How Can Directors Prevent Insolvency?

How Can Directors Prevent Insolvency?

It is vital for a director to continually monitor and assess the solvency of their company. Failure to do so may lead to insolvency and potential bankruptcy. This article will offer guidance to directors who are uncertain of their duties in managing the solvency of their company.

What is insolvency?

A company is deemed to be insolvent if it cannot pay its debts when they are due.

When determining a company’s solvency, the court will assess the commercial realty of the company’s financial status. This legal process involves various cash-flow and balance sheet tests, which measure the financial position of the company. If the tests show the company is at risk of insolvency, the director must prevent their company from incurring further debt.

What is insolvent trading? 

Under s588G Corporations Act 2001, directors must not trade if their company is insolvent or if by incurring debt the company will become insolvent. It is a director’s duty to prevent insolvent trading.

Consequences for breaching this duty include civil penalties, compensation proceedings and criminal charges. Civil penalties for insolvent trading include the disqualification from directing a company or a fiscal penalty of up to

$200,000. In addition to this, ASIC may prosecute and commence compensation orders against directors wherein payments are potentially unlimited. Not only is the director personally liable and at risk of bankruptcy, criminal proceedings may be issued by ASIC for insolvent trading which may lead to fines of up to $220,000 or imprisonment for up to 5 years.

What are a director’s duties?

To prevent insolvent trading, a company director must comply with the following duties:

  1. Directors must stay informed of their company’s financial position by continually assessing the company’s solvency. By monitoring bank lending facilities, cash flow and current assets, a director may predict and prepare for instances of poor liquidity ratios, overdue taxes or trade creditors. This assessment and preparation of potential financial difficulties is a duty which is essential to the solvency of a director’s company.
  2. Directors should obtain professional advice on the solvency of their Legal and financial guidance will inform directors of the risk of insolvent trading and provide options available to address financial difficulties. Options, based on advice, may include the injection of funds from an asset sale or the implementation of a restructuring plan.
  3. Directors should act in a timely manner should they, on reasonable grounds, suspect that the company is incurring debts they will not be able to In this event, appropriate action should be taken immediately on advice received from legal professionals as some solutions may take time. For example, restructures and turnarounds are very complex and may take several months to prepare and implement.

For more information regarding a director’s duty to monitor and assess the financial position of their company, please visit the ASIC website.

Seek Legal Advice

It is essential that directors are aware of the duties involved in preventing civil and criminal penalties for insolvent trading.

If you require guidance or advice regarding insolvency or if you are a creditor of an insolvent company please contact us on (02) 9963 9800 or via our contact form here.