The social and other policies behind the insolvent trading provisions of the Corporations Law Section 588G of the Corporations Law is generally regarded as providing directors of smaller companies in particular with their worst possible nightmares.
Apart from the fact that a breach of the provision carries with it the potential for heavy civil penalties, such a breach also exposes the directors to personal liability for the debts of the company incurred while the company was insolvent or which led to the company's insolvency.
While the law has been changed somewhat to make it marginally less likely that directors will be sued personally, because the liquidator must now be the primary litigator to recover the debts owed to the company (before it was the creditors who were the primary suitors), recent cases have shown that directors are still potentially exposed to significant liability. In Woodgate v Davis ((2002) 20 ACLC 1314) Justice Barrett in the Supreme Court of NSW had to decide whether a person, the sole director of two companies which carried on business in partnership with each other, could be liable for the debts of the companies when it was alleged that the relevant director had failed to prevent either of the companies from incurring debts at a time when they were insolvent. The director pleaded, among other things, that the relevant sections of the Corporations Law were not available to the liquidator because the debts were incurred by a partnership rather than by a company. His Honour held that the defence failed. In his view the fact that the debts were incurred by two companies in partnership did not preclude the insolvent trading provisions applying. The liquidator was successful in the action.
From the point of view of the company director, the most interesting part of the judgment is the observations made by Justice Barrett on the policy behind the insolvent trading provisions. He noted that the insolvent trading prohibition contained in S.588G (and the related provisions): "serve an important social purpose. They are intended to engender in directors of companies experiencing financial stress a proper sense of honest and responsible conduct directed towards the avoidance of any increase from the company's debt burden. The provisions are based on a concern for the welfare of creditors exposed to the operations of the principle of limited liability at a time when the prospect of that principle resulting in loss to creditors has become real. Very clear words would be needed to justify the conclusion that the underlying policy was displaced by the circumstance that the company operated not as a sole trader but in partnership; or that the directors of any company could exempt themselves from the need to be attentive and to act responsibly, on pain of personal liability to compensate, by the simple expedient of causing their company to carry on business in partnership. The force of this last point is illustrated by the case where a single individual becomes the sole shareholder and sole director of each of two companies and causes those companies to trade as partners."
The courts have been very strict in recent times in interpreting the insolvent trading provisions of the Corporations Law. While there has been the odd case in which a director has escaped liability, that scenario should not be regarded as any comfort for directors generally and the comments of Justice Barrett will act as a very sober reminder of that fact.
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