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Director and parent company liability
Under what circumstances can a director or parent company be held liable for a company’s insolvency?
There are two main ways in which a director may be held liable for their company’s insolvency.
First, Section 588G of the Corporations Act 2001 (Cth) prohibits companies from trading while insolvent. It imposes civil and criminal liability on directors who fail to prevent their company from incurring debts while insolvent. A director may be made personally liable in respect of debts incurred by their company where:
- the company is already insolvent or incurring the debt causes it to become insolvent; and
- the director is aware (or a reasonable person in the director’s position would be aware) that there are grounds for suspecting that the company is insolvent or would become insolvent.
In addition to civil or criminal penalties, directors may be ordered to pay compensation.
Parent companies, referred to in the Corporations Act as “holding companies”, can also be made liable for insolvent trading by their subsidiary companies (Section 588V). A holding company may be required to pay compensation to a liquidator for insolvent trading by a subsidiary.
Second, directors may be held liable if they acted in breach of their general duties as a director, including the duty:
- to exercise reasonable care and diligence;
- to act in good faith and for a proper purpose; and
- not to improperly use their position or information to gain an advantage or cause detriment to the corporation.
When a company is approaching insolvency (in the twilight zone of solvency), its directors must consider the interests of creditors (and not just shareholders) in discharging their duties to the company. A breach of any of these duties may attract civil penalties. Directors may also be held criminally responsible for reckless or dishonest breaches.
What defences are available to a liable director or parent company?
In relation to the duty to prevent insolvent trading, the following defences are available:
- the debt was incurred in connection with a course of action that was reasonably likely to lead to a better outcome for the company than an immediate liquidation or administration, provided that certain statutory prerequisites (including the payment of employee entitlements and the obtainment of advice from an appropriately qualified adviser) are met (the so-called ‘safe harbour’ defence, as set out in Section 588GA of the Corporations Act);
- the director had reasonable grounds to and did expect that the company was and would remain solvent (Section 588H(2) of the Corporations Act);
- the director did not, for illness or some other good reason, take part in the management of the company at the relevant time (Section 588H(4) of the Corporations Act); and
- the director took all reasonable steps to prevent the company from incurring the debt (Section 588H(5) of the Corporations Act).
A parent company also has a defence if it took reasonable steps to ensure that its subsidiary’s directors complied with the safe harbour provision.
In relation to directors’ general duty to exercise reasonable care and diligence, there is a defence for business judgements if the director:
- made the judgement in good faith for a proper purpose;
- had no material personal interest in the judgement’s subject matter;
- informed themselves of the judgement’s subject matter to the extent that they reasonably believed to be appropriate; and
- rationally believed that the judgement was in the corporation’s best interests.
What due diligence should be conducted to limit liability?
The duties that may give rise to liability in insolvency are closely linked. To ensure compliance, directors must inform themselves of and monitor their company’s financial position. They must check that:
- all employee entitlements are being paid;
- the company is meeting its tax reporting obligations;
- proper business records are being kept; and
- appropriate director and officer insurances are in place.
Where the company’s financial position is uncertain, it would be prudent for a director to obtain advice from an appropriately qualified adviser in relation to the company’s solvency and prospects. Following the introduction of the safe harbour defence, directors who take proactive steps to identify courses of action that will address a distressed company’s liquidity issues with the assistance of an appropriately qualified turnaround adviser can avail themselves of that defence.