A director's duties when insolvency looms

This information sheet provides general information on insolvency for directors whose companies are in financial difficulty, or are insolvent, and includes information on the most common forms of external administration.

An insolvent company is one that is unable to pay all its debts when they fall due for payment. There are serious penalties for allowing your company to trade while insolvent. If your company is in financial difficulty, you should seek independent advice on your duties and the options available.

Who is a director?

A director is not just a person appointed to that role. Under the Corporations Act 2001 (Corporations Act), a person may also be a director if they are not formally appointed but act in that role, or if the directors of the company act in accordance with their instructions or wishes.

Directors' duties

Generally, in addition to the requirement to ensure compliance with general and specific laws applying to your company's operations, your primary duty is to the shareholders. However, if your company is insolvent, or there is a real risk of insolvency, your duties expand to include creditors (including employees with outstanding entitlements).

General duties

General duties imposed by the Corporations Act on directors and officers of companies include:

• the duty to exercise your powers and duties with the care and diligence that a reasonable person would have, which includes taking steps to ensure you are properly informed about the financial position of the company and ensuring the company doesn't trade if it is insolvent
• the duty to exercise your powers and duties in good faith in the best interests of the company and for a proper purpose
• the duty not to improperly use your position to gain an advantage for yourself or someone else, or to cause detriment to the company, and
• the duty not to improperly use information obtained through your position to gain an advantage for yourself or someone else, or to cause detriment to the company.

Duty to not trade while insolvent

As well as general directors' duties, you also have a positive duty to prevent your company trading if it is insolvent. A company is insolvent if it is unable to pay all its debts when they are due. This means that before you incur a new debt you must consider whether you have reasonable grounds to suspect that the company is insolvent or will become insolvent as a result of incurring the debt.

An understanding of the financial position of your company only when you sign off on the yearly financial statements is insufficient. You need to be constantly aware of your company's financial position.

Duty to keep books and records

Your company must keep adequate financial records to correctly record and explain transactions and the company's financial position and performance. A failure of a director to take all reasonable steps to ensure a company fulfils this requirement contravenes the Corporations Act.

For the purposes of an insolvent trading action against a director, a company will generally be presumed to have been insolvent throughout a period where it can be shown to have failed to keep adequate financial records.

Consequences of insolvent trading

There are various penalties and consequences of insolvent trading, including civil penalties, compensation proceedings and criminal charges.

The Corporations Act provides some statutory defences for directors. However, directors may find it difficult to rely upon these if they have not taken steps to keep themselves informed about the company's financial position.

Civil penalties

Contravening the insolvent trading provisions of the Corporations Act can result in civil penalties against directors, including pecuniary penalties of up to $200,000.

Compensation proceedings

Compensation proceedings for amounts lost by creditors can be initiated by ASIC, a liquidator or a creditor against a director personally. A compensation order can be made in addition to civil penalties.

Compensation payments are potentially unlimited and could lead to the personal bankruptcy of directors. The personal bankruptcy of a director disqualifies that director from continuing as a director or managing a company.

Criminal charges

If dishonesty is found to be a factor in insolvent trading, a director may also be subject to criminal charges (which can lead to a fine of up to $220,000 or imprisonment for up to 5 years, or both). Being found guilty of the criminal offence of insolvent trading will also lead to a director's disqualification.

ASIC has successfully prosecuted directors for allowing companies to incur debts when the company is insolvent, and has sought orders making directors personally liable for company debts. ASIC also runs a program to visit directors, where appropriate, to make them aware of their responsibilities to prevent insolvent trading.

The good news is that taking steps to ensure your company remains financially sound will minimise the risk of an insolvent trading action. It may also improve your company's performance.

What to do if you suspect financial difficulty

If you suspect your company is in financial difficulty, get proper accounting and legal advice as early as possible, as this increases the likelihood of the company surviving. One of the most common reasons for the inability to save a company in financial distress is that professional advice was sought too late. Do not have a 'head in the sand' attitude, hoping that things will improve, they rarely do.

Signs that may indicate your company is at risk of insolvency

• ongoing losses
• poor cash flow
• absence of a business plan
• incomplete financial records or disorganised internal accounting procedures
• lack of cash-flow forecasts and other budgets
• increasing debt (liabilities greater than assets)
• problems selling stock or collecting debts
• unrecoverable loans to associated parties
• creditors unpaid outside usual terms
• solicitors' letters, demands, summonses, judgements or warrants issued against your company
• suppliers placing your company on cash-on-delivery (COD) terms
• issuing post-dated cheques or dishonouring cheques
• special arrangements with selected creditors
• payments to creditors of rounded sums that are not reconcilable to specific invoices
• overdraft limit reached or defaults on loan or interest payments
• problems obtaining finance
• change of bank, lender or increased monitoring/involvement by financier
• inability to raise funds from shareholders
• overdue taxes and superannuation liabilities
• board disputes and director resignations, or loss of management personnel
• increased level of complaints or queries raised with suppliers
• an expectation that the 'next' big job/sale/contract will save the company

Source: ASIC, Insolvency: a guide for directors. Link Read the full ASIC guide.