Return to Law Articles

GWM Lawyers and Conveyancers

Australian Law Articles - Miscellaneous

Insolvent Trading: Directors Liability

The past 10 years have seen the government implement significant changes in the laws relating to companies and particularly to the insolvent trading of companies.

Insolvent trading occurs when a reasonable person, when reviewing the financial circumstance of a company, would come to the conclusion that the company is incapable of meeting its debts.

In circumstances where a company becomes incapable of meeting its debts and trades insolvently a director of that company can in various circumstances be made liable for those debts.

Reliance on the Advice of Others

In limited circumstances a director may establish a defence to the liability for the debts of the company if that director can establish that he or she was provided with information about the company's solvency that came from a competent and reliable person and that that information disclosed the company trading as being solvent at the time.

A review of the relevant court cases indicates that the defence of reliance upon the advice of others as to the company's solvency has rarely been used and, more importantly, has been shown to be difficult to apply in circumstances of small regionally based company operations.

Unfortunately, it is common knowledge that insolvency tends, in the main, to affect small companies more than medium and large sized companies. Exceptions occur when major corporate collapses occur such as One-Tel and HIH. The majority of company insolvencies impact upon small operations. In most of the small company collapses many of the directors have active hands-on involvement in the operation of the company, and as a consequence it is difficult for those directors to rely upon the information of others as to the financial viability of a company's operation. The defence of reliance upon information provided by others is more generally available to larger companies who are likely to have professional accounting and financial staff that provide management reports to the Board of Directors and are key operational personnel. Providing that the Board of Directors and the key management personnel are not aware of the position of insolvency they can be excused of liability and responsibility for the poor performance of the company.

The Competent and Reliable Adviser

In Manpac Industries Pty Ltd v. Ceccattini the directors of a company appointed a business consultant who stated role was to "assist [the company] to survive [and] to continue building up the business". The consultant's report to the company and its directors included statements that the company was solvent. The company foundered. The directors subsequently faced an insolvent trading action by those companies that it owed money to. The directors defended the action by seeking to rely upon the consultant's reports to support their contention that they were of the opinion that the company was solvent.

In the Supreme Court of New South Wales the directors failed in their defence for two primary reasons:

1. The consultant's statements/reports were based on information supplied by the directors themselves. Mr Justice Young found that the directors could not reasonably rely upon reports prepared from information that the directors themselves had in turn provided to the consultant. Mr Justice Young in his Judgment noted that the reliance on others as a defence was not under normal circumstances aimed at smaller business structures, but rather larger corporations with competent credit controllers and financial managers whose duty it was to report solvency problems to the board. Statutory defence was not primarily aimed at small companies with directors who have little idea of accountancy, who bring in trouble shooters for the purposes of providing advice but who then provide only some or incomplete information for that trouble shooter to rely upon.
2. The consultant in this particular case did not in the view of the Judge fit within the terms of the statute as a competent and reliable person responsible for providing accurate and informative information as to the company's solvency to the board. There was no issue as to the competency of the consultant, but His Honour rather found, that it was not a part of the consultant's role to in the present case supply the directors with information as to the company's solvency.

Insolvency

In the decision Justice Young took the opportunity to review at what time a company became insolvent under the legislation, that is the Corporations Act. Justice Young considered the two primary tests that have evolved over a number of years:

(A) The Industry Test.     (B) The Economy Test.

The Industry Test

To determine the solvency of a company a person has to view that company in the context of the industry that that company trades within: that is, one has to take into account the relationships between business partners both creditors and debtors and the normal practices of similar companies operating within the industry. In the Judgment the construction industry was highlighted as a classic example of an industry where the terms of payment on individual invoices were not guidelines as to the operational protocols of practical business operations. The test was: would a reasonable person trading within that industry suspect that the company was insolvent purely because it was not meeting the payment of relevant debts within the time frames prescribed on the invoices themselves?

The Economy Test

The alternate test is seen as the objective test that was highlighted in the decision of the Supreme Court of South Australia in Olifent v. Emwest Products Pty Limited where Justice Anderson specifically rejected the Industry Test. Justice Anderson took the view the more literal view that if a company cannot pay its bills it is insolvent, notwithstanding the fact that it's insolvency in many respects is brought about by the common industry practices of delaying payment on invoices.

An appeal in the Olifent matter to the South Australian Full Court affirmed the view of Justice Anderson. The Court there rejected the view that reasonable grounds for suspecting insolvency could vary with the prevailing business climate:

'I am not sure that I would be prepared to accept the proposition that in a recessionary environment one might reach a conclusion that the debtor was unable to pay his debts as they became due from his own money by reason of the tardiness of payment of his debts, less readily than might be the case at other times. One of the characteristics of a recessionary environment is that it produces a high crop of bankruptcies. I am unable to accept that slow payment of an account during a recessionary environment should be treated differently for the purpose of drawing the necessary inference against the debtor as opposed to slow payment in an inflationary economy.'

The Industry and Economy Tests Reaffirmed

The judicial debate as to which test is to be preferred has to a substantial degree gone into hibernation of recent times, mainly due to the fact that since the late 90's the construction industry has enjoyed good economic fortune. This however, does not mean that the issue has gone away and the views of Justice Young provides a interesting reminder. In the Manpac Industries Pty Ltd v. Ceccattini Young clearly restates his support for the Industry Test by saying:

"Despite what is written on the invoices, etc as to time for payment, industry practice or dealings between the parties demonstrates that everyone accepts that debtors will often not pay creditors within normal trading terms. In business circumstances sometimes this is quite necessary in an industry which is experiencing recession because otherwise creditors may not be able to sell their product at all. Even though they would prefer people to stick to their 30 day terms, it is better to have a recalcitrant debtors than to sell no products at all. This [proposition] is not only quite in accordance with authority, but is also good commercial and legal common sense."

To Top of Page

Home | About GWM | Key Legal Staff | Australian Law | Testimonials | Contact
Legal Articles | Press Releases | Newsletters | GWM Commercial | Links

Privacy Statement | Website Feedback | Sitemap

©2001-2005 GWM Lawyers and Conveyancers, Port Macquarie New South Wales Australia
Australian Legal Business website