Insolvent trading substance and shadow AICD Review

Thursday, 01 November 2001


    Directors need to be constantly on guard that their companies have not slipped over the line of trading while insolvent. Gerard Breen and Brett Martelli from Abbott Tout solicitors provide a useful checklist.

    The existence of a company as a separate legal entity with the limited liability of its members is open to abuse, both deliberate and accidental. This is especially so in respect of those directors who incur unrecoverable debts on behalf of an insolvent company. However, the commercial law is not indifferent to shareholders and creditors who are left out of pocket. Indeed, Australian corporations law imposes a specific duty to prevent insolvent trading where the director suspects or should suspect the company is insolvent. Compliance with the duty is ensured by a system of sanctions, including the directors' personal liability for the company's debts. As well, various institutions or individuals may be held accountable as directors without ever being appointed as a director, if they exercise control whilst the company is engaging in insolvent trading. They are often referred to as "shadow" or "defacto" directors. The essential difference between the two is that defacto directors hold themselves out as directors and therefore are easily identified. Shadow directors remain behind the scenes while exerting strong influence over the running of the company. They have had a regular willingness and ability to exercise control, and an actuality of control, over the management and affairs of the company. Clearly, people who customarily engage in a company's affairs may not decline responsibility for their actions for lack of formal appointment.

    But before any duty or liability may arise the company must have incurred a debt. Normally this will not be difficult to establish as the debt will be due. However the issue is more complicated in relation to contingent debts such as guarantees where it is debatable whether the debt is incurred at the date of the guarantee, the date of default by the principal debtor or the time at which the guarantee becomes payable. At this point the courts appear content to decide the issue case by case, depending principally upon the terms of the agreement between the parties, express or implied. A company will be insolvent if it is unable to pay all its debts as and when they become due and payable. Thus the test normally relies on the cash flow position of the company not the balance between its assets and liabilities. For a director to be liable, at the time of incurring the debt, the directors must have either:

    1. been aware of reasonable grounds for suspecting the company is insolvent or would become insolvent; or

    2. ought to have been aware of reasonable grounds for suspecting the company is insolvent or would become insolvent.

    The precise amount of evidence necessary to constitute reasonable grounds for suspecting insolvency is uncertain. Over time a passage of decisions will determine where any given set of facts will fall within the spectrum. Having said that, it is a relatively simple test for directors to ask themselves if the debt is incurred, will the company still be able to pay its debts? The more difficult issue is when there is evidence to indicate debts cannot be paid, but the director is not aware of it, or does not recognise it as such. The objective standard the law applies therefore suffers from the flaw that the directors may escape accountability where they were not aware of the evidence. This potential injustice brings into the fray the second limb which makes directors liable if a reasonable director "in a like position in a company would be so aware". That begs the question what enquiries a reasonable director would make to ensure awareness of a solvency problem. The following list of enquiries and attributes might be expected from a reasonable director:-

    • Ensure that in a large company at least one of the directors is talented in corporate finance management.

    • To be able to read and understand the company's balance sheet and profit and loss statement.

    • Ensure skilled people carry out the company's accounting.

    After that, the critical issue will be whether the reasonable director would fear or determine insolvency on the evidence that emerges. Although the law does not specifically make some directors more equal than others regarding whether they should have suspected insolvency from the evidence, the courts seem prepared to vary what directors ought to have suspected, depending on whether an executive or non executive director was involved. Nevertheless, it is also apparent a minimum standard applies to all directors so that non executive directors can not entirely evade liability. The courts will not allow a director to be "willfully blind" to the company's financial position.


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