pay its debts as they become due not whether it might be able to do so in the future if given time to trade profitably …”

3. The law recognises that there is sometimes no clear dividing line between solvency and insolvency from the perspective of the directors of a trading company which is in difficulties.

4. Where a company has assets which, if realised, will pay outstanding debts and will enable debts incurred during the period of realisation to be paid as they fall due, the critical question for solvency is: how soon will the proceeds of realisation be available.

5. Bearing in mind the commercial reality that creditors will usually prefer to wait a reasonable time to have their debts paid in full rather than insist on putting the company into insolvency if it fails to pay strictly on time, as a very broad general rule, that a director would be justified in “expecting solvency” if an asset could be realised to pay accrued and future creditors in full within about ninety days.

6. The position becomes murkier the less certain are the outcomes. The market value of the asset may not be ascertainable until the market is tested, so that it is not certain that the realisation will pay in full both existing debts and those to be accrued during the realisation period. The time at which the proceeds of realisation become available may depend upon the state of the market and the complexity of the transaction.

7. There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors: “How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?”

8. If the honest and reasonable answer to the last question is “certain” or “probable”, the director can have a reasonable expectation of solvency.

9. If the honest and reasonable answer is anywhere from “possible” to “no way of knowing”, the director can have no reasonable expectation of solvency.

10. If the honest and reasonable answer is “more likely than not”, the director runs the risk that a Court will hold to the contrary in an insolvent trading claim.

11. If the honest and reasonable answer is “no way of knowing yet, we need more information”, the director must then ask: “How long before we have the information so that we can give a final answer?”

12. If the honest and reasonable answer to that question is: “By a definite date which will not extend the realisation period (if there is to be one) beyond three months”, the director may reasonably say: “Let’s wait until then before deciding”.

13. If the honest and reasonable answer is “there is no way of knowing yet when we will have the information to make a decision”, the director must say: “Then there is no way that we can now have a reasonable expectation of solvency and there is no way we can reasonably justify continuing to trade without knowing when we will know whether the company is insolvent. Call the administrators”.

By the series of questions and answers above, his Honour said that he was not intending to lay down some pro forma test of directors’ liability for insolvent trading. He emphasized that each case depends on its particular facts. The questions and answers were merely to illustrate that “when a company is struggling to pay its debts, the directors must face up to the issue of insolvent trading directly and with brutal honesty: they must not shirk from asking themselves the hard questions and from acting resolutely in accordance with the honest answers to those questions.”

Discretionary defences

In addition to s. 588H, there are discretionary defences under both s.1317S(2) and s.1318(1) of the Corporations Act.

The sections confer a very wide discretion. Their purpose is “to excuse company officers from liability in situations where it would be unjust and oppressive not to do so, recognising that such officers are businessmen and women who act in an environment involving risk in commercial decision-making.”10

To obtain relief under these sections it is ordinarily necessary for the director to show at least that he or she acted honestly and acted bona fide in the interests of the company, including its unsecured creditors.

G A Thompson QC

Footnotes

1. Taylor v Carroll (1991) 6 ACSR 255 at 259
2. Hymix Concrete Pty Ltd v Garritty (1977) 2 ACLR 559 , at 566; Re Newark Pty Ltd (in liq); Taylor v Carroll (1991) 6 ACSR 255.
3. See also Expo International Pty Ltd (in liq) v Chant [1979] 2 NSWLR 820 , at 837
4. Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation (2001) 53 NSWLR 213, 224-225.
5. Hoare Bros Pty Ltd v Deputy Federal Commissioner of Taxation (1995) 16 ACSR 213 , at 223; on appeal, Hoare Bros Pty Ltd v Deputy Commissioner of Taxation (1996) 19 ACSR 125 , at 135-136.
6. Rees v Bank of New South Wales (1964) 111 CLR 210, 218; Re Timbatec Pty Ltd (1974) 4 ALR 13 at 18; McPherson’s Company Liquidation Looseleaf at [11.540] p 11-3064.
7. Lewis v Doran [2004] NSWSC 608; (2004) 50 ACSR 175 at [116].
8. Hall v Poolman [2007] NSWSC 1330
9. citing Tourprint International Pty Ltd (in liq) v Bott [1999] NSWSC 581; (1999) 32 ACSR 201, at [67] per Austin J
10. Daniels v Anderson (1995) 37 NSWLR 438 at 525 per Clarke and Sheller JJA