In the current economic climate, an estimated 10% of Australian manufacturing companies are making losses or trading insolvent. This has several implications and company directors can be personally liable if they continue to operate and incur debts when insolvent, writes Damian Sutherland.

Firstly, and most importantly, making losses does not necessarily mean that your business is trading insolvent. Insolvency is the inability of a corporation to pay debts as and when they fall due for payment.

There is a common misconception that, as a director of a company, you are not personally liable for the company’s debts. However, S558G of the Corporations Act imposes liability on company directors who allow the company to incur a debt at a time when the company is insolvent, assuming they were aware of reasonable grounds to suspect insolvency.

Penalties and consequences for directors for trading insolvent include:

  • Civil penalties against directors, including pecuniary penalties of up to $200,000.
  • A claim can be made for compensation by creditors for losses resulting from insolvent trading. Compensation payments are potentially unlimited and may result in the bankruptcy of the directors.
  • If a director is found to be dishonest and intentionally or recklessly trading whilst insolvent, the Australian Securities and Investments Commission (ASIC) can prosecute for criminal charges, resulting in fines up to $220,000 and/or imprisonment up to five years, as well as disqualification from acting as a director.

One of the main issues faced by directors is being able to identify when a company is insolvent. Ensuring that a company’s balance sheet has a surplus of assets over liabilities is a positive indicator of solvency. However, if the assets are not liquid or include stock and debtors associated with working capital requirements of the business, the company may not have the cash flow to pay debts as they fall due.

This has particular resonance with manufacturing businesses. Typically manufacturing businesses carry accounts receivable, stock and work in progress and also have to fund plant and equipment necessary for their business needs. The carrying values of these assets in a balance sheet require significant equity and debt funding. Quite often, manufacturing businesses have a significant portion of their plant and equipment subsidised by hire purchase facilities or commercial bills. In addition they may use debt factoring to help finance their accounts receivable book.

This funding requirement can result in inconsistent and ‘lumpy’ cash flow. Knowing whether these are timing issues that will “smooth” out across a full trading year or whether it is a profit issue is something that is critical to be aware of on a regular basis.

As a director, you need to ensure you are properly informed about the current financial position of the company. During difficult trading periods, it is not uncommon to neglect the accounting and financial reporting. However, it is at this time that you should be regularly informed of the company’s current trading status.

Signs that indicate the company is at risk of insolvency include ongoing losses, poor cash flow, increasing debt and creditors unpaid outside usual terms, including overdue taxes and superannuation liabilities, problems obtaining finance, regularly defaulting on loans or overdraft limits, and a belief that the company will turn around when you get the next big job, sale or contract.

When a company first starts to have cash flow difficulties, the first liabilities that are usually overlooked are ATO liabilities and Superannuation Guarantee Charge (SGC) requirements. A director penalty notice may be issued when a company fails to meet a PAYG withholding or SGC liability in full by the due date, which automatically becomes personally liable for a penalty equal to the unpaid amount for all directors of the business.

Entering a payment arrangement with the ATO may help with the short-term cash flow of a company, though careful consideration needs to be taken before entering any such ATO payment arrangement. Directors may be liable if the ATO needs to refund monies to a liquidator under the unfair preference provisions in section 588FGA of the Corporations Act. Directors are personally liable to the ATO for payments originally made by a company to the ATO under a payment arrangement in the previous 12 months before the liquidator was appointed. That is, if a liquidator forces the ATO to return the money to the company, the directors become liable to the ATO for that amount, as well as any costs the ATO is ordered to pay to the liquidator.

Directors may be liable to compensate a company for a loss if the director causes the company to enter while insolvent into a director-related transaction that resulted in an ‘unreasonable’ benefit. A transaction is ‘unreasonable’ if a reasonable person in the same circumstances would not have entered into the transaction after considering any benefits or disadvantages to the company or any related parties to the transaction. A liquidator can make a demand upon a director to compensate the liquidator for the amount of the unreasonable transaction.

Directors of companies who want to reduce their risk of becoming personally liable and reduce their likelihood of wrongful trading while insolvent should ensure they always have adequate and timely financial information, be alert to danger signs such as pressure from creditors, hold regular board meetings to discuss/review the company’s situation, ensure they consider the interests of creditors, as well as comply with their statutory directors’ duties and consider stopping trading and starting appropriate insolvency proceedings before creditors do.

If your company is under financial distress, it is critical that you seek specialist, professional advice to address solvency issues as early as possible to ensure that you are fully informed of the facts.

Damian Sutherland is a director of William Buck (Vic) Pty Ltd Chartered Accountants. AMTIL has a service partnership with William Buck as an exclusive benefit to our members. For more information, contact AMTIL’s Corporate Services Manager Greg Chalker by calling 03 9800 3666 or emailing Damian Sutherland can be contacted on 03 9824 8555.


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