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Directors may gain a new defence to insolvent trading

The global financial crisis has brought issues of insolvent trading into keen focus for many company directors.

In the current economic climate, companies which have been well managed, adequately capitalised and have a viable underlying business can quickly find themselves at real risk of insolvent trading.  This can be as a result of falling revenue, tightening credit conditions, slow or defaulting payments from customers or a combination of all of these.

Under current legislation, Australian company directors are effectively compelled to act conservatively where they suspect their company is insolvent.

In broad terms, a company is insolvent if it is unable to pay all its debts when they are due.  While it seems simple enough, the test of solvency is often difficult to apply in practice and can lead to company directors, particularly non-executive directors, taking a very cautious approach.

If company directors believe their company is insolvent, they must generally appoint a voluntary administrator or a liquidator.

Aside from New Zealand, Australia’s insolvent trading laws are possibly the strictest in the developed world.  However, questions are now being asked whether the current laws are leading to undesirable outcomes, particularly in tough economic times.

Both the Law Council of Australia and the Insolvency Practitioners Association have put proposals to Treasury that the law be amended to provide an additional defence for directors based around the current "business judgement" rule. 

The defence would operate so that if directors have an honest belief that the interests of their company and its creditors are best served by pursuing restructuring options then they would be shielded from liability.  For the defence to apply, the company would need to have received restructuring advice on the basis of accurate accounts.

Currently, where insolvency is suspected by company directors, the Corporations Act strongly encourages directors to pursue a formal insolvency process as a defensive mechanism to potential personal liability.  This necessarily leads them away from any restructuring of the company.   

The appointment of an administrator usually results in a considerable loss of value for the company as well as loss of business confidence. The law reform proposals put forward by the Law Council of Australia and the Insolvency Practitioners Association are designed to overcome this issue and encourage responsible and reasonable risk taking to salvage a business.

The Minister for Corporate Law is yet to publicly respond to these proposals.

While the Government has the important objective of promoting confidence and integrity in the market, the Law Council of Australia and others argue that this must be balanced against preserving company value for shareholders and ensuring companies have access to the best possible executive and non-executive directors.

Until this issue has been resolved, directors should be mindful of their liabilities under the Corporations Act and seek appropriate legal advice where they suspect their company may be insolvent.

Please contact Geoff Green on 03 8319 1866 or at or Jai Singh on 03 8319 1872 or at for further information.

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