Author
Domenic CalabrettaChief Executive Officer & ASIC Registered Liquidator
Where there’s smoke there’s fire, and the impact of financial distress on a company should never be underestimated. Many companies may appear financially stable but are, in reality, trading while insolvent. This guide provides information on important aspects of insolvent trading including director duties, indicators of insolvency, legal implications, and the most appropriate course of action to take.
What does insolvent trading mean?
Insolvent trading occurs when a company or person is unable to meet financial commitments (pay debts on time) and continues to incur debt. Under Australian law, directors have a legal duty to prevent their company from trading while insolvent.
It is essential to first note the difference between corporate insolvency and bankruptcy. The former relates to incorporated companies, while bankruptcy is the legal process taken by individuals who cannot pay off their debts. We will focus on companies, and more specifically, the roles and responsibilities of Directors.
What are the most common indicators of insolvency?
On the surface, many indicators of insolvency are clearly identifiable and obvious. Unfortunately, it is common for Directors to ignore these signs as it often means a realisation that they have been unable to place their company in a position of success. This highlights the importance of taking an objective view as a Director when assessing key aspects of your company including its financial position, accounting procedures, organisational issues and equity status.
Some of the most common indicators of insolvency are:
Financial Warning Signs
- Mounting unpaid creditors and overdue invoices
- Cash flow shortages making it difficult to cover operating expenses
- Growing company debts that exceed assets
- Declining profits and ongoing financial losses
- Regularly selling assets to meet financial obligations
- Relying on payment plans with creditors or the ATO
Accounting Red Flags
- Overdue tax payments and superannuation contributions
- Inconsistent or inaccurate financial records
- Errors in payroll and employee entitlements
- Inability to generate accurate financial reports
Operational & Management Issues
- Internal communication breakdowns and low morale
- Delays in paying staff wages or cutting employee benefits
- Key staff resigning due to financial uncertainty
- Struggles to secure additional funding or loans
If there are signs that your business is in trouble, do not ignore them. Acting early as a Director will provide your company with the best prospects of returning to a position of financial stability.
Who is personally liable for insolvent trading?
The structure of a company is unique as they are recognised as a separate legal entity. Companies share the same rights as a person in that they can accrue debt, commence legal proceedings, and be held legally accountable. Limited liability applies to companies and there are circumstances where Directors may be personally liable for any debt accumulated by a company.
Here’s when a director may face personal liability:
- Insolvent Trading: It is illegal to trade while insolvent, and preventing this from occurring is one of the fiduciary duties of a Director. If it is determined that a Director allowed a company to continue trading while insolvent, they may be held personally liable for any debts incurred.
- Loans and Guarantees: If personal assets have been used as security, they will be used to pay off any outstanding company debts. Similarly, a Director will be liable for any personal or Director guarantees that were signed.
- Tax Implications: Directors should always be abreast of any tax debts. This includes any unpaid PAYG, superannuation contributions, or Director Penalty Notices that have not been dealt with accordingly.
Director responsibilities and insolvency
There are numerous fundamentals that Directors must adhere to while carrying out their role.
Some of the key Director responsibilities outlined by ASIC¹ are to:
- Act in good faith and in the best interests of the company
- Avoid conflicts of interest and act with integrity
- Understand the company’s financial position before making major decisions
- Ensure debts can be paid on time before incurring new liabilities
- Seek professional advice if the business is in financial distress
Failing to meet these obligations can result in serious penalties, including personal liability for debts, financial penalties, and even disqualification from managing companies.
What is insolvent trading in Australian law?
The Corporations Act 2001² sets out the laws for business entities and the way they operate in Australia. Its application is universal and applies at both federal and state levels. The legislation covers all business entities, including companies and partnerships. The Corporations Act also specifies the duties and responsibilities of Directors along with the penalties for any breaches.
The Act also gives power to the Australian Securities Investment Commission (ASIC) for its administration. They are an independent government body who are the financial services regulator. Part of ASIC’s role is to provide key information about companies to the public and enforce the law - taking action where necessary.
Understanding insolvent trading and the Corporations Act can be complex and one of the major reasons why businesses should invest in legal advice. There have been significant changes to insolvency laws, and it is a key responsibility of a Director to be aware of their implications.
What are the penalties for trading insolvent?
The penalties for insolvent trading³ can be severe. The consequences may include criminal charges including substantial financial penalties, civil implications, and compensation proceedings.
Directors who allow insolvent trading can face:
- Criminal Charges: A Director may be subject to criminal proceedings if it is determined that their dishonest actions were a contributing factor to insolvent trading. The penalties are up to 5 years imprisonment and 2,000 penalty units which equates to $444,000 as of 1 July 2020.
- Civil Penalties: Breaches of the insolvent trading provisions of the Corporations Act can result in civil penalties against Directors up to the amount of $200,000.
- Compensation Proceedings: Unpaid creditors can initiate compensation against Directors personally. The amount of compensation is unlimited and may lead to the personal bankruptcy of a Director. There are associated implications with personal bankruptcy including disqualification from continuing as a director. There are a series of recommended steps that can be taken for those looking to recover from bankruptcy.
What should I do if my company is trading while insolvent?
If you have recognised that your company is trading while insolvent you must act immediately. There are a range of options available including restructure and turnaround, liquidation, voluntary administration, and receivership.
Restructure and Turnaround: This may be a viable option for some companies and involves changing the financial/organisational structure to address financial difficulties. The process may involve debt consolidation, cost reduction, or organisational restructure. Acting early will increase the prospects of a successful restructure and turnaround.
Voluntary Administration: Company administration could provide your company with the breathing space required to devise a plan for growth. The process does not have to be a costly exercise and can prevent your business from being forced into liquidation.
Receivership: If you have mounting debts owed to a secured creditor, you may be faced with the prospects of receivership. A receiver and manager may be appointed by a creditor or court. They will conduct a thorough analysis of the company before beginning the process of collecting, selling, and distributing assets.
Liquidation: When a company is trading insolvent and no longer viable, liquidation is in many instances the most appropriate course of action. There are a variety of liquidation options including creditors’ voluntary liquidation (CVL), members’ voluntary liquidation (MVL), provisional liquidation, and simplified liquidation for small businesses.
References:
https://asic.gov.au/for-business/small-business/starting-a-small-business-company/small-business-company-directors/#responsibilities
https://www5.austlii.edu.au/au/legis/cth/consol_act/ca2001172/
https://asic.gov.au/regulatory-resources/insolvency/insolvency-for-directors/#consequences-of-insolvent-trading
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