The Australian Securities and Investments Commission (ASIC) has released Regulatory Guide 217 (RG 217) to assist directors in understanding and complying with their duty to prevent insolvent trading under the Corporations Act 2001 (Cth) (the Act). It should be noted from the outset that ASIC regulatory guides indicate ASIC’s policy on specific issues, they do not have legislative force or constitute legal advice. Insolvent trading involves complex legal and accounting issues and it is therefore recommended that you seek professional advice to find out how the Act may apply to you.  

When is a company insolvent

Generally a company is insolvent when it is unable to pay all its debts when they fall due. The Appendix to RG 217 usefully lists a number of indicators of potential insolvency. These indicators include:

  • the company is experiencing difficulties in selling its stock, or collecting debts owed to it  
  • cheques are being returned dishonoured  
  • legal action is being threatened or has commenced against the company, or judgments are entered against the company, in relation to outstanding debts.  

The list is indicative only and is not exhaustive. Directors should check that list and if their company exhibits one or more of those indicators then they should investigate and obtain appropriate advice about the financial position of the company. Further, RG 217 details a number factors which ASIC will take into account (and what evidence will be considered in relation to those factors) in assessing whether a director has breached his or her duty to prevent insolvent trading. These factors include:  

  • The information the director had at their disposal to form the view that the company was solvent, and how accurate that view was.  
  • Whether the director monitored the financial affairs of the company and made sufficient inquiries into its financial affairs on a regular basis.  

What is the duty

The statutory duty to prevent insolvent trading is found in section 588G of the Act. Section 588G requires a director to prevent the company from incurring a debt:  

  • if the company is already insolvent, or  
  • if the company will become insolvent by incurring that debt or a range of debts including that debt,  
  • if at the time of incurring the debt there are reasonable grounds for suspecting that the company is already insolvent or would become insolvent by incurring that debt.  

Section 588G has two levels of contravention – civil and criminal. A person commits a civil contravention where he or she fails to prevent the debt being incurred and he or she was aware that there were grounds for suspecting insolvency (or where a reasonable person in a like position would have suspected insolvency). A person commits a criminal offence where he or she fails to prevent the debt being incurred, and he or she suspected at the time that the company was insolvent or would become insolvent as a result and that the director’s failure to prevent the company incurring the debt was dishonest.  

Why does it matter  

Upon commission of a civil contravention, the Court may make one or more of the following orders:

  • Compensation order – pay compensation to the company equal to the amount of the loss suffered as a result of the director failing to prevent the company from trading whilst insolvent;  
  • Pecuniary penalty order – pay up to $200,000 to the government if the Court finds that the director’s failure to prevent insolvent trading is serious or materially prejudices the interests of the company or the company’s ability to pay its creditors;  
  • Disqualification from managing a corporation – the Court may, if considered justified, disqualify a person for a period that the court considers appropriate.  

Upon commission of a criminal contravention, the Court may make one or more of the following orders:

Criminal penalty – up to $220,000

Imprisonment – up to five years.  

RG 217 sets out the defences that are available to directors in response to a civil claim for insolvent trading under section 588G(2). A director has a defence, if at the time the debt was incurred, the director:

  • had reasonable grounds, and did expect, that the company was solvent at that time and would remain solvent even if it incurred the debt, or a range of debts including that debt  
  • had reasonable grounds to believe, and did believe, that a competent and reliable person who was responsible for providing adequate information about the company’s solvency was fulfilling that responsibility, and the director expected that, based on the information that person provided to the director, the company was, and would remain, solvent even if it incurred the debt, or incurred a range of debts including that debt  
  • because of illness or other good reason did not take part in the management of the company at that time  
  • took all reasonable steps to prevent the company incurring the debt. Matters that may be considered when determining whether this defence is made out include but are not limited to any action the director took to appoint an administrator to the company, when that action was taken and the results of that action.

ASIC’s four key principles

RG 217 sets out four broad key principles which ASIC considers directors should follow to meet their obligation to prevent insolvent trading. These are:  

  • keep informed about the financial affairs of the company and regularly assess the company’s solvency  
  • immediately, on identifying concerns about the company’s financial viability, take positive steps to confirm the company’s financial position and realistically assess the options available to deal with the company’s financial difficulties  
  • obtain appropriate professional advice to help address the company’s financial difficulties where necessary  
  • consider advice and take appropriate action in a timely manner.  

What to do if the company is already insolvent  

If a director knows, or has reasonable grounds to suspect, that the company is incurring debts that it will not be able to pay, the director is required to take all reasonable steps to prevent the company from incurring further debts. This may include:

  • actively trying to persuade, in writing, the other directors to not allow the company to incur further debt  
  • convening a meeting of the board to resolve that further debts not be incurred by the company, and ensuring such meeting is accurately minuted to reflect the attempt to prevent further debt being incurred  
  • obtaining appropriate advice as to the options if the other directors resolve to incur further debt despite the director’s dissent  
  • consider reporting the circumstances to ASIC.  

Conclusion  

Whilst RG 217 should not be used as a comprehensive self-help manual for directors seeking to avoid breaching their duty to prevent insolvent trading, it does provide useful guidance for such directors. The actual steps taken by a director to comply with his or her duty to prevent insolvent trading will always depend on the specific circumstances of the company, and the size and complexity of the company’s business. It is important to remember that an insolvent trading claim may be brought not just by ASIC but by liquidators and creditors who may also take action against directors for failing in their duty to prevent insolvent trading. Ultimately the Court will determine whether a particular director has breached his or her duty to prevent insolvent trading.