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What Are A Director's Duties When It Comes To Insolvency?

  • December 13th, 2021
  • Domenic Calabretta

A company is recognised as being a separate legal entity and it is the Directors who must act in the best interests of the company and any associated shareholders. Once appointed, a Director has statutory and legal duties with respect to the company. These duties expand to include creditors in matters of insolvency and a failure to act accordingly may result in a Director being held personally liable for any company debts.

Why are Director duties altered during insolvency?

It is essential to touch on the core Director duties before explaining how they are altered during insolvency. In short, the Corporations Act 2001 (Cth) outline that a Director must:

  • Act with reasonable care and diligence including preventing insolvent trading
  • Exercise powers and duties in the company’s best interests
  • Not improperly use position, powers or information for personal advantage or gain of someone else.

When a company is in danger of becoming insolvent, Directors must take the appropriate steps to prevent the company from trading while insolvent. Trading while insolvent is illegal, and Directors can be held personally liable for any debts incurred by the company while insolvent. There are numerous indicators of insolvency which in many instances are easy to identify.

What happens if a Director breaches their duties?

Directors face criminal charges, civil penalties, and compensation proceedings if they fail to carry out their duties. The consequences for breaches such as insolvent trading are outlined below:

  • Criminal charges: Up to $444,000 in fines and/or up to 15 years in prison.
  • Civil penalties: Financial penalties of up to $200,000.
  • Compensation proceedings: ASIC, liquidators and creditors can initiate compensation proceedings against the Director for an unlimited amount.

Director fines and penalties change regularly and can be found on the ASIC website.

Do Directors owe duties to creditors?

When a company is solvent, Director duties with respect to creditors are limited to their fiduciary duties. This includes acting in the best interests of the company, acting with reasonable care and in good faith – all of which encompass a Director’s relationship with creditors.

During insolvency and times of financial distress in general, Director duties extend to consider the interests of creditors. When a company is in this position, a Director has a duty to prevent insolvent trading and prevent creditor-defeating dispositions.

Prevent Insolvent Trading

This is one of the fundamental responsibilities of a Director which directly impacts creditors. If a company is unable to pay its debts a Director should not allow it to incur further debt unless there are reasonable grounds to do so. Directors may be in a position to do so if they have accessed the safe harbour provisions or if the company has implemented a restructure and turnaround. The ASIC guide to insolvent trading outlines the key principles of section 588G of the Corporations Act 2001.

Prevent creditor-defeating dispositions

Creditor-defeating dispositions relate to transactions where property is sold for less than the best reasonable attainable price. This effectively hinders creditors in winding-up proceedings as there is less money available to pay outstanding debts. Phoenix activity is a primary example where a new entity is formed and any assets are transferred to the new company for little or no cost.

Can creditors sue Directors for breach of duty?

As mentioned earlier, Directors can face criminal charges, civil penalties and compensation proceedings if they fail to carry out their duties. There are circumstances where creditors have the right to sue Directors for breach of duty, but the process varies depending on the breach.

If the breach is trading while insolvent, a creditor can apply to the court to initiate compensation proceedings. Depending on the circumstances, a Director may be personally liable for continuing to incur debt when the company was in a position of insolvency.

This differs from illegal phoenix activity where creditors do not apply directly to the court. Instead, if you suspect that a company is engaging in phoenix activity, the first course of action is to report the company to ASIC. The regulatory body will then investigate the matter and take the relevant steps to obtain compensation. If the matter is relating to a liquidated company that you had previously dealt with, the preferred option is to contact the liquidator that wound up the company.

What are the consequences for a company Director if the company trades while insolvent?

The consequences for trading while insolvent are not limited to criminal charges, civil penalties and compensation. A Director that is found guilty of insolvent trading can be disqualified from future directorship. It is also necessary to note that a liquidator can commence an action against a Director for insolvent trading up to 6 years after the beginning of the liquidation. This is vital as creditors can only take action against Directors for their own debt while a liquidator can claim on behalf of creditors in instances of insolvent trading.

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