What does the law say?
There are a lot of legal provisions that a director needs to consider in a situation where their company is possibly insolvent. We have provided below some of the relevant sections of the Corporations Act and other director’s duties that are developed through case law and the Tax Act. But this is a very complicated area of the law so after you’ve had a read of the information below we strongly recommend that you call us for specific advice.
Mentioned below are some of the more important sections of the Corporations Act, Tax Act and general case law:
Section 95 (A) (1) Insolvency Definition
The section defines insolvency as simply the inability to pay debts as and when they fall due. However, the reality is much more complicated than that. There is a mountain of case law on the topic and no director can be expected to be on top of all of that. We suggest you have a look at our page Is my company insolvent? where we summarise the case law into a series of easy questions.
Section 588G Insolvent Trading
A director may incur civil and criminal liability for debts incurred during trading when there are reasonable grounds for suspecting that the company is, or may become, insolvent. We have explained this concept in more detail at Insolvent Trading.
Section 588V Holding Company liability for subsidiary debts
If a subsidiary should incur a debt when there are reasonable grounds for the directors of the holding company to suspect that the company is insolvent, then the holding company may be liable for a compensation claim made by the liquidator of the subsidiary.
Section 60 Definition of director
An adviser to a company may be defined as a director. Whilst it is the duty of a director to prevent a company from trading whilst insolvent, the definition of director may be extended to advisers. Anyone who instructs or directs the directors on a day-to-day basis may be defined as being actively involved in the direction of the corporation and may incur a personal liability for the company’s debts. This possibly may extend to bankers if they are actively involved in rehabilitating a company. Care should be taken by lenders and advisors not to involve themselves in director’s decisions.
Duty of care
It is now a generally accepted principle that where a company is insolvent, its directors owe a duty to the company not to prejudice the interests of its creditors in the exercise of their powers. Where a third party takes the benefit of a transaction with the company, knowing that it has been effected by directors of the company in breach of their duty, that benefit may be clawed back. This may well apply to transactions involving banks obtaining security in respect of a past debt or obtaining a guarantee from a technically insolvent company.
Section 588FJ – Floating Charges
This section seeks to prevent companies from creating a floating charge to secure past debt in the dying days of its business. With certain exceptions, including if new funds are advanced to a company, this section provides that a floating charge created in the six months prior to winding up is void as against a liquidator. It is of utmost importance that floating charges are registered in accordance with the Corporations Act.
Section 588E – Inadequate Books and Records
Companies are required to keep accounting records in accordance with section 286 of the Corporations Act. If the company is wound up and it is found that the company didn’t keep proper records, it is then deemed to be insolvent throughout the period it did not keep proper records. It follows that if proper accounting records are not maintained, directors can hardly form a view as to a company’s current or future position, and likely would have no defence to claims that the company traded while insolvent.
Section 588FA – Unfair Preferences
Payment of accounts outside normal trading terms may be recovered as an unfair preference by a future liquidator if the liquidator can show that the creditor had a suspicion that the company was insolvent. It is not uncommon for a director to ensure that those creditors paid before liquidation are those where the directors have provided a personal guarantee. In such a case, the directors need to be aware that the repayment could be “clawed back” by the liquidator leaving the director again exposed under the personal guarantee. The director can also become personally liable to the liquidator for the value of benefit he or she obtains as a result of the creditor being given the preferential payment.
Income Tax Assessment Act Schedule 1 Director Penalty Notices
That section allows the Commissioner of Taxation to issue notices on directors of the company whereby they will automatically become personally liable for any unremitted deductions by the company, without any formal court hearing. The serving of such a notice will force the directors of the company to remit those deductions; or have the company placed into voluntary administration; or have the company placed into liquidation.