Whilst there have been several recent legislative changes in the corporate insolvency landscape including the introduction of small business restructuring, simplified liquidation and an increase in the statutory demand minimum to $4,000, one area which has remained constant is the requirement for Directors to act in the best interests of their Company.
General duties of a director
Per the Corporations Act 2001, Directors have several duties which they must discharge in the interests of the Company. These include:
Section 180 – exercising their powers and discharging their duties with care and diligence.
Section 181 – exercising their powers and discharging their duties in good faith in the best interests of the corporation, and for a proper purpose.
Section 182 – must not improperly use their position to gain an advantage for themselves or someone else, or cause detriment to the corporation.
Section 183 – must not improperly use the information to gain an advantage for themselves or someone else or cause detriment to the corporation.
The act makes it clear that Directors must not derive a personal advantage to the Company's detriment. Further, in an article titled ‘Directors “best interests” duty in practice’ issued in the Australian Institute of Company Directors in July 2022, authored by Bret Walker SC and Gerald Ng, the courts have confirmed that directors have considerable discretion in identifying the best interests of a Company and its shareholders.
Such discretion includes the genuine best interests of a Company (financial, environmental, social etc) and the time period for which those interests are assessed.
Duties of a Director in financial distress
In the event, a Company is approaching insolvency or is insolvent the duties of a director extend to those of creditors both past and future. The interests of the Company and its creditors should be viewed on a spectrum, the closer that a Company is to insolvency, the greater the weight should be given to the interests of creditors.
Why are the duties of a director widened in the event of insolvency? Well, this is primarily due to insolvent trading and the impacts trading a Company whilst it is insolvent can have on the ability of creditors to be paid.
The consequences of trading a Company whilst it is insolvent are severe in Australia.
Consequences include the following, as advised by ASIC:
Civil penalties: Penalties of up to $200,000;
Compensation proceedings: Proceedings commenced for amounts lost by creditors can be initiated by ASIC, a Liquidator or a creditor against a Director personally. The compensation can potentially be unlimited and lead to the bankruptcy of the Director(s); and
Criminal charges include up to five years imprisonment.
Warning signs for a Company in financial distress
To avoid trading a Company whilst it is insolvent, a Director should look for the following warning signs and take immediate action where necessary;
Negative operating cash flow;
Consistent delays from customers in meeting agreed to payment terms;
Suppliers requiring cash on delivery terms;
Regular trading losses over a 6-12 month period;
Liquidity ratios below 1;
Enforcement action is being commenced by creditors to pursue debts; and
Inability to obtain alternative finance due to poor credit rating.
Options available to Directors when a business is distressed
To ensure a director continues to discharge their duties in the interests of a Company, the following options are available to them.
Directors are able to incur debts on behalf of the Company if they are developing one or more courses of action that are reasonably likely to lead to a better outcome for the Company than an immediate appointment of a Liquidator or Administrator.
A Company must meet the eligibility criteria as provided in the Act for the Directors to have the benefit of Safe Harbour.
All employee entitlements must be paid;
All tax reporting obligations are up to date; and
Adequate books and records are maintained.
An assessment of eligibility is commonly undertaken at a point in time and then is updated regularly as the course of action progresses. Responsibility for eligibility ultimately rests with a Director.
Section 588GA(2) of the Act provides several examples of where regard may be had to whether a course of action is reasonably likely to lead to a better outcome for the Company. These examples focus on the conduct of the Directors when embarking upon the course of action:
properly informing themselves of the Company’s financial position; or
taking appropriate steps to ensure that the Company is keeping appropriate financial records consistent with the size and nature of the Company; or
is obtaining advice from an appropriately qualified entity that was given sufficient information to give appropriate advice.
In my experience, Safe Harbour can be a very useful option for Directors to explore when faced with insolvency. It is important for Directors to understand that engaging an advisor does not mean their Company is automatically relieved from insolvent trading. A Director or a Board are ultimately responsible for the course of action and an advisor can assist with the assessment of whether the action is a better outcome than the immediate appointment of an external administrator.
It is also appropriate for Boards to document, in their meeting minutes, that they are in or using Safe Harbour. These minutes can then be provided at a later stage if necessary to a Liquidator pursuing an insolvent trading claim.
In circumstances where Directors and their Companies are ineligible for Safe Harbour, they can still undertake an informal restructuring plan. This option is similar to safe harbour however Directors are not afforded protection from insolvent trading.
Appointment of External Administrator
If all other options have been exhausted a director may decide to place the Company into voluntary administration or liquidation. Responsibility for the Company is passed to an independent party who investigates the Company’s affairs and reports to creditors accordingly.