The purpose of this paper is to provide a very brief overview of the law relating to directors' liability for insolvent trading and, more importantly, a practical guide to defending proceedings brought against a director for such a claim. Hopefully, the paper will inform directors of some of the important issues that arise in the defence of an insolvent trading claim.
The Overview
Directors of a company are under a statutory duty not to incur debts whilst a company is insolvent or incurring a debt that makes the company insolvent. The duty is imposed by section 588G of the Corporations Act (Cth). That section provides that a director breaches the section if, whilst he or she is a director, the company incurs a debt and the company is insolvent at that time or becomes insolvent by incurring the debt provided that there are reasonable grounds for suspecting that the company is insolvent or will become insolvent.
If a director does not prevent the company from incurring such a debt, he or she breaches section 588G which can have both criminal and civil consequences.
It is important to remember that the term "director" includes an actual director or a 'shadow director' (i.e. someone who although not formally appointed as a director in facts conducts himself or herself as a director).
The meaning of insolvency
A company that is not solvent is insolvent: section 95A. A company is solvent if it is able to pay its debts as and when they become due and payable.
The test therefore is a cash flow test, rather than a balance sheet test. However, the Courts do recognise that consideration should be given to "near cash" assets (i.e. assets which can be readily and quickly realised) in determining solvency as well as the commercial realities (for example, the company's ability to obtain borrowings or voluntary extensions of time from creditors): Lewis v Doran.
If there are insufficient accounting records because the company failed to keep proper accounting records (in contravention of section 286), then the company will be presumed to be insolvent.
Suspecting insolvency
"To 'suspect' is to have more than a mere idle wondering"; it is "a positive feeling of actual apprehension or mistrust, amounting to a 'slight opinion, but without sufficient evidence'": Queensland Bacon Pty Limited v Rees.
Some of the things that the court would look at to see whether there were reasonable grounds for suspecting insolvency include: negotiations toward payment arrangements, payments to creditors of rounded amounts (rather than specific invoiced amounts), receipt of letters of demand, overdue taxes, banking facilities at or over limits, creditors being paid out of normal trading terms and issuing of post-dated cheques.
It is important to remember that the director needs not have the subjective opinion that the company is insolvent or will become insolvent: all that he needs be aware of, to become liable, is of the grounds upon which a reasonable suspicion could be objectively based.
The meaning of a debt
The director becomes liable if he fails to prevent the company incurring a debt. What is required is that the company commit some positive act and in so doing that the company becomes bound to pay money. Therefore, a company only incurs a debt when it enters a lease, not each time another month's rent becomes due. But on the other hand, the ongoing liability to pay workers' compensation insurance is a debt that arises each month even though the obligation arises out of the conclusion of a single contract of employment. The position in relation to interest is even less clear.
The statutory defences
Section 588H provides the director with a number of defences.
Firstly, a director has a defence if the director proves that when the debt was incurred he or she had reasonable grounds for expecting (and did so expect) that the company was solvent at the time the debt was incurred and would remain solvent even if the debt was incurred.
Secondly, a director also has a defence if the director can show that he or she expected the company to be and remain solvent on the basis of information provided to him or her by a competent and reliable person responsible for providing information about solvency to the director.
A third defence that can be raised is that the director, at the time the company incurred the debt, did not take part in the management of the company because of illness or "some other good reason" (abdicating the responsibilities of being a director is not a good reason).
Finally, it is a defence if proved that the director took all reasonable steps (which can include the appointment of an administrator) to prevent the company incurring the debt.
In addition to s588H, ss 1318 and 1317S provide that the court can excuse a contravention, if a director has acted honestly, after having regard to all the circumstances, where the court finds that the director ought to be excused from all or part of any liability.
These defences may seem very helpful and not too arduous to raise but in reality, the courts look to the legislative intent of the insolvent trading provisions when considering the availability of a defence and the clear intent of the legislation is to impose a heavy burden on directors not to allow the company to incur further debts when it becomes insolvent.
The Practical Guide
Defending a claim brought against a director for insolvent trading successfully requires a complex balancing of competing considerations.
On the one hand, the defence should involve a rigorous testing of the liquidator's claim and a strong presentation of any defence. However, on the other hand, most individual directors simply do not possess the funds required to fight on all the possible fronts. To achieve success, the defence must utilise its resources in the most effective way. To further complicate matters, the director may have to balance the benefits of presenting a united front with his or her co-directors against the liquidator with the cost of advancing their own interests.
Attacking the liquidator's claim
The liquidator bears the onus of proving the elements of a claim for insolvent trading. This means that he has to prove that the company incurred a debt, at a time when the company was insolvent or became insolvent by incurring the debt, and that the director was aware of the grounds upon which a reasonable suspicion of insolvency would have arisen.
Usually, the facts relating to the incurring of the debt don't raise too much controversy. However, the question of whether the company was insolvent at the time that the debt was incurred is often a far more contentious issue. Bear in mind that the liquidator will attempt to push back this date as far as possible so as to increase the size of his claim.
To prove insolvency, the liquidator will often rely upon a "solvency report" prepared by an independent expert (usual an accountant or another liquidator) or himself.
That report will express an opinion as to when the company became insolvent and will often provide a series of closer dates as fallback position. The reports will often contain a reconstituted cash flow statement, working capital calculation and an analysis of the debts outstanding at the relevant dates and the available funds to meet those debts.
These reports can be challenged on any number of bases including bias of the author, the inadmissibility of the evidence used in support of the report, the failure to prove the underlying assumptions in the report as well as the form of the report. There have been some spectacular failures to admit into evidence substantial solvency reports, costing hundreds of thousands of dollars, because of what might be construed as technical grounds.
Disputing solvency
In addition to mounting a challenge to the solvency report relied upon by the liquidator, consideration has to be given to the filing of an opposing report by an expert briefed by the director's solicitors.
There are occasions when accounting experts have different views as to whether a complex company is insolvent or not. For instance, how does one determine whether an insurance company, which might have large sums of money in its bank account but substantial and unquantifiable pending claims was insolvent or not at a particular date?
However, in a large number of cases, the circumstances of a company are fairly straight forward (and often dire) and it may be difficult to adduce competent evidence to the contrary. Bear in mind also that all solicitors and barristers owe a duty to the court not to advance defences which are not reasonably arguable.
In such cases, it would often be better to admit the company was insolvent (at an early stage of the proceedings) so as to avoid the liquidator's costs associated with preparing the report (which are usually quite substantial) for which the director will be liable if the defence fails and which will have to be taken into account when trying to settle the matter.
Advancing the statutory defences
This can be the trickiest part of the litigation particularly if there are multiple defendants.
On the one hand, one would assume that the directors all have a common interest in defeating the liquidator's claim. However, on the other hand, each director also has to be concerned that if the other directors succeed in their defences, he or she will be left with the full amount of the claim when judgment is handed down.
If one director raises the "reasonable reliance" defence, other directors might try to undermine that defence, particularly if they are alleged to be the source of the information relied upon. Furthermore, directors often advance cases that the other directors kept them in the dark and that they had no idea of what was going on. All of this in-fighting of course is greatly appreciated by the liquidator as it advances his case on the knowledge each director had.
There is also the risk (often exploited by liquidators) that one of the directors will break ranks and do a deal with the liquidator in exchange for testimony against other directors.
Often the best tactic in large multi-party proceedings is for a director to keep a low profile (and in so doing, save costs) and concentrate on the evidence specifically implicating him whilst the other directors attack the liquidator on all other fronts. Careful and discrete cross-examination may quietly establish all the facts upon which a statutory defence can be made out.
Settlement and the point of no return
Sometimes, a realistic assessment of the prospects of success in defending an insolvent trading claim indicates that the defence will be a waste of costs. What to do then? Some directors choose to bankrupt themselves. Others engage in desperate attempts to conceal their assets by transferring them to their husband, wife or a related entity.
A more constructive approach may be to consider approaching the liquidator with a settlement proposal. A liquidator will only act if he is funded. In some cases he receives that funding from the proceeds of the company's assets or even prior preference actions he may have instituted. Increasingly, he may have received litigation funding.
An early success in a recovery action can be very important to a liquidator who is concerned that protracted litigation will deplete the available funds for creditors. A director can use this to his or her advantage by approaching a liquidator early on in the litigation with an offer. The liquidator may offer a substantial discount for an early settlement.
On the other hand, the liquidator may be overly bullish about his claim and not be prepared to offer a reasonable compromise. In such a case it may be necessary to temper his enthusiasm by some successful interlocutory proceedings. Timing can be everything.
Unfortunately, often settlement is only considered when all other avenues have been exhausted and it appears that a judgment is inevitable. This is hardly the time to settle, particularly if the liquidator has spent large sums of money on the litigation (or worse, a funder has advanced large sums of money for the litigation). In those cases, the legal costs alone will demand a substantial payment and the amount required to settle the matter is simply beyond what a director can pay.
Staying power
Litigation, whether as a plaintiff or as a defendant, is stressful. Commercial litigation of this nature is even more stressful. The proceedings can stretch over several months, even years. The costs of participating are high, particularly for an individual. In addition to the stress of a possible judgment hanging over the director's head, there is the ongoing distraction of having to give solicitors instructions, depose to affidavits and follow the proceedings generally. And then there is the prospect of being cross-examined by the opposing barristers in open court.
All of this takes its toll on a director and lawyers can often forget this. It is important that the director have a clear understanding of the road ahead, the time it will take and what will be expected of him or her. Financial planning of the defence is important. It does the defence no good if there is the additional stress of fighting between the director and his solicitors over the payment of fees. Directors should have a clear understanding of how much will be required and when it will be required. Allowance should also be made for a contingency fund for when unexpected developments arise.
Conclusion
All of this may present a very daunting scenario but it is one that, unfortunately, can easily arise and has become an unavoidable occupational hazard for those who accept appointments as directors.
Swaab was recently named winner 'Best Law Firm in Australia (Revenue < $20m)' and 'Attribute Award for Exceptional Service (Australia Wide)' and at the 2008 BRW- Client Choice Awards.
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.
