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Focus: Insolvency – May 2004

Elliott v ASIC: non-executive directors and insolvent trading

In brief: Partner Paul Meadows and Special Counsel Anne Ferguson review the recent Water Wheel decision in Elliott v ASIC and its impact on non-executive directors.

The Victorian Supreme Court of Appeal has confirmed that businessman John Elliott, as a non-executive director, failed to prevent the Water Wheel companies from trading while they were insolvent.

In its decision in Elliott v ASIC [2004] VSCA 54 handed down recently, the Court of Appeal agreed with the trial judge that Mr Elliott's 'contraventions over a period of five months were serious and inexcusable'.

It also confirmed that Mr Elliott, in his role as a board member (albeit as a non-executive director), did nothing to protect the creditors from the inevitable insolvency of the companies. The fact that the Water Wheel companies had entered into deeds of company arrangement did not prevent the Australian Securities & Investments Commission (ASIC) from obtaining a $1.4 million compensation order against Mr Elliott, or the court from disqualifying him from managing a corporation for four years.

Mr Elliott is seeking leave to appeal to the High Court from the Court of Appeal's decision. In the meantime, the Court of Appeal has refused to extend the stay on the order banning Mr Elliott from managing corporations. The four-year ban will come into operation this Friday, 7 May 2004.

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The trial judge's decision

In ASIC v Plymin, Elliott and Harrison, Justice Mandie of the Victorian Supreme Court found that Mr Elliott, as a non-executive director, had failed to prevent a company from incurring debts while it was insolvent and had contravened the Corporations Law.

Justice Mandie was satisfied that ASIC had proved that:

  • the Water Wheel companies were insolvent at the time debts were incurred;
  • at that time, there were reasonable grounds for suspecting that the companies were, or would, become insolvent; and
  • the directors were, or a person in a like position would have been, aware that there were reasonable grounds for suspecting insolvency.

In relation to non-executive directors, Justice Mandie said:

A non-executive director is expected to take steps to put himself in a position to monitor the company and to exercise and form an independent judgment and to take a diligent and intelligent interest in the information either available to him or which he might with fairness demand from the executives or other employees and agents of the company.

Justice Mandie held that Mr Elliott was aware of facts and matters that gave rise to reasonable grounds for suspecting insolvency. These matters included:

  • concerns that the financial controller had raised that the company might be insolvent;
  • the audited loss for the year ending 3 December 1998 was $879,000 and losses for the half year to 3 June 1999 were $2.135 million;
  • Deloitte Touche Tohmatsu was engaged to investigate whether the 1998 loss could be attributed to unrecorded flour sales due to a new computer system. By April 1999, Deloitte had not found any evidence of unrecorded sales;
  • creditors were not being paid in accordance with normal trading terms and the company had worsening liquidity problems;
  • by April 1999, it was known that off-balance sheet finance was unlikely to come from existing financiers and no replacement financiers could be found;
  • at an April 1999 board meeting, a co-director expressed concern about the lack of financial results and information for the first three months of the year and asked about the solvency of the companies. That director resigned two days later without explanation;
  • the ANZ Bank appointed an investigative accountant in June 1999 and, by August 1999, the bank indicated the company was in default of its credit facility arrangements and had placed all facility arrangements on demand; and
  • by August 1999, it was known that creditors were owed $10.4 million, the ANZ Bank debt was $5.7 million, and that current assets were $12.3 million.

The court can excuse a director who has acted honestly and who, having regard to all the circumstances of the case, ought fairly to be excused for the contravention. ASIC conceded that Mr Elliott had acted honestly. Justice Mandie held that, in considering whether a person ought 'fairly' to be excused, the court could take into account:

  • any action to appoint an administrator, the timing and result of that action;
  • the way in which the breach occurred; and
  • the circumstances of the person seeking to be excused.

Although administrators were appointed to the Water Wheel companies, in Justice Mandie's view, the appointment was made too late. Justice Mandie accepted ASIC's submission that Mr Elliott was 'confronted with unmistakable evidence and repeated warnings that Water Wheel was heading towards insolvency in the first half of 1999 and that it was insolvent by 14 September 1999.' In the opinion of Justice Mandie, Mr Elliott disregarded the position of unsecured creditors. For these reasons, Mr Elliott was not excused for his contravention.

Justice Mandie made a prohibition order against Mr Elliott, disqualifying him from managing a corporation for four years. He also ordered that Mr Elliott pay compensation of approximately $1.4 million, and a pecuniary penalty of $15,000 to ASIC.

Mr Elliott appealed from Justice Mandie's decision.

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The appeal

On appeal, Mr Elliott did not challenge the judge's findings that:

  • from 14 September 1999, the Water Wheel companies were insolvent; and
  • from that time, until the companies were placed into administration, he was aware of reasonable grounds for suspecting insolvency.

The appeal therefore centred on whether:

  • Mr Elliott as an individual non-executive director was under a duty to, and failed to take a step that would have been effective to, prevent Water Wheel from incurring the debt;
  • the court should look at each individual debt that was incurred to determine whether there had been a contravention of the law for each debt; and
  • the fact that the companies entered into deeds of company arrangement meant that a compensation order could not or should not be made against Mr Elliott.

The Court of Appeal (Chief Justice Warren and Justices Charles and O'Bryan) agreed with Justice Mandie's decision. The court held that a director (including a non-executive director) breaches the insolvent trading provisions by 'not preventing' or 'failing to prevent' a company from incurring a debt. If the debt is incurred when there are reasonable grounds for suspecting insolvency, then the director will be taken to have failed. The court also held that:

  • it is not necessary to prove that an individual director was under a duty to take a step or a particular step which would have been effective to prevent the company from incurring the debt and that the director did not take that step;
  • it was not necessary to consider what duty Mr Elliott had to prevent the company from incurring each particular debt; and
  • when making a compensation order, the court does not have to examine each particular debt to see if there has been a breach by a director of his/her duty to prevent that debt being incurred.

In regard to the order prohibiting Mr Elliott from managing a corporation for four years, the Court of Appeal stated:

We agree with the judge's conclusions that Elliott's contraventions over a period of five months were serious and inexcusable and showed continuing disregard for the position of creditors. In his role as a member of the Board of Water Wheel, albeit as a non-executive director, Elliott had stubbornly and tenaciously allowed Water Wheel to trade after 14 September 1999 and did nothing to protect the creditors from the inevitable insolvency of the company. No doubt the judge was impressed by the character evidence as to Elliott's past performance, which explains why a lenient prohibition order was imposed.

As to the pecuniary penalty order of $15,000 against Mr Elliott, the Court of Appeal agreed with the trial judge. It held that Justice Mandie was entitled to find that the contraventions were 'serious and represented a sustained and continuous course of inexcusable and unjustified neglect of important duties of a non-executive director'.

The Court of Appeal also confirmed the trial judge's compensation order of $1.4 million against Mr Elliott. The fact that the companies entered into deeds of company arrangement did not mean that creditors had not suffered. The court confirmed that 'so far as the dividends payable under the deed of company arrangement do not fully repay to the creditor the amount of the debt, the creditor has still suffered loss and damage because of the company's insolvency, even if the debt is extinguished and the company has the benefit of a release under the deed of arrangement'.

Mr Elliott has applied for leave to appeal to the High Court.

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Non-executive directors should watch out for...

The Water Wheel case sounds a warning for non-executive directors. They will not be excused because in that role they are not capable themselves of preventing the company from incurring debts. Nor will they be protected if they do not act to appoint an administrator as soon as it is objectively apparent that the company is insolvent or is likely to become insolvent.

To avoid a claim that they have failed to prevent a company trading while insolvent, directors will need to establish a number of things including that:

  • the board has questioned sufficiently the company's financial position;
  • the board has been informed sufficiently by competent and reliable managers about the financial position (among other things, this involves the director being reasonably comfortable that the level and quality of information provided is adequate and that information-providers are competent);
  • external advice has been sought where appropriate from an expert insolvency practitioner; and
  • proper and timely consideration has been given to the appointment of an administrator.

In summary, to protect themselves against a successful insolvent trading claim being made, directors must ensure that they are fully and appropriately informed of the company's financial position. If it objectively appears that the company is, or might become, insolvent, then immediate steps must be taken to appoint an administrator. If the director cannot persuade the majority of other directors that the company should not continue to trade, then the director should resign.

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