COVID-19 – Temporary protection from insolvent trading

On 24 March a new section was introduced into the Corporations Act 2001 (Cth) (588GAAA) that would temporarily protect company directors from personal liability for insolvent trading.

The amendment provides a new safe harbour from the directors’ duty to prevent insolvent trading, and was introduced in response to the growing number of businesses facing insolvency as a direct result of the economic effects of COVID-19.

Under the amendments, companies that may be at risk of insolvency in the wake of COVID-19 can continue to operate and incur debts ‘in the ordinary course of the company’s business’, without the fear of being punished for insolvent trading.

The safe harbour will be effective for six months.

To be able to rely on these measures, the debt incurred must be incurred:

  • In the ordinary course of the company’s business;
  • During the six-month period commencing from 25 March 2020; and
  • Before any appointment of an administrator or liquidator during the temporary safe harbour application period.
What does this mean for me? If your company is facing insolvency as a result of COVID-19, this new safe harbour may provide an adequate opportunity to review your company’s position before developing a turnaround strategy, or pursuing voluntary administration. The temporary period may also give your company the time it needs to reclaim enough business to enable you to return to normal operations and start paying back debts.
Remember… Even though there is now temporary relief from the insolvent trading provisions, that relief does not apply to a director’s duties under statutory and common law.
 
It is still vital that company directors:
  • Act in the best interests of the company as a whole;
  • Act with care, diligence and good faith; and
  • Do not use their position or information obtained as a director to gain an advantage or cause detriment to the company.

‘Insolvent Trading’ or ‘Trading While Insolvent’ occurs when a company continues to trade and incur new liabilities, even though it is unable to pay its debts as and when they fall due. 

A range of options are available to directors who suspect insolvency, but most importantly directors need to act immediately if they suspect that the company is insolvent. Figuring out if your company is insolvent or will face insolvency in the future is critical, because there are many legal consequences that can follow if you fail to act.

Identifying Insolvent Trading

The Corporations Act 2001 (Cth) states that the overriding question a director must answer is: can the company pay all of its debts as and when they become due and payable?

In the following circumstances, directors may be personally liable for insolvent trading by the company:

  • A person is a director at the time a company incurs a debt;
  • The company is insolvent at the time of incurring the debt or becomes insolvent because of incurring the debt;
  • At the time the debt was incurred, there were reasonable grounds to suspect that the company was insolvent;
  • The director was aware such grounds for suspicion existed; and
  • A reasonable person in a like position would have been so aware.

The law provides that the liquidator, and in certain circumstances the creditor who suffered the loss, may recover “an amount equal to the loss or damage suffered” from the director. Similar provisions exist to pursue holding companies for debts incurred by their subsidiaries. 

Consequences of Insolvent Trading

There are serious consequences for companies and their directors found to be trading while insolvent. There are civil penalties, compensation proceedings and even criminal charges.

Civil penalties 

Contravening the insolvent trading provisions of the Corporations Act 2001 (Cth) can result in civil penalties against directors, including pecuniary penalties of up to $200,000.

Compensation proceedings 

Compensation proceedings for amounts lost by creditors can be initiated by the Australian Securities and Investment Commission (ASIC), a liquidator or a creditor against a director personally. A compensation order can be made in addition to civil penalties.

Compensation payments are potentially unlimited and could lead to the personal bankruptcy of directors. The personal bankruptcy of a director disqualifies that director from continuing as a director or managing a company.

Criminal charges

If dishonesty is found to be a factor in insolvent trading, a director may also be subject to criminal charges (which can lead to a fine of up to $220,000 or imprisonment for up to five years, or both). Being found guilty of the criminal offence of insolvent trading will also lead to a director’s disqualification.

Defending against Insolvent Trading

Insolvency can be complex and not all directors deliberately choose to trade while insolvent. There are a number of situations where companies and directors can be spared from the long arm of the law.

According to ASIC, a director has a defence if it is proved that, at the time the debt was incurred:
 
  • The director had reasonable grounds to expect, and did expect, that the company was solvent and would remain solvent even if it incurred debt;
  • The director had reasonable grounds to believe, and did believe, that a competent and reliable person who was responsible for providing adequate information about the company’s solvency was fulfilling that responsibility – in other words, if the director received information they believed to be credible that the company was, and would remain, solvent even if it incurred the debt;
  • Illness or other good reason caused a director to not take part in the management of the company at that time; or
  • The director took all reasonable steps to prevent the company incurring the debt.