Directors and officers

Directors’ liability – failure to commence proceedings and trading while insolvent

If proceedings are not commenced, what liability can result for directors and officers? What are the consequences for directors and officers if a company carries on business while insolvent?

Under section 588G of the Corporations Act 2001 (Cth) (the Act), directors have a duty to prevent insolvent trading. If a company enters into liquidation, Part 5.7B, division 4 makes directors who breach this duty liable to compensate the company for all new debts incurred from the time a company is found to have become cash-flow insolvent. Therefore, a director may suffer civil or criminal liability for insolvent trading where he or she knew, or had reasonable grounds for suspecting, that the company was insolvent or would become insolvent. These provisions are intended to compel directors to take active steps (such as the appointment of a voluntary administrator) in an expeditious manner, thereby protecting members and creditors from the continuation of insolvent businesses.

In addition to the potential liability for directors, if the company continues to carry on business while insolvent, certain transactions that the company entered into with third parties during that time may be subject to challenge and ultimately be held to be void if the company formally enters into liquidation (for example, unfair preference or uncommercial transaction).

Directors’ liability – other sources of liability

Apart from failure to file for proceedings, are corporate officers and directors personally liable for their corporation’s obligations? Are they liable for corporate pre-insolvency or pre-reorganisation actions? Can they be subject to sanctions for other reasons?

A director or officer of a company may be held liable under the Act for civil and criminal penalties or to compensate the company if the company incurs a debt while insolvent (otherwise known as insolvent trading). Directors and officers may also attract personal liability for breaching their statutory duties of reasonable care and diligence in the exercise of their powers and to act in good faith and for proper purposes. Statutory liability may also be imposed where directors or officers improperly use their position or information acquired because of their position to gain an advantage for themselves or cause detriment to the company.

In some situations, directors may become personally liable for unremitted amounts of income tax or goods and services tax. The Commissioner of Taxation must give 14 days’ notice to the directors setting out the details of the unpaid amount and the penalty. Directors may avoid a penalty if the company pays the unremitted amount, the company enters into an agreement relating to the unremitted amount, an administrator is appointed or the company goes into liquidation.

The courts maintain discretion under the Act to excuse directors from liability in some circumstances if they can be shown to have acted honestly and reasonably.

Directors’ liability – defences

What defences are available to directors and officers in the context of an insolvency or reorganisation?

The statutory defences available to a director for a breach of the duty to prevent insolvent trading are set out in section 588H of the Act. A director is not liable for a breach of duty if it is proved that, at the time the relevant debt was incurred, the director had reasonable grounds to expect and did expect that the company was solvent at that time and would remain solvent even if it incurred that debt (as well as any other debts that it incurred at the same time).

Further, a director is not liable if it is proved that he or she took all reasonable steps to prevent the relevant debt being incurred. In this context, the Act states specifically that matters to which regard is to be made in considering this defence include any action the director took with a view to appointing an administrator when such action was taken and the results of that action.

A breach of the duty to prevent insolvent trading by a director will expose that director to prospective liability for a civil penalty order, an order for payment of compensation to the company or an order for payment of compensation to the creditor. The amount of compensation awarded against a director who breaches such a duty will be calculated by reference to the actual loss that the company or the creditor suffers by reason of the debt being incurred. In ascertaining the quantum risk of a potential insolvent trading action, the question as to when a debt is incurred becomes important. Ordinarily, a director will not be liable for a pre-existing debt that falls due when a company is found to be insolvent. Rather, directors are liable if the debt is ‘incurred’ at a time when the company is insolvent.

With effect from September 2017, a new section, 588GA, was introduced into the Act to afford directors protection in certain circumstances to enable a company to delay entering into a formal insolvency process and instead pursue a turnaround plan (ie, provide directors with a ‘safe harbour’ protection). Under this new section, a director will not be liable for debts incurred by a company while it is insolvent if, ‘at a particular time after the director starts to suspect the company may become or be insolvent, the director starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company’ than the ‘immediate appointment of an administrator or liquidator to the company’.

A director that seeks to rely upon section 588GA of the Act bears the evidential burden in relation to that matter. That is, adducing or pointing to evidence that suggests a reasonable possibility that the matter exists or does not exist. The safe harbour protection will not apply in certain circumstances, including where, at the time the debt is incurred, the company has failed to pay employee entitlements or comply with certain reporting or taxation requirements. The new safe harbour provision also extends to providing a safe harbour for holding companies from liability to compensate its subsidiaries’ creditors where directors of those subsidiaries hold the benefit of the safe harbour. Holding companies bear the same evidential burden as directors to adduce evidence that suggests a reasonable possibility that the company took steps to ensure that the directors did enjoy the benefit of the safe harbour provisions.

While the introduction of this ‘safe harbour’ provision is seen as a positive development, section 588GA of the Act will not provide protection for directors against more general breach of duty claims.

Shift in directors’ duties

Do the duties that directors owe to the corporation shift to the creditors when an insolvency or reorganisation proceeding is likely? When?

In discharging their duty to act in good faith and in the best interests of a company, directors must have regard to the interests of the company’s creditors as the company is nearing insolvency.

However, it is not an independent duty to creditors, and any claim must be brought by the company (or more likely, its external administrators).

Directors’ powers after proceedings commence

What powers can directors and officers exercise after liquidation or reorganisation proceedings are commenced by, or against, their corporation?

Upon the appointment of a voluntary administrator or while the company is being wound up, company officers are not removed from office but, in general, they cannot, without the administrator or liquidator’s written approval, perform or exercise a function or power as an officer of the company.

If the receiver is appointed over all or most of the assets of a company, the receiver effectively has control, although the directors still have certain responsibilities and duties, and may retain residual control.

Law stated date

Correct on:

Give the date on which the above content was accurate.

28 September 2020.