Director Liability during Insolvency – what are the risks?
Directors have a range of responsibilities when a company becomes insolvent, or when there is a real risk of insolvency, that if not fulfilled may give rise to personal legal liability. This includes protecting the interests of creditors and the duty to prevent the company from trading whilst insolvent.
An insolvent company is one that cannot pay its debts when they fall due for payment. There are various tests used to determine whether a company is insolvent, these include the cash-flow test and the balance sheet test.
- The cash-flow test is satisfied when a company is currently, or in the future, unable to pay its debts as and when they fall due for payment; or
- The balance sheet test is fulfilled when a company’s assets are less than the amount of its liabilities, taking into account future liabilities. If either of these tests is satisfied, the company may be considered insolvent.
There are strict consequences where the director can be held personally liable when a company is insolvent including civil penalties, compensation proceedings and criminal charges.
Infringing the insolvent trading provisions of the Corporations Act can result in civil penalties personally against directors, including penalties of up to $200 000.
In addition to civil penalties, compensation proceedings against a director for amounts lost by creditors can be initiated by ASIC, a liquidator or a creditor against a director personally. The amount of a compensation payment could lead to the personal bankruptcy of a director, in the event of disqualifies the director from continuing as a director or managing a company.
A director may also be subject to criminal charges of up to a fine of $220 000 or imprisonment for up to 5 years, or both. This occurs in the event that dishonesty is found to be a factor in insolvent trading.
Obtaining Independent Legal Advice
If you suspect that your company is in financial difficulty, legal advice should be sought immediately to determine your potential director liability. It is particularly important that a director engages a separate, independent lawyer for confidential advice about their circumstances. This is because if a director chooses to receive personal advice from the company’s lawyer under the company’s retainer prior to insolvency, this may only be privileged for the company and not the individual director. As a result, where conflicts arise, the advice could be accessed by any formal insolvency appointee to the company.
Notably, the Federal Government has recently introduced the Insolvency Law Reform Act 2016 that will offer more protection for company directors during insolvency. The legislation proposes a ‘safe harbour’ for directors that would protect them from personal liability for insolvent trading in certain circumstances. The legislation is due to take effect in two stages on 1 March 2017 and 1 September 2017 and attempts to encourage innovation by reducing penalties on entrepreneurs.
Checklist for directors
A director should seek independent legal advice from a solicitor regarding insolvency on multiple issues, including:
- Creditors meetings protocols;
- Proof of debt and voting rights;
- Personal guarantee obligations;
- Directors & Officers Insurance rights;
- Breach of duty claims;
- Public examinations;
- ASIC enquiries, examinations or claims.