What Are The Duties of Directors to Prevent Insolvent Trading?

Directors of Australian companies have duties both under common law and statute to ensure that the company does not incur debts while insolvent.

Common Law Duties

At common law, this duty falls under the director’s duty of care and diligence. Generally, this duty of care and diligence is not measured by a subjective standard, but rather by that of an ordinary prudent person acting on their own behalf. More specifically, case law has developed the principle that a director may not rely upon their actual knowledge as a basis of claiming that he or she had no reasonable cause to expect the company was insolvent when a debt was incurred. A director can therefore not claim ignorance with respect to a company’s insolvency if the director has not made appropriate inquiries into the financial capabilities of the company, because such a director has not discharged his or her duty of care and diligence.

A successful action brought against a director at common law for breach of the duty of care and diligence will show that the director’s conduct caused the plaintiff (likely a shareholder or group of shareholders) to suffer damage, and that a reasonable person acting in the position of the director would have acted differently. Factors relevant to the reasonableness of the director’s actions may include the efforts made by the director to discover and keep up to date of the financial position of the company, including the number of times and the manner in which the efforts were made, and whether the director acted in good faith with respect to communicating with other directors or key employees in this regard. A director held to be in breach of his or her common law duty would face a financial liability in the amount of the damages determined by the court.

Statutory Duties

The Corporations Act 2001 (Cth) (Act) also imposes duties on directors. Section 180 of the Act imposes an obligation on a director to act with a degree of care and diligence that a reasonable person would exercise if they were a director of another company in the company’s circumstances and occupied the position and had the same responsibilities of the director. The statutory duty of care and diligence therefore imports a standard of reasonableness similar to that of the common law duty. Section 180 further clarifies that both the statutory and common law duties are satisfied if the director meets certain requirements in making a business judgment.

The Act also imposes a more specific duty on directors to ensure that the company does not trade while insolvent. If a company incurs a debt while insolvent or the incurring of the debt makes the company insolvent (Insolvency Position), a director will be in breach of this provision if there are reasonable grounds for suspecting, or a reasonable person acting as a director of a company in the company’s circumstances would suspect, that the Insolvency Position existed at the time the debt was incurred. Again, reasonableness is a key concept in this duty. A breach of the statutory duty to prevent insolvent trading will generally give rise to a civil penalty unless the director is able to prove one of the defenses provided under the Act. A number of these defenses also import a notion of reasonableness, namely:

The director had reasonable grounds to expect that the company was solvent and would remain solvent even if it incurred the debt;
The director had reasonable grounds to believe, and did believe, that a competent and reliable person was responsible for providing information about the solvency of the company and that the person was fulfilling that responsibility, and the director expected on this basis that the company was not in an Insolvency Position; andr
The director took all reasonable steps to prevent the company from incurring the debt, including the appointment of an administrator.

The concept of reasonableness is not present, however, in the criminal offense of insolvent trading, which is committed if the director suspected that the Insolvency Position existed and the director’s failure to prevent the company incurring the debt was dishonest.

A director found to have contravened a civil penalty provision by breaching a statutory duty could face a penalty order of up to $200,000 or an order disqualifying the director from managing a company.

A director found to have committed an offense of insolvent trading faces up to 5 years’ imprisonment and $220,000 in fines.