Trading While Insolvent
Insolvent trading occurs when a company, already unable to meet debts as they fall due, continues incurring more debt. This practice, highlighting financial distress, can lead to civil and criminal penalties for directors. Solvency means being able to pay debts on time; insolvency is the opposite.
What is Insolvent Trading?
Insolvent trading occurs when a director allows a company to incur a new debt while the company is insolvent. Insolvent trading is illegal in Australia under the Corporations Act 2001. Knowingly trading whilst insolvent can result in serious penalties, such as fines, jail time and directors being held personally liable for company debts.
When is a Company Insolvent?
A company is insolvent if it cannot pay its debts as and when they are due. This typically stems from excessive liabilities and/or insufficient cash flow within the business.
Insolvency is a serious matter. It affects employees, creditors, shareholders, directors and other stakeholders, and it may result in the business being placed into Administration or Liquidation to help creditors recover the money they are owed.
Determining the solvency of your company can be challenging. As corporations grow, cash flow and liabilities become increasingly complex to monitor. For the purposes of Australian legislation, there are two common tests used to determine the solvency of a company:
- Cash flow assessment. A cash flow assessment examines all cash that moves into and out of the company over a specific period of time (courts typically examine cash flow over a number of months, rather than years). This includes where the cash comes from, where it goes and whether the business generates enough cash to cover its liabilities. The company is solvent if it has sufficient cash flow to pay its debts when they are due.
- Balance sheet assessment. A balance sheet assessment analyses a company’s assets, liabilities and equity at a single point in time. The company is considered solvent if its total assets outweigh its total liabilities.
When determining the solvency of a company, the courts generally consider its cash flow, balance sheet, pending prospects and overall position.
Insolvent Trading and the Corporations Act
Insolvent trading is covered by Section 588G of the Corporations Act. Section 588G states that directors have a duty to prevent insolvent trading by the company. This applies if:
- A person is the director of company at the time when the company incurs a debt; and
- The company was insolvent at the time, or if it becomes insolvent by incurring the debt; and
- There are reasonable grounds to suspect that the company is insolvent or that it would become insolvent
A director becomes guilty of insolvent trading if they fail to prevent the company from incurring the new debt, and:
- The director is aware that the company is insolvent, or if there are reasonable grounds for suspecting the company is insolvent; or
- If a reasonable person in a similar position could be expected to be aware of the company’s situation
If the director claims to be unaware of the company’s insolvency, Australian Courts apply the “reasonable person” test. This test determines whether the director should have been reasonably aware of the company’s financial situation. Given that directors have a duty to prevent insolvent trading, it’s likely that a Court would find that the director should have been aware of the company’s insolvency.
The Consequences of Trading While Insolvent
Directors that are found guilty of insolvent trading may be subject to civil penalties, personal liability proceedings and criminal charges.
The civil penalties include:
- Fines of up to $200,000
The personal liabilities include:
- Personal compensation proceedings being brought against the director by ASIC, a Liquidator or creditor
Personal compensation payments are potentially unlimited. This may result in the director declaring personal bankruptcy.
The criminal charges include:
- A fine of up to 2,000 penalty units (currently valued at $550,000); and/or
- Imprisonment for up to 5 years
If the consequences of insolvent trading cause a director to declare bankruptcy, or if you are found guilty of the criminal offence of insolvent trading, you may also be disqualified. Disqualification prevents you from continuing as a director or managing another company for a period of up to 5 years.
Managing the Risk of Trading While Insolvent
Insolvent trading is a serious matter that carries lasting consequences. Fortunately, doing your due diligence as a director largely allows you to avoid the risks of insolvent trading. If you stay on top of the company’s finances and act quickly when issues arise, it is highly unlikely that you will incur insolvent trading claims.
To reduce the risk of trading whilst insolvent, directors should:
- Stay informed about the business. Directors have a duty to oversee company affairs and make decisions that are in the company’s best interests. That means directors should make an effort to stay informed about all areas of the business, including things like cash flow, prospects, liabilities and industry changes. You can read ASIC’s ‘RG217 Duty to prevent insolvent trading: Guide for directors’ to find out more about your responsibilities
- Investigate financial concerns. Financial issues can quickly spiral out of control when left unaddressed. Serious difficulties may be avoided through early intervention, so it’s a good idea for directors to thoroughly investigate new debts, investments, upcoming prospects and any financial concerns.
- Act quickly when a problem arises. Taking early action is the best thing a director can do to prevent insolvency and insolvent trading. Delays in taking action can be fatal to the company and they may result in personal liability.
- Seek professional advice. As the director of a company, it’s your responsibility to seek professional advice if you need help in particular areas. Given the complexity of corporate finances, it’s worth building a relationship with a professional financial advisory. Financial advisers can help you stay on top of the company’s situation, plan effective strategies and manage small issues before they become serious financial difficulties.
Insolvent Trading and Safe Harbour
As discussed above, the penalties that come with insolvent trading can be severe. This has created a situation where directors may prematurely liquidate a company to avoid insolvent trading claims. While this protects the directors from risks, it may result in a viable company being wound up, which negatively affects employees, creditors and other stakeholders.
Safe harbour laws are designed to prevent this situation. Under Australia’s Safe Harbour Provisions, the directors of a company are protected from insolvent trading claims that arise due to actions taken while attempting to save the company from liquidation. This improves the chances of the company continuing to trade and benefits the business and its creditors.
Manage the Risks of Insolvent Trading with Professional Advice from SV Partners
Company directors have a responsibility to prevent the business from trading whilst insolvent. This duty is a cornerstone of the Corporations Act, and it ensures that companies are operated in the best interests of their shareholders, creditors and employees. However, keeping track of your company’s financial position can be a challenge, so it’s often helpful to work with the team at SV Partners.
SV Partners is a professional financial advisory firm that works with businesses all over Australia. As independent Liquidators and Administrators, we have decades of experience in dealing with insolvent companies, which allows us to deliver tailored advice that can help manage your situation. Contact us at any time if you are concerned about your company’s situation, or call our confidential assist line on 1800 246 801 for a consultation.