The whole truth and nothing but the truth

When can a director rely on other directors to escape liability for insolvent trading – not very often it seems

In a separate note in this issue I discuss the philosophy behind the insolvent trading provisions of the Corporations Act as enunciated by Justice Barrett of the Supreme Court of New South Wales in Woodgate v Davis. In a judgment that is of more direct relevance to the average director, Chief Justice Young of the New South Wales Supreme Court (Chief Justice in Equity) made an important ruling in relation to when directors could rely on others in a company to escape liability for insolvent trading pursuant to the terms of section 588H(3) of the Corporations Act. Section 588H of the Act provides that where a claim for insolvent trading is brought against a director it is a defence if the director can prove that at the time that the debt was incurred that the relevant director:

"(a) had reasonable grounds to believe and did believe:

(i) that a competent and reliable person ('the other person') was responsible for providing to the first mentioned person (that is the director) adequate information about whether the company was solvent; and

(ii) that the other person was fulfilling that responsibility; and

(b) expected, on the basis of information provided to the first mentioned person (ie the director) by the other person, that the company was solvent at that time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time."

This defence is sometimes stated to be the "business judgment defence" in relation to the insolvent trading rules. But as we shall see from the following discussion of the judgment of Young CJ in another case, this approach is likely to provide much comfort to directors. In Manpac Industries Pty Ltd v Ceccattini ((2002) 20 ACLC 1304), the facts come from the CCH headnote. A company, Industrial Concrete Manufacturing Pty Ltd (referred to either as ICM or the company) owned a concrete batching plant, which it erected on land owned by an associated company, Mercap Pty Ltd (Mercap). Mercap in turn leased the concrete batching plant from ICM and agreed to sell it concrete. ICM became indebted to Manpac in relation to the concrete supplied to it in the amount of $399,090.

The company, finding itself in financial difficulties, engaged Turner Capital Services to assist it and Mercap 'to survive'. Turner was the principal consultant of Turner Capital Services. The arrangements were (if survival could be achieved) for Turner Capital Services to assist in the continued building up of the company's business, to arrange for the injection of capital to refinance loans and organise office administration to ensure that everything operated effectively. Turner prepared reports for the directorsof both companies. In the first report he stated: "We now know the company is solvent and has a solid business base. It appears to have weathered the worse [sic] and is now able to look forward." The report analysed the two companies as a group (which was not appropriate). It was also based on an interview with one of the former directors (described in the report as the main source of information), the records of the company (which were in disarray), an interview with the accountants and solicitors for the group, and a meeting with a bank which provided financial support to the group. However, Turner was not given full details of ICM's trade debtors and creditors and did not have sufficient time to verify many of the statements made.

ICM subsequently went into liquidation. The company's liquidator allowed Manpac to bring proceedings against the two former directors of the company under section 588M of the Corporations Act. Manpac commenced proceedings claiming the amount referred to above. The directors, relying on the defences set out in section 588H of the Corporations Act, contended that they were not liable because:

• The company was not insolvent in the relevant period;

• At the relevant time, the directors had reasonable grounds to believe that a competent and reliable person, Turner, was responsible for providing to them adequate information concerning the company's solvency and Turner was fulfilling that responsibility; and

• The directors expected, on the basis of information provided to them by Turner, that the company was solvent at that time and would remain so even if it incurred the debt to Manpac.

The directors also contended that they should be excused from liability under section 1318 of the Corporations Act. Justice Young discussed a number of issues in relation to the operation of the insolvent trading provisions of the Act. In his view the test of solvency is as defined in the Corporations Act in rather blunt words – a company which is unable to pay all its debts as and when they become due and payable is insolvent. In his view the definition required a cash flow rather than the balance sheet test. When one applied a cash flow test it was relevant, in his view, "to take into consideration the relationships between the company and its creditors and any agreement as well as the course of conduct." Further, when one considered the course of conduct "one can take into account industry practice or dealings between the parties which may demonstrate that company debtors will often not take creditors within normal trading terms". He added:

"In business circumstances sometimes this is quite necessary in an industry which is experiencing recession because otherwise creditors may not be able to sell their product at all. Even though they would prefer people to stick to their thirty day terms it is better to have recalcitrant debtors than sell no product at all."

He suggested that his comments needed to be read in the context of good commercial and legal common sense as well as an examination of the relevant legislation. He then turned to deal with the defence under section 588H(3) of the Corporations Act. To establish such a defence, the directors must believe that the person who is providing information on which the director relied in forming the view that the company was solvent, must in fact be able to establish the relevant evidence to the satisfaction of the court. It was no defence if the defendant involved had no knowledge at all as to whether the company was solvent or not. In his view neither director could have believed that ICM was solvent, or could have had reasonable grounds for any such belief apart from the material supplied by Turner. In the judge's view "there was no doubt at all prior to September 1994 that such a belief could not have been held." The question was whether the remedial work undertaken by Turner as briefly described above provided reasonable grounds for such a belief. In the judge's view it did not.

He considered a number of other interesting issues including what was meant by the words "competent and reliable person" as used in section 588H(3)(a)(i) referred to above. In his view the directors could not have reasonable grounds to believe that Turner was fulfilling the responsibility. He summed up the position in this way: "While Turner appears to have had a pretty good grasp of what was happening in the books and what was happening with the [Commonwealth Bank], and indeed, what was happening with the [plaintiff company (Manpac)], he was not given full and proper details of what was occurring with the trade creditors and debtors. ... It is extremely difficult for a person to say that a person is responsible for providing adequate information about solvency and was fulfilling that responsibility when the person allegedly relying on the other person was the source of the supply of information and that supply of information was not completely full." (see paras 51 and 52 of the judgment) He also provided a useful reminder on the basis of the defence in section 580H(3). It was contained in a report on bankruptcy reform which stated:

"[The Law Reform Commission] considers that the defence is clearly necessary in the case of larger companies in which it cannot be expected that directors will have control over every action taken in the conduct of the company's business. Additionally, a defence of this nature may encourage a proper system of financial management." (see para 53) The judge noted that the main aim of such a defence was to cover situations where "there is a large corporation with bulky accounts and where there is a system in place of competent accountants, credit controllers and financial management and the board has a regime whereby those people, provided they are competent and responsible, will report to the board any problems that the board may pick up" (see para 54). In his view the exception was not aimed at dealing with situations where there was a small company with directors who "have little idea of accountancy, bring in a trouble-shooter, supply the trouble-shooter with information which may not be complete, receive reports back from the trouble-shooter and then intend to rely on a report which is incomplete because they have provided incomplete information." (see para 54)

In addition, in the judge's view, the belief that the company would remain solvent couldn't have been based on the facts. When he examined the facts and the behaviour of the relevant directors, he ruled that the directors had not done enough to satisfy themselves that the information being provided was based on sound principles and could have been relied on in all of the circumstances. The judge then turned to deal with the request by the directors that they should be excused from liability under the Corporations Act for various "breaches" – negligence, default, breach of trust or breach of duty where it appears to the court that the person who might otherwise be liable had acted honestly and that, "having regard to all the circumstances of the case ... the person ought fairly to be excused for [the relevant breach]". While the judge may have probably applied the wrong section (he discussed section 1318, even though an application was also made under section 1317S of the Corporations Act which deals with civil penalty breaches – insolvent trading is such a penalty provision) – the same issues are relevant in relation to both provisions and the distinction is of no real consequence.

In considering whether the directors should be excused the judge held that they had not made out the relevant basis for the court intervening. In conclusion he held that unfortunately the directors were liable. He provided some final sobering thoughts, not dissimilar to those of Justice Barrett in the case of Woodgate v Davis which is discussed in this Reporter: "The essence of the matter is that the law provides limited liability to people carrying on business using a corporate vehicle because it is in the community's interest that people should venture and take commercial risks in their trade without the constant worry of being personally liable for any risk which happens to go wrong. However, there is a limit to that protection and the limit is reached when directors have reasonable grounds to believe that the company is no longer solvent. When that point is reached, the field of limited liability to a degree evaporates unless the directors can demonstrate some special circumstances as to why they should still be protected. In the instant case they have not." (para 78)

The clear message from this case (and Woodgate v Davis) is that the insolvent trading provisions of the Corporations Act operate quite vigorously. The case for a business judgment rule in a situation where directors should be genuinely excused if they rely on others should be considered as part of the reform of the insolvency law to take place shortly. Unfortunately, because that review is limited to international issues, it appears unlikely that this pressing problem facing directors generally will remain unresolved.

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