The recent global financial crisis has placed many company directors in a difficult position.

They may have valuable assets on their balance sheets, yet little chance to borrow against them or to sell them at a reasonable value. Potential buyers of assets are also likely to be restricted due to a lack of access to funds.

Directors, with debts falling due and working under Australian law, may find their company has become insolvent.

It’s no coincidence that Australia has some of the most punitive insolvent trading laws in the world. A director’s willingness to expose him or herself to the risks of trading while insolvent in Australia has more far-reaching consequences than elsewhere.

So, are directors risking more than they think? Ever thought your big idea could be flushed by litigious jargon, ironically, for not paying the water bill?

Let’s investigate.

What is insolvency?

Section 95A of the Corporations Act states that “a person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.”

In Australia, a cash flow test, rather than a balance sheet or net asset test, has generally been used to determine a company’s level of solvency. The differences between these tests are vast. The cash flow test will trigger a state of insolvency much earlier than the balance sheet test, as it fails to take into account current assets that may be liquidated in order to pay debts.

If you are a director and are found to have been reckless or intentionally dishonest when your company is found to be trading while insolvent, then you face penalties of up to $220,000 and/or 5 years’ imprisonment!

And that’s even if you didn’t know about it, because Australian law says that as a director, you should have known. Crikey! Fair suck of the sauce bottle! (And insert other intentionally overt Aussie slang tirade here.)

Defences

You do have some defence options, but they better be good:

1. Reasonable grounds to expect solvency

A director must be able to demonstrate that they have actively participated in the company’s affairs and informed themselves of its position accurately.

2. Information supplied by a subordinate

A director must be able to show that, at the time of incurring the debt, he had reasonable grounds to believe (and did believe) that the company had delegated to the other person the task of providing adequate information and had no reason to suspect the legitimacy of that information.

3. Ill health or other good reason

If the director was ill or unable to actively participate in the company at the time of incurring the debt. “Other good reason” will be defined by the court on a case-by-case basis.

4. Reasonable steps taken to prevent the debt being incurred

Namely:

• Oppose the incurring of the debt;
• Revoke the authority of officers to incur debts on behalf of the company;
• Propose a resolution that the company appoint a voluntary administrator.

How Australia compares with the UK and the US

Under Australian law it is possible for a director to be liable if there are reasonable grounds for suspecting that the company is insolvent, if the director is aware of this or ought to have made himself aware.

There is also no need for a director to have actually participated in the relevant transactions, as long as he failed to stop the company from trading if insolvency was suspected.

The balance sheet test

United Kingdom law, in a riveting twist, states that a director must know or ought to have concluded that there was no reasonable prospect that the company would avoid insolvency. A company in the UK slides into insolvency “at a time when its assets are insufficient for the payment of its debts.”

The UK imposes the balance sheet test rather than the cash flow test, which means that the time in which insolvency is triggered occurs much later than for companies trading under Australian law.

Not only would directors in the UK be found liable under Australian law in a greater number of cases, the directors would also find that their companies were trading while insolvent for some time if judged under Australian Law.

Let the buyer beware

In contrast to Australian and UK laws, the United States does not impose personal liability on directors for insolvent trading. Provisions for fraudulent conduct do exist (Enron anyone?); however, potential creditors are expected to protect themselves from the effects of insolvent trading through a contract.

The aim of the insolvent trading laws in Australia and the UK is to stop directors continuing to trade while insolvent, thereby reducing the potential loss suffered by creditors. However, the inflexible and finite nature of the wording within these laws may also damage the interests of creditors, as the opportunity for a company to trade out of its predicament will affect the future potential revenues of the creditor and, in turn, the employees and third parties of all companies involved.

US law, on the other hand, seems to impose the adage of “buyer beware” too much and relies on the proof of general fraudulent behaviour before stepping in (i.e. ‘let ‘em slug it out in court, pilgrims’).

Conclusion

The recent global financial crisis invites a revision of Australia’s legislation: how best to protect creditors whilst still allowing a company the opportunity to trade out of its financial difficulties.

Think about it: even Germany relaxed the laws during the recent crisis to protect the greater economy. And they’re German!

After comparing Australia’s insolvency laws with that of its closest western allies, it can be safely determined that Australia’s laws are the most litigious.

But are Australia’s laws too rigid?

If the laws are created to solely protect creditor interests and hold directors accountable for all financial transactions of a company, the answer would be no.

If extenuating environmental factors, such as the recent global financial crisis, require a level of leniency to ensure a continued flow of trade, the answer is yes.

Or, we could just leave it as is and have our entrepreneurs scratching their heads as to whether to open the doors tomorrow or not.

No one wants to see corporate fat cats sucking up everyone else’s money. For budding Aussie entrepreneurs, however, insolvency is not meant to be a punitive process, effectively killing potentially great ideas, but rather an opportunity for a fresh start.

Ben Flavel (MEI) is an entrepreneur and innovation consultant assisting corporate, SME and fast growth companies through innovation creation and evaluation, culture development and strategic renewal.

Image by Mark Coggins