Insolvent Trading: When Directors Become Personally Liable

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

In Australia, a corporation being a separate legal entity means that usually directors are not personally liable for debts of a company.

0:21
However, insolvent trading is one of the few areas where directors can be personally liable, even when they had the best intentions.

Today, to unpack the topic of insolvent trading, I'm joined by Director Seamus Ryan, who is an insolvency, restructuring and dispute resolution lawyer.

0:39
Welcome.

Thanks, Andrew.

Seamus, let's start with the 101. What is insolvent trading and why should directors care?

Sure, Andrew. So this is one of these topics that comes up a lot, and it's a term that gets thrown around a lot, trading whilst insolvent, insolvent trading, but there are a lot of misconceptions about it.

0:59
Effectively, it's just that a director has a duty to prevent a company from trading whilst insolvent, and where they allow a company to trade whilst insolvent and debts are incurred during that period, they can be personally liable to the extent that debts are incurred.

1:16
It's, as with all of these things, more complicated than that.

There needs to be reasonable grounds for suspecting the company is insolvent or may become insolvent at the time that the payments occurred, and working out what the value of the claim is can be a hassle.

So it's not as straightforward as people think.

1:33
I get a lot of people calling and saying, you know, is my client going to be up for some massive claim if this company goes into liquidation because we worry it's been insolvent for a while?

Well, that's a really hard thing to work out, and it requires a real analysis of the books and records of the company.

DPNs, which are not the subject of today's podcast.

1:51
They're a relatively new creation, but insolvent trading, that's been around for quite a long time, I understand. And I understand from a policy perspective it's really to avoid companies racking up debts when they have no hope in hell of paying them.

2:07
Yeah. I mean, the whole purpose of the company as a vehicle is to limit your personal liability.

But obviously that can be abused, and it's to prevent that abuse.

You mentioned DPNs, and there is some overlap in the sense that it's an attempt to make directors personally liable for company debts in certain circumstances.

2:27
And very often the biggest creditor of a company is the ATO, and there's overlap between the amounts.

So you might get hit with a DPN as well as an insolvent trading claim.

Payment of one may end up being part payment of another, and that's something we might touch on a bit later on perhaps.

2:45
Well, let's start by just unpacking the process.

We'll get into what insolvent trading is in a bit, but how does the process start?

Who makes a claim and how does it play out in practice?

Yeah. Well, in practice is the critical thing.

I mean, there's potential for ASIC to bring proceedings.

3:04
There are civil penalties and what have you, but in my experience that tends to be for the really big matters, I think.

Those that end up in the press and?

Yeah, absolutely. Yeah.

And as a matter of practice for smaller companies, it tends to just be the liquidator.

3:20
Every liquidator that is appointed will look at the books and try to work out if the company has traded whilst insolvent, and if so, whether the directors ought reasonably have known that the company, or reasonably have suspected the company, was insolvent at the time the debts were incurred.

3:37
That's just 101.

And when they publish their reports, there'll often be a segment of the report dedicated to whether such a claim exists.

So as a matter of practice, for most business owners, the company will go into liquidation and it will be the liquidator that kicks off any claim.

3:54
There's also the potential for a creditor to bring a claim for insolvent trading with the permission of the liquidator.

I will say that is relatively rare.

It'd have to be a pretty large, pretty large and well-motivated creditor, I guess.

Yeah, well motivated is very much the thing.

I mean, it might be where they don't think the liquidator is going to do anything or the liquidator is without funds, or as you say, they're very motivated.

4:16
Yes, there's an obvious difficulty in that there's this issue about the company having been insolvent at the time, and it might be difficult from a standing start for a creditor who's not the liquidator to work out the date at which the company became insolvent.

So getting to that question of, okay, when is the company insolvent?

4:34
How do you actually work out that start date for this potential liability?

Yeah, well, putting yourself in the liquidator's shoes, there are a few ways.

I mean, first things first, if a company goes into liquidation, you know that it must have been insolvent at some point.

There are statutory presumptions that they can rely on, but often, particularly with respect to this kind of claim, it requires a deep analysis of the books and records of the company.

5:01
There are ratios that can inform a liquidator, for example, ratios as to the ability to meet your short-term debt from basically short-term assets.

And a net asset deficiency, for example, is an indicator of insolvency, and there are numerous other indicators, and it isn't necessarily ever one thing, it's usually the tapestry.

5:25
So, for example, if you are behind on payments, you've entered into a payment plan and you've defaulted, and you don't have enough cash available to meet your payments and you have a net asset deficiency, at that point it's looking grim.

5:43
But even then, it's a question for the court to decide if a claim's pursued, and working out what that date is.

Sometimes it's extremely obvious, sometimes it can be murky, sometimes it's very obvious at one point.

But if you want to go back a further six months because there's more to be had, that can be a far more difficult area.

6:02
So it might be that the court decides the insolvent trading claim applies only in the case of, say, the last year that the company was trading, not, say, the last two.

And just to clarify that point, you say that directors can be personally liable for debts, but it's debts incurred only from that critical start time when the company is insolvent.

6:24
So I guess there's some strategy and consideration of when that time actually starts.

Totally. Yeah.

So one thing about it is that it's the time at which the director reasonably suspects that the company is insolvent.

And it's at least theoretically possible that a company could be insolvent, but the directors have done a reasonable job keeping the records of the company.

6:46
And it's just not obvious.

I mean, often it will be. And certainly there's a point at which it's quite subjective.

You might be starting to get a bit apprehensive, but have good reason to think you'll be able to trade through where, for example, work is seasonal and you can't pay your debts for a month or two.

7:04
But you think we're going to have a cracking period when this new product arrives, we'll be able to trade through this, but then that doesn't happen and the company goes under.

It's not necessarily the case that you knew it was insolvent at the time.

But if you're starting to get those tingles at the back of your neck and worrying day to day about the ability for the company to meet its debts, at that point, that's probably the time to start talking to the accountant about how realistic your expectations of a recovery are and how close you might be to the line.

7:37
And if you're teetering towards that point, there might be some evasive action you can take.

I mean, and that can be in the form of capital injections or, perhaps we'll touch on it briefly, safe harbour, which is a defence to an insolvent trading claim where you've gone through a safe harbour process, appointing an independent person to try to help you restructure.

7:58
And so that might be something that you could undertake to try to turn things around and protect yourself while you're working it out.

So that's the kind of strategic advice that directors can seek if they're alive to the issue early.

Yeah.

I wanted to ask, you mentioned claims can be brought by a liquidator or a creditor, perhaps ASIC, but all these people are going to require someone to do something, funds to be put up, etcetera.

8:26
I sort of think about it. It's not a criminal offence, although they might be related to one.

But, you know, in criminal matters, the police are not going to prosecute something that's, you know, 50/50, is it?

Is your experience that you really see these matters progressing when it's pretty black and white?

8:45
As a matter of practice, obviously the liquidator is usually the person bringing the claim.

If they are funded, for example, there are assets in the company or they're able to make other recoveries and they have an amount available to them to fund the liquidation, then they're probably more likely to bring it.

9:03
If they don't have funds in the liquidation, they're more likely to have to spec it, pursue a no win no fee effectively.

And in that case, they and the solicitors that would act for them are likely to want to see some avenue to recovery at the end of the day.

9:21
So if a director, for example, has personal assets and things to protect, they're probably more likely to be pursued.

And that may be an asset structuring issue.

So if you run a couple of property searches and say there's some property interest in the person's name.

Yeah.

9:36
Sometimes they might publicly examine a director to find out about what other assets there might be that aren't so obvious.

Try and find out if there's cash in accounts, shares, things like that.

If a director has a healthy asset position, they're more likely to be pursued.

If they've had sort of proactive advice well ahead of time, well before the issue about the insolvency of the company arose.

9:57
I mean, the classic example is putting property in a spouse's name, those sorts of things.

And if the liquidator can't see assets that they might be able to get at, then it's less likely that it will be pursued.

And it might be that either they just elect not to pursue it, or the claim can be resolved via a commercial settlement because there's just not the likelihood of recovery.

10:20
So again, good advice early makes a big difference at the end.

Yeah.

Seamus, I wanted to ask about your experience during COVID, I guess from two different perspectives.

One, COVID was a crazy time where everyone thought the sky was going to fall in until really the government jumped in and intervened.

10:37
So I just wanted to get your experience on that period.

But then also in the post-COVID period where we've had big interest rate rises, cost of living increases, etcetera, and some businesses struggling.

What have you found both of those like? What's been your experience as a practitioner during those times?

10:55
Both great points.

So one thing about the COVID period is that there was effectively a carve-out period for insolvent trading claims because the government wanted to encourage people to continue to trade through.

So people who continued to trade through 2020 had some cover against insolvent trading claims.

11:12
If at the end of, say, 2020 they decided, oh, it's time to put it into liquidation, they wouldn't have to worry about that period.

Post-COVID, I think a lot of people, possibly even because of that first step, continued to trade maybe where a company wasn't so great anyway.

11:31
And then they've continued to trade a company that is hopelessly insolvent.

One thing we touched on earlier was the ATO, and ATO enforcement was nowhere near as high during the COVID years.

And that doesn't mean that the debt goes away. It just means that down the track they've started pursuing companies, issuing DPNs and the like.

11:51
And so I think for companies that just perhaps travelled on a wing and a prayer because of short-term protection, some of those companies have since gone into liquidation and we've seen some insolvent trading claims brought against directors for the period just after the COVID years, because they just continued to barrel on, on the assumption perhaps that they had a lot of time.

12:15
Yeah. It's an interesting one.

It's sort of almost as if you perhaps have been conditioned to that unreality that existed as a reality at one point in time.

But then when we're back to normal, they're under a wrong assumption about how insolvent trading works.

12:35
Yeah. I mean, in some cases, I think directors sort of used the ATO as a bit of a lender and just continued to trade and used company money that should have been kept aside for the ATO to just continue to service other debts.

And if at the end of all of that, say 2023, 2024 or now, a creditor has finally jumped up, and very often it is the ATO, and said, well, no, we need to be paid now, and the company's gone into liquidation, then yes, they have a liability.

13:04
I've got a few myths for you to bust, Seamus.

As you said earlier, this is an area that's rife with those.

First question I wanted to ask was the situation where there's multiple directors.

Where does the liability fall?

13:21
So I suppose first things first, if you're a director and you reasonably suspect that the company's insolvent, then you have a liability.

So a claim may be brought against all of the directors, obviously, and it might be if a claim was brought against one director and not against others, then it might be that contribution could be sought from them.

13:44
One thing that I hear raised a lot is, well, do I just resign?

And the short point is that if you're starting to suspect a company is insolvent, I mean, the first port of call as far as we're concerned is look at an external appointment, for the purpose of DPNs and also insolvent trading.

14:01
But particularly if you are starting to get concerned about it and can't manoeuvre the company towards it.

You're one of three directors, let's say.

Yeah. And you resign. If the company then continues to incur debt well into the future, your liability will be limited.

14:18
You know, you're not responsible for debts incurred a long time after you ceased to be a director.

So there is some benefit in getting out of it.

But I think the gold standard is just to deal with it when it becomes a problem, if it's possible to do it.

14:34
Yeah.

Next question, is intention relevant?

Are we just going off books and records, or does the hopes and wishes and well-meaningness of a director count for anything?

Well, look, I mean, I suppose there's that question about whether you reasonably suspect the company's insolvent.

14:55
And one thing that we often come across is wide-eyed, naive directors who think that there is a way through, and they're trying to do the right thing.

I think it will really come down to that reasonableness. You know, was it reasonable to believe it?

15:11
Because some people just get pie in the sky ideas about future cash and things like that.

Angel investor that's going to come in.

Yeah, the angel investor, that's exactly right.

You know, the season that's coming up that's better than any season they've ever had before, and it doesn't materialise.

15:27
I mean, it's not that these things aren't relevant, but you need to be realistic.

And if the books are already saying you're insolvent, then if you continue to incur debts in the hope of this promised land, you've just got to be mindful that if the company ends up in liquidation at the end of all of that and it's never been brought out of an insolvent state, then there may be a liability.

15:51
I suppose there's always the chance that you could be insolvent, salvage the company, no longer be insolvent and then start again down the track.

It's a risk you take though.

Yeah. And it's also a difficult thing for a liquidator where perhaps it's arguable at one point that it was insolvent, then not, then insolvent again.

16:08
And that makes the claim hard.

But generally it comes down to that, you know, we can all have kind wishes and good intentions, but ultimately if the company is insolvent and you continue to trade, you're at risk.

One thing I've seen before is directors who are unpaid, or even that don't have equity in the relevant entity.

16:29
And you might tell them, don't become a director, but are they safe? Is there any protection?

No. I mean, the short point is that your role as a director is what it is.

It doesn't matter whether you're benefiting from it, whether you're taking a fee.

You might wonder why you're taking on a role if you're not taking on a benefit for being a director.

16:51
And I think that it's one of these things that comes up where I'll get, for example, my accountant calling me saying, look, the director wants me to come on as a director. What do you think about that?

And usually it's hard to come up with a great reason for them to do it because you don't always know what you don't know.

17:09
I mean, an accountant's obviously in a good position to evaluate a company, but even then they're limited by the information that they're given, and there could be some things they don't know.

So as a general rule, coming into a company, there's always a risk and you should make sure you really understand where it's at intimately before you become a director.

17:29
Another question, if you Google insolvent trading, you know, you come up with, as we talked about, the egregious ones, the ASIC prosecutions, the big dollars.

But is this just something for the big end of town, or is this highly relevant to small businesses as well?

17:47
I've certainly seen claims pursued with respect to relatively small businesses, and I've pursued them on behalf of liquidators in relation to relatively small companies.

I mean, a relatively small company can still have an $800,000 insolvent trading claim.

18:04
And if the director appears to have assets, then that's a viable claim.

So you shouldn't go assuming that it'll fly under the radar.

I think we touched on this earlier in terms of intervention by the regulator. Yes, that probably is more rare for smaller matters.

I don't think you could totally exclude the possibility of ASIC doing something if it's really egregious.

18:27
Yeah. So you can't make the assumption just because you're at the small end of town that you're not going to suffer the consequences.

I think we've all seen plenty of articles in the AFR and what have you about insolvent trading claims involving the big end of town.

But I think the ones that get the spotlight on them, that's it.

18:45
Yeah.

Seamus, I wanted to ask, how can a director who's in a company that might be under some financial pressure, what practical things should they be doing?

What questions should they be asking?

Who should they be talking to?

First and foremost, obviously the accountant, and that's on multiple fronts.

19:06
I mean, I think in the very long term, particularly if you're not currently in jeopardy, looking at your own personal asset situation to see if there would be a vulnerability in the future.

Because I think that for anyone who takes on the role of director, even if things look rosy now, they may not be.

19:23
And so making sure you're structured in the optimal way far before there's any issue. You know, when everything's all good.

Because if you start moving assets out of your name, then if you get bankrupted at a future date, it's not likely to be effective.

That's number one.

But number two is really having great books and records that reliably record the company's position.

19:45
If you start to get nervous about your ability to meet your debts, that doesn't necessarily mean it's crisis stations, but it does mean it's time to act.

So it might be making sure that you have a viable plan going forward.

If you're starting to get nervous, perhaps seeing a lawyer about the safe harbour provisions if it's starting to get into that territory, and seeing whether the company can be turned around in a restructuring process.

20:14
Well ahead of time.

I think that what you often see is people half-heartedly trying to step into that land when the horse has already bolted and making a half-hearted effort rather than fully engaging with the process at a time when the company could be turned around.

20:34
The other thing is that it's hard to get around the fact that once you've gone down the path of trying to get somebody involved for a safe harbour process, you obviously know that there's a problem.

Yes, yes, yeah.

There's smoke, there's fire.

20:49
Yeah, and there are ways solicitors work around that.

I mean, a solicitor engaging the accountant is one way, but it's still an issue and it should be telling you that it's almost time to talk about an external appointment if it's not going to be salvageable.

21:10
Yeah. So one of your practical takeaways is too often people take too long to do something about it.

That's right, and the steps that they do end up taking are done in a panic.

Yes, yeah.

We've talked about insolvent trading, what it is, how directors can be personally liable for debts of a company, and how it can be preventable if directors act early and take the appropriate advice.

21:35
If your business is under financial pressure or you're worried about personal exposure, talk to the restructuring and insolvency experts at Velocity Legal.

Thanks, Seamus.

Thanks, Andrew.