Directors have responsibilities to the company they manage, its shareholders, third party creditors and consumers. If you are a director of a company facing difficult financial circumstances, it is wise to obtain professional advice immediately.
Insolvent trading laws
An incorporated company is a legal entity in its own right and accordingly, directors are not generally liable for a company’s losses or debts, unless they breach their statutory and fiduciary duties.
The Corporations Act 2001 (Cth) prohibits a company from trading whilst it is insolvent, and directors have a duty to prevent insolvent trading. Directors who allow a company to continue incurring debt where it is reasonably foreseeable that the company is, or is likely to become insolvent, may be held personally liable for financial losses.
Essentially, a company is considered insolvent when it cannot pay its debts on time.
Defences for insolvent trading
There are limited statutory defences that may be available to directors for insolvent trading. These are, that a director:
- had reasonable grounds to expect the company was solvent at the time the debt was incurred;
- was not involved in the company’s management due to illness or another good reason when the debt was incurred;
- took all reasonable steps to prevent the company from incurring the debt.
Safe harbour provisions
Safe harbour provisions were introduced to protect directors who take positive steps that are reasonably likely to result in a better outcome for a company facing insolvency, than administration or liquidation.
During a ‘safe harbour period’ the duty to prevent insolvent trading is relaxed and a director may not be liable for the debts of a company if:
- after suspecting the company is in threat of insolvency, the director develops a course of action that could reasonably be likely to lead to a better outcome for the company than immediate administration or liquidation; and
- the debts were incurred directly or indirectly in connection with this course of action.
The safe harbour period begins from the time a director suspects that the company may become insolvent and begins to take the steps outlined above. The safe harbour period ends if the director ceases taking the course of action, the course of action is no longer reasonably likely to lead to a better outcome, or the proposed action is not implemented within a reasonable time.
Factors to be considered in determining that a course of action would likely lead to a better outcome include whether a director is:
- properly informed of the company’s financial position;
- preparing a plan to improve the financial viability of the company such as a restructure or amalgamation;
- retaining a suitably qualified person to advise on the restructuring or amalgamation;
- taking appropriate steps to prevent any misconduct within the company that could adversely affect its ability to pay its debts;
- taking positive steps to ensure the company is maintaining appropriate financial records.
The safe harbour provisions cannot be relied upon where, at the time the debt has been incurred, the company has failed to:
- meet its obligations for employee entitlements as they fall due; or
- maintain accurate financial accounts and records; or
- substantially comply with reporting and filing requirements under taxation laws.
The safe harbour provisions aim to protect prudent directors of a company experiencing transient cashflow problems, from personal liability, provided they are adopting appropriate strategies to improve the company’s financial position.
The decision to invoke the safe harbour provisions should not be taken lightly. Directors must make an informed and reasonable judgment, at board level, that the proposed action is likely to improve the company’s outcome, and ensure that employee entitlements, financial records and taxation reporting requirements have been met. In such circumstances, professional advice should be obtained.
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