Legal development

Ashurst Restructuring Roundup

By Richard Fisher

23 January 2025

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    ASIC issues a Guide for Directors on the Duty to Prevent Insolvent Trading

    Directors have a duty to prevent a company from insolvent trading. A breach of that duty can result in a director being personally liable to pay compensation for loss or damage suffered. ASIC has produced an important guide on the factors ASIC will take into account in assessing whether a director has breached their duty, which we discuss below.

    Introduction

    Directors have a duty to prevent a company from engaging in insolvent trading.

    That duty is imposed by s 588G, Corporations Act ("CA") which provides:

    "(1) This section applies if:

    (a) a person is a director of a company at the time when the company incurs a debt; and

    (b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and

    (c) at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, as the case may be;

    … 

    (2) By failing to prevent the company from incurring the debt, the person contravenes this section if:

    (a) the person is aware at that time that there are such grounds for so suspecting; or

    (b) a reasonable person in a like position in the company's circumstances would be so aware." 

    As to the operation of s 588G(2), CA and, in particular, s 588G(2)(b), CA, in Quin v Vlahos [2021] VSCA 205 the Court said (at [219]):

    "The second limb of s 588G(2) of the Act calls for an objective analysis.  In relation to the second limb, we note the following:(a) First, in one sense, s 588G(2)(b) provides an alternative to s 588G(2)

    (a) If it cannot be demonstrated that the relevant person was aware of the facts and matters that can be objectively characterised as reasonable grounds for suspecting insolvency, but a reasonable person in a like position would or ought to have ascertained those facts and matters, then s 588G(2) (b) may be relied upon. But that is not to say that in each case it is necessary to decide whether the relevant person has the subjective knowledge required for the purposes of s 588G(2)(a), before considering s 588G(2)(b). It is permissible for the Court to proceed immediately to consider s 588G(2)(b).  

    (b) Secondly, what a reasonable person in a like position in a company would be aware of will depend on the particular person's duties as a director or officer of the company."

    Incurring a debt can involve not merely contracting a liability for the payment of goods or services but can also involve:

    (a) paying a dividend;

    (b) making a reduction of share capital;

    (c) buying back shares;

    (d) redeeming redeemable preference shares that are redeemable at the company's option;

    (e) issuing redeemable preference shares that are redeemable otherwise than at the company's option; 

    (f) financially assisting a person to acquire shares (or units of shares) in the company or a holding company; and

    (g) entering into an uncommercial transaction other than one that a court orders, or a prescribed agency directs, the company to enter into, s 588G(1A), CA.

    A breach of the director's duty to prevent insolvent trading can result in:

    (a) a liability to pay compensation for the loss or damage suffered as a result of a breach of the duty; ss 588J and 1317H, CA; 

    (b) the imposition of a civil penalty order; s 1317G, CA; or

    (c) disqualifying the director from managing a corporation; s 206C, CA.

    ASIC Regulatory Guide 217 provides guidance for directors as to how they may discharge their duty.

    The Guide includes details on what directors should do if they wish to avail themselves of the safe harbour protection in the event that insolvent trading is alleged.

    Discharge of Duty to Prevent Insolvent Trading

    The Guide refers to four key principles to which regard should be had when assessing whether directors have discharged the duty.

    Those key principles are:

    • actively monitor the company's solvency; 
    • investigate financial difficulties;
    • obtain advice from professional advisers where necessary; and
    • act in a timely manner.

    Table 2 to the Guide lists the factors which ASIC will take into account when assessing whether a director has breached their duty to prevent insolvent trading.  Those factors provide directors with a useful checklist both as to the information they should seek in respect of the company's financial circumstances when they have a concern about its solvency and the courses of action which they should take when seeking to discharge that duty.  The Table is set out below (with some small inconsequential modifications to aid readability):

     

    Key principle 1: Actively monitor company solvency

    		  

    Factors ASIC takes into account

    Evidentiary method

    The information the director had at their disposal to form the view that the company was solvent, and its accuracy

     

     

    ASIC will look at the systems and processes that the director has put in place and used to allow them to actively monitor the solvency of the company, including the documents that were available to the director to obtain and review. For example, ASIC will look at whether the following documents were available:

    • a bank reconciliation prepared on a regular basis that shows what cash at bank is available to pay debts;
    • a list of debtors and creditors, showing the age and size of all debts and amounts owing;
    • regular profit and loss, balance sheet and cash flow statements; and
    • a report of any arrangements or negotiations with creditors whose debts are outside normal trading terms.

    Whether the director monitored the financial affairs of the company and made sufficient inquiries into its financial affairs on a regular basis

    Of the information that was available to the director, ASIC will look at what the director actually obtained and reviewed, including:

    • the available financial information;
    • information about whether debts owed to the company can be collected and are being collected;
    • information about when debts are due to be paid and whether they are being paid on time;
    • information presented to directors about the financial operations and position of the company;
    • actual trading performance and, by comparison, projections; and
    • the assumptions on which cash-flow projections are based (and whether these were updated, as necessary).

     

    Whether the director took part in the management of the company at the time the debt was incurred

    If the director did not take part in the management of the company at the time the debt was incurred, ASIC will look at:1

    • the reasons given by the director to explain the absence; and
    • whether these reasons are adequate to excuse the director (e.g. because the director was ill).

    Where the director relied on a third party to provide information about the solvency of the company, whether the director made diligent and timely inquiries of them

    ASIC will look at whether:2

    • the person relied on was, in fact, responsible for providing information about the company's solvency to the director;
    • the director took reasonable steps to establish that the person was suitably qualified to provide such information about the company's solvency;
    • the director provided sufficient information to enable the third party to adequately and properly perform their task;
    • the director trusted the third party to provide the information; and
    • the director asked sufficient questions to understand the financial effect of the advice they received and be satisfied that the information on which the advice was based was accurate and complete.

     

    Key principle 2: Investigate financial difficulties

     

    Whether there were indicators of potential insolvency that a reasonable person would have taken into account in determining whether the company was insolvent

    Appendix 1 to this note sets out some of the common indicators of potential insolvency which ASIC has identified. ASIC will look at whether any of these, or other indicators not listed, were present

    Whether the director took positive steps to confirm the company's financial position and realistically assess the options available to deal with the company's financial difficulties

    ASIC will look at:

    • what information was available to the director, and the steps they took and inquiries they made, to investigate and confirm the company's financial position and assess the options to deal with the company's financial difficulties;
    • whether the director considered the company's solvency before incurring new debts; and
    • what evidence there is that the director acted quickly after becoming aware of potential indicators of insolvency.

     

    Key principle 3: Obtain advice from professional advisers where necessary

     

     Whether the director sought advice immediately on identifying concerns about the company's viability

     ASIC will look at:

    • whether the director obtained appropriate advice, including external professional advice if necessary, from a suitably qualified person as soon as the concerns about the company's financial viability were identified;
    • whether the director gave full, complete, accurate and up-to-date information to the adviser (or ensured that such information was given to the adviser by the company) to enable the adviser to provide appropriate and competent advice;
    • what steps the director took to consider the effect and reasonableness of the advice they received; and
    • what steps the director took to act on the advice.

     

    Key principle 4: Act in a timely manner

     

    If the director knew, or had reasonable grounds to suspect, that the company was not able to meet its debts, whether the director took active, timely and genuine steps to prevent the debt being incurred

    ASIC will examine a range of company material including:

    • board minutes and correspondence indicating whether the director expressed concern at incurring further debts;3
    • internal documents, such as working papers from the in-house or external accountant (including financial statements and cash flow forecasts), that indicate whether the company has sufficient cash flow to pay its debts as and when they become due and payable.

    The defences which are available to directors who are alleged to have breached their duty to prevent a company from engaging in insolvent trading include:

    (a) the director had reasonable grounds to expect, and did expect, that the company was solvent at that time and would remain solvent despite all its debts incurred, and dispositions of its property made, at that time: section 588H(2), CA. Key Principles 1 and 2 are important when assessing the availability of this defence; 

    (b) the director believed that a competent and reliable person was responsible for providing the director with information concerning the solvency of the company, that that responsibility was being fulfilled and that the directorexpected, on the basis of that information, that the company was solvent and would remain solvent despite all its debts incurred and dispositions of property made: section 588H(3), CA;4  

    (c) the director at the time the debt was incurred proved that, because of illness or for some other good reason, they did not take part in the management of the company: section 588H(4), CA;5  or

    (d) the director proved that they took all reasonable steps to prevent the company from incurring the debt or making the disposition of its property: section 588H(5), CA.6 

    "Safe Harbour" protection

    In addition to the defences against insolvent trading, a director may be able to establish the so-called "safe harbour" protection.

    Section 588GA(1), CA  (which provides for that protection) reads:

    "Sub-section 588G(2) does not apply in relation to a person and a debt … if:

    (a) at a particular time after the person starts to suspect the company may become or be insolvent, the person starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and

    (b) the debt is incurred, or the disposition is made, directly or indirectly in connection with any such course of action during the period starting at that time, and ending at the earliest of any of the following times:

    (i) if the person fails to take any such course of action within a reasonable period after that time – the end of that reasonable period; 

    (ii) when the person ceases to take any such course of action; 

    (iii) when any such course of action ceases to be reasonably likely to lead to a better outcome for the company; 

    (iv) the appointment of an administrator, or liquidator, of the company."

    Again, the Guide in Table 3 identifies the factors which ASIC will consider when assessing whether a director may establish the "safe harbour" protection. This Table also provides a useful checklist for both directors of a company and their advisers when reliance is sought to be placed on the "safe harbour" protection in conjunction with navigating the company through its financial difficulties. That Table is set out below (with some small inconsequential modifications to aid readability).

    Factors ASIC takes into account 

     Evidentiary method

    If the director started to suspect the company may become or be insolvent, whether the director developed an alternative course of action reasonably likely to result in a better outcome for the company than the immediate appointment of an administrator or liquidator

    ASIC will look for:

    • a documented and well-developed plan for an alternative course of action setting out the director's rationale as to why the alternative course of action is reasonably likely to provide a better outcome for the company;
    • evidence of whether the director continued to assess the merits of the alternative course of action on an ongoing basis;
    • materials that verify that the alternative course of action was in fact implemented by the director as planned;
    • evidence of whether the director has properly informed themselves as to the company's financial position, taken steps to prevent misconduct by officers and employees, and maintained appropriate financial records.

     Whether the director obtained advice from an appropriately  qualified entity who was given sufficient information to give appropriate advice

    ASIC will look at:

    • any advice received from advisers appointed to the company;
    • whether the adviser was appropriately qualified to provide the advice;
    • the accuracy and reasonableness of the information, assumptions and instructions provided to the adviser;
    • evidence of whether the professional advice was followed by the director.

     Whether debts incurred by the company were incurred directly or indirectly in connection with the alternative course of action

    ASIC will look at the company's financial and other internal records to confirm the nature of the debts incurred during the time the alternative course of action was being implemented.

     Whether any of the factors preventing safe harbour protection are present

    ASIC will look at the company's records to confirm whether during the time the company was implementing the alternative course of action:7 

    • employee entitlements were being paid when they fell due; and
    • the company gave all returns, notices, statements, applications or other documents as required by taxation laws.

    ASIC will also seek verification from the company's receiver, administrator and/or liquidator that the director complied with his or her obligations to provide assistance to the receiver, administrator and/or liquidators after their appointment.8
     

    So far as concerns whether a course of action is reasonably likely to lead to a better outcome for the company, s 588GA(2),CA provides:

    "(2) … regard may be had to whether the person:

    (a) is properly informing himself or herself of the company's financial position; or

    (b) is taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company's ability to pay all its debts; or

    (c) is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company; or

    (d) is obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; or

    (e) is developing or implementing a plan for restructuring the company to improve its financial position."

    So far as courses of action that may be likely to lead to a better outcome for the company, the Guide provides the following examples:9

    • undertaking a restructure;
    • undertaking the sale of assets;
    • ceasing the incurrence of debts;
    • restructuring of debt facilities;
    • negotiating key creditor claims;
    • reducing expenses;
    • appointing an experienced director or directors;
    • undertaking a business review.

    As to what amounts to an outcome which is "reasonably likely", the Guide refers to paragraph 1.52 of the Explanatory Memorandum for the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill which emphasise that:

    "The phrase 'reasonably likely' does not require a better than 50 per cent chance of a better outcome than the immediate appointment of an administrator or liquidator.  'Reasonably likely' here requires that there is a chance of achieving a better outcome that is not fanciful or remote, but is 'fair', 'sufficient' or 'worth noting'".

    The Act and the Guide provide that a "better outcome" for the company means an outcome that is better for the company than the immediate appointment of an administrator, or liquidator, of the company. Neither provide assistance as to what, in purely financial terms, constitutes a "better outcome".

    A director may also have safe harbour protection from insolvent trading in respect of debts incurred during the course of a small business restructuring where those debts are incurred in the ordinary course of the company's business, or with the consent of the restructuring practitioner or by order of the court: s 588GAAB, CA.

    Appendix 1

    Indicators of potential insolvency 
    • The company has a history of continuing trading losses.
    • The company is experiencing cash flow difficulties.
    • The company is experiencing difficulties selling its stock, or collecting debts owed to it.
    • The sum of realisable current assets (cash, inventory, debtors) is less than the sum of current liabilities (trade creditors, tax debts including superannuation payable, other short term liabilities) i.e. liquidity ratio is less than 1
    • Creditors are not being paid on agreed trading terms and are either placing the company on cash-on-delivery terms, or requiring special payments on existing debts before they will supply further goods and services.
    • The company is not paying its Commonwealth and state taxes when due (e.g. pay-as-you-go (PAYG)) instalments are outstanding, goods and services tax (GST) is payable, or superannuation guarantee contributions are payable).
    • Legal action is being threatened or has commenced against the company, or judgements are entered against the company, in relation to outstanding debts, such as solicitor's letters, demands, court summonses, judgements or warrants against the company or directors.
    • The company has taken out special arrangements with selected creditors or seeking alternative credit arrangements, such as high interest loans from non-traditional lenders.
    • The company has reached the limits of its funding facilities and is unable to obtain appropriate further finance to fund operations-for example, through:
      • negotiating a new limit with its current financier, or
      • refinancing or raising money from another party.
    • There is no further support available from related entities (e.g. shareholders or holding company—if any).
    • The company is unable to produce accurate financial information on a timely basis that shows the company's trading performance (profit and loss) and financial position (balance sheet) or that can be used to prepare reliable financial forecasts.
    • Company directors and/or key personnel have resigned, citing concerns about the financial position of the company or its ability to produce accurate financial information on the company's affairs.
    • The company auditor has qualified their audit opinion, on the grounds of uncertainty that the company can continue as a going concern.
    • The company has defaulted, or is likely to default, on its agreements with its financier.
    • One or more of the company's financiers has taken action to recover debt, including but not limited to the appointment of an investigating accountant to assess the lender's exposure.
    • Employees, or the company's bookkeeper, accountant or financial controller, have raised concerns about the company's ability to meet, and continue to meet, its financial obligations.
    • It is not certain that there are assets that can be sold in a relatively short period of time to provide funds to help meet debts owed, without affecting the company's ongoing ability to continue to trade profitably.
    • Inability to secure relevant and appropriate insurance coverage for the company.
    • Loss of key customers or contracts that cannot be replaced.

    Authors: Richard Fisher AM, Consultant and Emanuel Poulos, Partner.

      1 These factors are relevant to the defence under s 588H(4), CA.
      2 These factors are relevant to the defence under s 588H(3), CA.
      3 This is relevant to the defence under s 588H(5), CA.
      4 See also Key Principle 1.
      5 See also Key Principle 1.
      6 See Key Principle 4.
      7 These factors are pre-requisites to being able to rely on "safe harbour" protection: s 588GA(4), CA.
      8 See also s 588GB, CA. 
      9 Regulatory Guide 217; [217.95].

     

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.

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