COVID-19: Directors’ Duties and Liabilities for Insolvent Trading
Written by Domenica Caridi
As companies continue to feel the impact and uncertainty brought on by COVID-19, it has never been more difficult for directors fully to discharge their duties – and the risks when they do not do so have never been higher. Owing to the issues arising from the current circumstances, it is crucial for managers and directors to be aware of how their duties and liabilities are impacted when the company is in financial distress.
This article highlights the duties and practical steps that managers and directors should be taking in order to avoid incurring personal liability. What follows is a reminder of duties owed by directors in Australia, how these duties can change in an insolvency situation, and practical guidance to ensure compliance with the relevant rules and maintain good corporate governance.
What is insolvency, and how do directors recognise it?
Even in normal circumstances, it is difficult to identify the precise point in time at which insolvency cannot reasonably be avoided. In the current climate, that has become even harder. Signs that may indicate that a company is in financial distress include ongoing losses, poor cashflow, unpaid creditors outside usual trading terms and problems obtaining finance.
Under section 95A of the Corporations Act 2001(Cth), a company is deemed to be insolvent if it is not able to pay all of its debts, as and when they become due and payable. Technically, there are 2 ways of determining whether a business is insolvent - the cashflow test and the balance sheet test:
If a company cannot meet all its present and due payment obligations, the company is likely to be insolvent on a cash flow basis (i.e. it is unable to pay its debts when they fall due);
If the value of a company’s assets is less than the amount of its liabilities (taking into account its contingent and prospective liabilities), it is likely to be balance sheet insolvent.
Directors’ Duties in time of financial distress
Whilst the company trades solvently, directors must act in good faith and in the best interests of the company “as a whole” which means for the benefit of its shareholders.
However, when the company becomes insolvent, or nears insolvency, the directors’ duties that are owed to the company must also become subject to other interests to which the directors should have regard, such as those of the creditors of the company.
A director who breaches these duties may be ordered by a court to pay a civil penalty and/or to pay to the company, its liquidator or the relevant creditor compensation equal to the amount of loss suffered by the creditor. In addition, a director who breaches this duty dishonestly may incur criminal penalties.
What should directors be doing if insolvency occurs and what are the consequences of insolvent trading?
Directors of a company in financial distress will often wish to keep the company trading in the hope of trading through such financial difficulties. However, upon reaching the point where liquidation or administration cannot be reasonably avoided, the directors must consider when to cease trading. If the directors continue with normal trading past that point they may be liable for insolvent trading under section 588G of the Australian Corporations Act 2001(Cth).
In order to avoid liability for insolvent trading, the directors would need to show that either:
having regard to information available to them and the standards of skill and care expected of them, there was a reasonable prospect of avoiding administration insolvent liquidation and/or
they took every step which they ought to have taken with a view to minimising the losses to creditors.
Temporary protection from Insolvent Trading
Importantly, on 24 March 2020, the Australian Government introduced temporary changes to protect company directors from personal liability from insolvent trading. The amendment provides a new safe harbour from the directors’ duty to prevent insolvent trading, and was introduced in response to the growing number of businesses facing insolvency as a direct result of the economic effects of COVID-19.
Under the new safe harbour, directors will be temporarily relieved of their obligations to prevent a company from trading whilst insolvent commencing 25 March 2020 for 6 months, which means they lapse 25 September 2020 (unless extended or amended on the advice by the Federal Government).
This protection will only apply:
to debts that are incurred on or after 25 March 2020;
to debts incurred in the ordinary course of the company’s business.
The six months period may also give companies in financial distress a better chance to resume normal operations and start paying back debts when the COVID-19 crisis has passed.
However, the temporary relief does NOT apply to the directors’ duties under statutory and common law. It is still essential that company directors:
• Act with care, diligence and good faith;
• Act in the best interests of the company as a whole; and
• Do not use their position or information obtained as a director to gain an advantage or cause detriment to the company.
Some practical suggestions
Directors need to be proactive in monitoring the situation, ensuring they act in accordance with their duties.
Discussions with stakeholders are essential, particularly with those in the supply chain. If necessary, directors may need to consider whether alternative suppliers are available.
Directors should check the terms of finance documentation to see whether they are at risk of breaching covenants. Realistic financial forecasting and early conversations with lenders can make a big difference to the survival of businesses, particularly now, when the Government is working with banks to help businesses affected by coronavirus.
How we can help
If you suspect your company is in financial difficulty, do not allow it to incur further debt. You should seek our professional advice as early as possible, as this ensures the fulfillment of your duties and increases the likelihood of the company surviving.
This information is part of a series of Ferraro & Co Lawyers, focusing on legal and business operational issues arising in the current COVID-19 crisis.
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