What is Insolvent Trading in Australian Law

In Australia, business entities and companies, are generally governed by the Corporations Act 2001 (the Act). One of the Act’s primary purposes is to set out the obligations of the company, its executives, and its members. A breach of these duties could result in civil liability, and in some instances, criminal penalties.

What is insolvent trading?

One of the harsh realities of starting your own business or company is that it could end up failing and winding up. For various reasons, a company can be financially distressed to the point that it becomes insolvent, unable to pay its debts as and when they become due and payable. When a company becomes insolvent, it should not trade or carry on the business of exchanging goods and services. This is where the Act’s insolvent trading provisions come in.

How do you know if a company is insolvent?

The Act’s definition of insolvency is quite ambiguous, but it is generally ascertained by considering the company’s financial position and what resources are available to the company to meet its liabilities as they fall due. Consequently, we often need to turn to case law to examine and interpret legislation. In the case of ASIC v Plymin (2203), the indicia of insolvency are as follows:

ongoing losses
liquidity ratio is less than 1
overdue taxes
poor relationship with the bank
no access to alternative finance
inability to raise further equity capital
suppliers placing the company on cash-on-delivery (COD) or otherwise demanding special payment before resuming supply
creditors unpaid outside trading terms
issuing post-dated cheques
dishonoured cheques
special arrangements with selected creditors
solicitors’ letters, judgments, or warrants issued against the company
payments to creditors of rounded sums that are not reconcilable to specific invoices
inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts

The assessment of a company’s solvency must be undertaken by considering not only the company’s cash resources immediately available but also the money it can procure through sales and borrowing against the security of its assets. The inability to use such resources to meet debts as they fall due indicates insolvency.

Is it illegal to trade insolvent?

Yes, there are serious penalties for allowing your business to trade or operate while it is insolvent. The duty to prevent insolvent trading specifically applies to the company directors. Side by side with this director’s duty is the duty to constantly stay up to date about the company’s financial position. It’s not enough that directors only check their financial position when reviewing and signing annual financial statements. Directors are also duty-bound to ensure that the company keeps adequate and accurate books and records of its transactions and its financial performance.

Director’s duty to prevent insolvent trading

Company directors need to adhere to Section 588G of the Act, which states their duty to prevent insolvent trading. A person is considered to have failed this specific duty if:

the company incurred a debt at a particular time (and at that time, the person is a director of the company);
the company is insolvent at that time or becomes insolvent by incurring that debt;
the person suspected at the time when the company incurred the debt that the company was insolvent or would become insolvent as a result of incurring that debt; and
the person’s failure to prevent the company from incurring that debt was dishonest.

What are the consequences of insolvent trading?

If the company is allowed to trade while insolvent, the consequences can include civil penalty orders, criminal charges, and personal liability for compensation. While the Act provides statutory defences, directors may not find it easy to rely on these.

Civil penalties

Company directors may face pecuniary penalties (monetary fines) of up to $200,000 if they failed to keep the company from incurring debt and the creditors suffered losses because of the company’s insolvency.

Criminal charges

If a director is found to be dishonest with respect to performing their duty to prevent insolvent trading, they may be subject to charges of up to $444,000 and imprisonment of up to 5 years. The criminal offence could also lead to the director’s disqualification.

Personal liability for compensation

Directors can be held personally liable for the recovery of compensation for loss due to insolvent trading. A creditor, liquidator, or the Australian Securities and Investments Commission (ASIC) can take legal action against a director to recover the amount of loss or damage.

What to do if your company is in financial trouble

If you suspect that your company is insolvent or will become insolvent if it incurs another debt, make sure to get legal advice and/or professional accounting advice as soon as possible. This is to minimise the risks of insolvent trading occurring and maybe increase the survival of your company. TNS Lawyers can advise you on your options moving forward, whether it’s external administration, receivership, or restructuring. We can also assist with litigation, asset tracing and recovery (including investigations), corporate finance, and property transfers. To connect with our insolvency lawyers, give us a call on 03 9052 3214 or fill in the contact form below.

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