Corporate insolvency

What is insolvent trading?

Insolvent trading is an offence. ASIC can investigate and may prosecute offending directors.

Insolvent trading is when directors allow their company to incur debts when the company was insolvent. The liquidator can make a compensation claim against a director if those debts are unpaid when the liquidation commences. A director may be held personally liable to compensate creditors for the amount of the unpaid debts incurred from the time the company became insolvent to the start of the liquidation.

Liquidators are obliged under the provisions of the Corporations Act 2001 to investigate the existence of any insolvent trading claim, and if so, take appropriate action. Further, directors have a duty to stop a company from incurring debts it is unable to pay. Under the Corporations Act, failing to stop a company from incurring debts it is unable to pay is a breach of the directors’ duty. Directors may have to pay compensation to the company for losses creditors have incurred under that breach of duty.

Liquidators have the first opportunity to make insolvent trading claims. If they decide not to make a claim, creditors may start their own actions, but creditors’ claims are limited to the amount of their individual debt.

If a liquidator does not pursue an insolvent trading claim, the company’s creditors (individually or in a group) can make a claim. Creditors may start an action either with a liquidator’s consent or if the liquidator fails to provide their consent, the creditors can seek leave of the court in certain circumstances.

Creditors can only take action against directors for their own debts. Whereas a liquidator can pursue an insolvent trading claim on behalf of all creditors’ unpaid claims.

A creditor cannot commence action when a liquidator has already begun proceedings or has intervened in an application for a civil penalty order. That is, claims are restricted when the liquidator has started their own action.

What factors into an insolvent trading claim?

Aside from the company being in liquidation, the factors in an insolvent trading claim are:

  1. The company must have been insolvent when the debts were incurred.

  2. The debts must remain unpaid at the time of the liquidation.

  3. The claims must be made against people who were company directors at the time debts were incurred.

  4. There were reasonable grounds for the director to suspect the company was insolvent.

A company is insolvent when it cannot pay its debts as and when they become due and payable. The Corporations Act defines solvency and insolvency as:

Section 95A — Solvency and Insolvency

(1) 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.

(2) A person who is not solvent is insolvent. A person is defined to include a corporation.

For an insolvent trading claim, the debt must be incurred, not just accrued, when the company is insolvent. Incurring a debt is the legal creation of a debt that did not previously exist. Accrued debts usually relate to ongoing contractual agreements.

Contractual agreements are incurred at the time of the original agreement and only become payable (or accrue) at a later date. If the original agreement was made while the company was solvent, and the later amounts only accrue because of that original contract, those debts will not form part of an insolvent trading claim. For example, reoccurring lease payments are under a contract that was entered into prior to the company’s insolvency.

Disclaimer

The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

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