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Focus: Guidance for directors on duty to prevent insolvent trading

25 November 2009

In brief: Guidance to help directors understand and comply with their duty to prevent insolvent trading is contained in a new Australian Securities and Investments Commission consultation paper released yesterday. Partner Michael Quinlan (view CV) and Lawyer Catherine Zahra report.

How does it affect you?

  • The consultation paper, which provides a summary of the insolvent trading provisions in the Corporations Act 2001 (Cth), is a helpful starting point for directors in understanding their obligations under the Act as the Australian Securities and Investments Commission (ASIC) perceives them.
  • Directors, professional advisers and other interested parties have an opportunity to comment on ASIC's approach to Australia's insolvent trading laws.
  • Comments on the consultation paper are due by 22 January 2010.

The consultation paper

Consultation Paper 124, released on 24 November, outlines proposals to help directors understand and comply with their duty to prevent insolvent trading. A draft regulatory guide covering ASIC's proposed guidance to directors is attached to the paper. The guide is divided into three parts. Section A provides a concise summary of the insolvent trading provisions in the Corporations Act, including sections 588G (director's duty to prevent insolvent trading) and 588H (defences to a civil claim for insolvent trading).

Section B sets out the key principles that ASIC considers directors need to take into account in order to comply with the duty to prevent insolvent trading, namely:

  • directors must keep themselves informed about the company's financial affairs and regularly assess the company's solvency;
  • directors should investigate financial difficulties immediately as soon as they identify concerns about the company's financial viability;
  • directors should seek appropriate professional advice to help address the company's financial difficulties; and
  • directors should consider and act appropriately on the advice received, in a timely manner.

ASIC suggests that, if a director fails to actively monitor the solvency of the company, investigate financial difficulties, seek advice where appropriate, and consider and act appropriately on that advice, they are at serious risk of breaching their duty to prevent insolvent trading. The guide sets out practical ways in which directors can achieve these principles in practice and provides short case studies. For example, ASIC suggests that some of the activities a director may need to undertake in order to ensure that they are sufficiently informed about the company's position may include:

  • being involved in, or overseeing the preparation of, profit and cash-flow budgets and regular management accounts, and monitoring actual results against budget expectations;
  • reviewing the company's ability to collect debts owed to it and to realise other current assets, including stock, on a regular basis;
  • monitoring when creditors are due to be paid and the company's ability to comply with normal terms of trade; and
  • reviewing the current level of bank lending facilities and the ability to access additional funding if required.

Section C provides guidance on how ASIC will assess whether a director has breached their duty to prevent insolvent trading. It sets out the specific factors that ASIC will take into account in assessing the extent to which a director has complied with the key principles set out in Section B and the evidentiary material ASIC will look for. Section C demonstrates the importance of a company maintaining proper books and records, and the need for directors to actively monitor the solvency of the company.

Finally, the Appendix sets out some of the common indicators of potential insolvency that ASIC will look for in assessing whether insolvency existed at a particular time. Indicators of potential insolvency include:

  • the company has a history of continuing trading losses;
  • the company is experiencing cash-flow difficulties;
  • the company is experiencing difficulties selling its stock, or collecting debts owed to it; or
  • creditors are not being paid on agreed trading terms and/or are either placing the company on cash-on-delivery terms requiring special payments on existing debts, before they will supply further goods and services.

ASIC suggests that, should the financial position of a company display one or more of these indicators, a director should seek professional advice about the financial position of the company, and how any financial difficulties can be addressed.

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Directors beware

There are a number of important factors to take into account when considering the consultation paper. First, the paper is only an indication of the approach that ASIC may take in a particular case and is not its final policy. Secondly, the paper does not provide a one-stop solution to every situation facing a director of a company in financial distress. It does not address in detail all of the issues that arise in relation to insolvent trading. In particular, it does not address issues such as:

  • what a 'debt' is for insolvent trading purposes;
  • when a debt is 'incurred' for insolvent trading purposes;
  • when a debt is 'due' for insolvent trading purposes;
  • how far into the future a director must look in considering a company's current solvency or insolvency; and
  • the extent to which access to funding from external sources can be taken into account in determining whether a company is able to pay its debts.

Directors will need to seek expert legal and accounting advice and do further reading1 for guidance on these issues. The emphasis placed by ASIC on the need for directors to seek appropriate professional advice, and to consider and act appropriately on the advice received in a timely manner, reinforces this.

Thirdly, the paper addresses only ASIC's view of the law. ASIC is only one of the potential claimants against directors for insolvent trading. Most insolvent trading claims are brought by liquidators and (to a lesser extent) creditors.

Finally, the paper does not consider or recommend any changes to the existing law, even though relief for directors from insolvent trading exposure has been much talked about by the financial press and relief from similar laws has occurred in some other countries (for example, Germany). Australia continues to have some of the most punitive insolvent trading laws in the world.

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Conclusion

The consultation paper provides some guidance to directors as to how ASIC will assess whether they have breached their duty to prevent insolvent trading. Directors and their advisors, insolvency practitioners and other interested parties should read it, as it provides an important opportunity to comment on ASIC's approach to the insolvent trading laws. Comments are due by 22 January 2010.

Footnote
  1. For example, Allens Arthur Robinson Directors' Duties During Insolvency 2nd ed Lawbook Co 2007 and relevant past papers presented at Allens Arthur Robinson Corporate Insolvency & Restructuring Forums, available at www.aar.com.au.

For further information, please contact:

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