When is a company in trouble? The risk of insolvent trading
Directors of companies facing financial stress constantly find themselves in the difficult position of deciding whether to cease or continue operating. The decision to continue to operate may prove detrimental to the directors should the company subsequently fail. Accordingly, it is important for directors to recognise when a company’s business can no longer be saved.
Key indicators that a business may be in trouble include the following:
- Earning expectations are not met
- Cash flow is tight and operating losses persist
- Credit lines are fully extended, the company is unable to make principal and interest payments and the company is not complying with debt covenants
- There is significant turnover of senior staff
- Accounting irregularities have occurred
- Customer relationships are deteriorating
- Market share is declining
- The company is reliant on a small number of customers
- The company is behind on lodgement of its Business Activity Statements
- Business Activity Statements are lodged, however, payments are not made
- Creditor calls demanding payments have increased or creditors have stopped supply
- Statutory Demands for payment have been received.
While the above list is not exhaustive, should directors find themselves facing a number of these issues, they must consider whether continuing to operate may result in their receipt of an insolvent trading claim from a liquidator subsequently appointed to the company.
Such a claim may be made because directors who allow a company to incur debts while it is insolvent, risk being held personally liable for those debts.
Specifically, directors have a duty to prevent a company from incurring further debts where:
- The company is insolvent or becomes insolvent at the time it incurs a debt or debts including that debt; and
- There are reasonable grounds for suspecting that the company is insolvent or would become insolvent as a result of incurring that debt or debts.
This duty applies to individuals who may not be formally appointed as directors, such as shadow directors or de facto directors. The lack of a formal appointment does not excuse an individual from liability. Further, a director who resigns while a company is insolvent, but prior to the company being placed into liquidation, may still be held liable for all debts incurred from the date the company was considered to be insolvent to their resignation date.
Where directors have concerns as to the solvency of a company, there are a number of matters which they should consider to minimise the risk that they will breach the insolvent trading provisions. These matters include the following:
- Consider whether the company’s business is viable. If it is viable, directors should prepare a business review and a realistic program to return the company to profitable trading
- Surplus staff should be dismissed and directors should consider the sale or closing of unprofitable or marginal segments of the business
- The company should conduct frequent meetings of the board of directors and keep minutes of those meetings at which the financial position of the company is discussed
- Directors should ensure that responsibilities are properly delegated while ensuring that important decisions are not delegated
- Financial accounts must be up to date and properly kept. If accounts are found not to be up to date, immediate steps are required to ensure that this occurs
- Directors should receive an updated budget and a complete and accurate report of the company’s trading and financial position on a regular basis
- All directors should be kept informed and agree on future actions. Dissenting directors should resign as a last resort knowing that they will only be spared from personal liability in relation to debts incurred after they resign
- External professional advice in relation to solvency issues should be sought as soon as practicable
- Major creditors should be kept appraised of developments
- A contingency plan should be developed detailing the steps to be taken should the company’s solvency not improve within a defined period. This may involve appointing a Voluntary Administrator or approaching a secured creditor and requesting that a Receiver and Manager be appointed to the company.
While directors would like a company to trade out of its difficulties, they are obliged to act in the best interests of creditors while complying with their other duties. Taking the above steps will promote appropriate action in a timely manner by directors and thereby mitigate the potential for personal liability. If you feel that you may be at risk please contact us.