If your company is experiencing a cash flow or liquidity crisis, you need to consider whether it can still pay its debts when they become due. If it can’t, then your company may be insolvent.
Section 588G of the Corporations Act 2001 (Cth) (Act) imposes a duty on Directors to prevent insolvent trading. But what is ‘insolvent trading’? How can you tell if your company is insolvent or not? And what can you do to avoid personal liability?
When is a Company Considered Trading Insolvent?
Insolvent trading occurs when a company:
- can’t pay its debts when they fall due
- continues to incur further debt.
A Director must ensure their company is solvent before incurring additional debt. If a Director breaches their statutory duty under the Act, they risk being held personally liable for the unpaid debts if the company goes into liquidation.
The Australian Securities and Investments Commission (ASIC) has a useful resource to help you understand your duty to prevent insolvent trading. It lists matters you should take into account when considering the solvency (or otherwise) of your company.
Key Principles
Sections 588G-Z of the Act relate to insolvent trading, and apply to all company Directors. Note that under the Act, ‘Director’ can also mean shadow and de facto Directors, or any alternate Director appointed to act in that capacity.
In other words, even though you might not have been appointed as a Director, you may be deemed to be a shadow or de facto Director if you’ve had extensive involvement in the company or have acted in the position of a Director.
In summary, you probably breached the Act if:
- you are a Director when your company incurs a debt
- your company is insolvent at the time, or becomes insolvent by incurring that debt or other debts at that time
- there are reasonable grounds to expect your company is (or will become) insolvent
- you are aware (or ought to reasonably be aware) there are grounds for expecting insolvency in your company’s circumstances
- you fail to prevent the company from incurring the debt.
What Should You Do?
According to ASIC you should do these 6 things:
- Stay informed. Monitor profit and cash flow budgets, review financial statements, review the company’s level of lending facilities and keep an eye on creditor payments and arrangements.
- Investigate financial difficulties. Make reasonable enquiries to keep informed of the company’s financial position, and investigate when the company is in distress.
- Get advice. Ensure your advisors and employees have the skills and expertise so you can rely on their advice, and ask your advisors the right questions to keep chief financial officers and accountants well informed.
- Act quickly. Not acting as soon as you suspect insolvency can be fatal to the company and expose you to personal liability.
- Apply the ‘cash flow’ test. Work out whether the company’s anticipated current and future cash flows will be enough to pay current and future liabilities when they fall due.
- Apply the ‘balance sheet’ test. Look at the company’s finances as a whole. For example, see if the company can raise finance quickly, or whether surplus assets can be sold quickly so the company can keep trading.
The Consequences of Insolvent Trading (section 588G)
If you’re found to have breached section 588G of the Act, you may face civil and criminal sanctions including:
- a fine of up to $200,000 and/or imprisonment for up to five years
- disqualification as a Company Director (particularly if an element of dishonesty was involved).
The Liquidator may also bring proceedings against you to recover the debts incurred to distribute to the creditors. And an individual creditor may bring a claim against you personally for the sum of the creditor’s individual claim.
To avoid personal liability you should remain informed at all times, and seek advice regularly. See how we can help with our Instant Online Assessment. Alternatively, get in touch with our team of financial professionals on 1800 861 247.