When a company is in liquidation a liquidator can make claims against directors of the company if the directors have allowed their company to incur debts when the company was insolvent (or the company becomes insolvent as a result of the debts being incurred) and those debts are unpaid when the liquidation commences.
The critical issue is – when is a company insolvent? Section 95A of the Corporations Act 2001 (Cth) (“the Act”) defines solvency and insolvency as:
- A person is solvent if, and only if, the person is able to pay all the person’s debts, “as and when they become due and payable”.
- A person who is not solvent is insolvent. A person is defined to include a corporation.
Indicators of insolvency include the following:
- Liquidity ratio below 1;
- Continuing losses;
- No access to alternative finance;
- Overdue Commonwealth and State taxes;
- Suppliers placing the debtor company on a cash on delivery basis;
- Inability to raise further capital;
- Issuing of post-dated and dishonoured cheques;
- Creditors being paid outside of trading terms;
- Summonses, judgments, creditors statutory demands or warrants issued against the company;
- Payments to creditors of rounded amounts which are not reconcilable to specific invoices.
If a company makes a loss or a series of losses it does not mean it is insolvent. Insolvency is usually a combination of losses and insufficient working capital. There is a distinction between “balance sheet solvency”, “cash flow insolvency” and “temporary cash flow insolvency”.
Directors should be aware of the date when their company becomes insolvent as this is relevant to liquidators (or creditors) pursuing the directors for insolvent trading claims.
Section 588G of the Act sets out a director’s duty to prevent insolvent trading.
When directors breach their duties the provisions of section 588M of the Act allow compensation to be recovered from the directors.
The Act provides statutory defences for directors which in summary are as follows:
- the director had reasonable grounds to expect (not just suspect) the company was solvent;
- a reasonable, competent person produced information that would reasonably lead the director to a belief that the company was solvent;
- the director had a good reason for not taking part in the management of the company at the relevant time;
- the director took all reasonable steps to prevent the company incurring the debt, including attempting to appoint a voluntary administrator.