Legal Case: Court forgives Director’s insolvent trading

15 February 2010 By Michael Quinlan, Partner and Catherine Zahra, Lawyer, Allens Arthur Robinson www.aar.com.au

s. 588H and 1317S of the Corporations Act

We have reproduced this article with some amendments but the essence of the article has not been changed. It is a very important case for directors and their advisors and accountants.

In brief:

For the first time, a judge has exercised his discretion under the Corporations Act 2001 (Cth) to provide a director with complete relief from penalty following a finding of insolvent trading.

Justice Goldberg’s decision reinforces the need for directors to actively seek out professional advice and monitor the affairs of their company when they suspect the company may be, or is close to, insolvency. More importantly, this decision is the first case in which a judge in the exercise of his discretion under s1317S has provided a director with complete relief from penalty following a finding of insolvent trading. Whether other judges will follow the same approach in similar circumstances remains to be seen.

The facts

  • Section 1317S of the Corporations Act 2001 (Cth) (the Act) empowers a court to relieve a director from liability for contravening the Act (including the insolvent trading provisions) if that person has acted honestly and, having regard to all the circumstances of the case, ought fairly to be excused. Relief is usually only partial.
  • This is the first time that the Federal Court of Australia has relieved a director wholly from liability for contravention of the insolvent trading provisions.
  • The case highlights the importance the courts place on evidence as to a director’s reliance on professional advice and the extent to which the director has actively taken steps to rectify their company’s cashflow problems.

The liquidator of The Stake Man Pty Ltd (in liquidation) commenced proceedings against the sole director, Mr Carroll, for insolvent trading. Until 2004, the company operated a profitable business of processing and wholesaling raw timber. To expand production, the company acquired plant and equipment to enable it to kiln dry and machine its own timber. From the outset of the kiln-installation process, the company incurred cost blow-outs and had problems in relation to the installation and operations of the kilns. Progressively, the delay in having the kilns operational affected the company’s cashflow.

In March 2005, Mr Carroll retained an accountant, Mr Bright, to provide business advice regarding the company’s cashflows, costs and expenses and an analysis of the business model and its profits and losses.

In July 2005, Mr Bright told Mr Carroll that the company was very close to being insolvent and that the business needed a serious capital injection until such time as the kilns could be made operational or a decision was made not to proceed any further with the kilns. Mr Carroll, with the assistance of an investor, advanced further funds to the company.

In February the following year, Mr Carroll sought advice from an insolvency practitioner, who advised him that if he believed that the company was viable, it would be necessary to find an investor or further capital to enable the company to continue to trade. Mr Carroll then engaged a consultant to help him find an investor in the company. He also sought further avenues of finance for the company’s business. Despite the company’s cashflow situation, Mr Bright did not consider that the company was insolvent. He made this clear to Mr Carroll on a number of occasions throughout the period January 2006 to April 2006.

On 3 May 2006, the Australian Taxation Office (the ATO) contacted Mr Carroll and told him that the company owed it $110,000. Mr Bright told Mr Carroll that the company did not have $110,000 on hand to pay the tax bill and suggested that he meet with a business restructure specialist, Mr McLellan. Mr Carroll met with Mr McLellan on 8 May 2006. Mr McLellan recommended that the company be placed into voluntary administration. On 10 May 2006, Mr McLellan was appointed as voluntary administrator. The following month, creditors of the company resolved that the company be wound up and Mr McLellan became liquidator of the company.

The liquidator alleged insolvent trading between 31 December 2005 and 10 May 2006 (the relevant period). Mr Carroll denied that the company was insolvent during the relevant period and contended that he:

  • had reasonable grounds to expect that the company was solvent during the relevant period (in reliance on section 588H(2) of the Act). This expectation was based upon, inter alia, the inventory of the stock of timber held by the company during the relevant period and the company’s ability to realise and sell that stock; and
  • expected that, on the basis of information provided by Mr Bright, the company was, and would remain solvent, even if it incurred the debts (in reliance on s588H(3)).

In the alternative, Mr Carroll relied on s1317S and s1318 of the Act.

Contravention of s588G

Justice Goldberg held that all of the elements in s588G had been established affirmatively by the liquidator. His Honour observed that:

  • Mr Carroll had acknowledged that he knew that the company had a cashflow shortage after 31 December 2005. He also conceded that, from at least January 2006, the company was not paying its debts as and when they became due and payable. The company’s inability to pay its debts out of cashflow as and when they fell due continued throughout the relevant period;
  • there were no assets of the company that could be provided as security to support the borrowing of sufficient money to provide sufficient cash to discharge the company’s debts then due and payable. Nor was there any source to which Mr Carroll could have had recourse to obtain further investment in order to overcome the company’s cashflow problems;
  • given the ongoing problems in relation to the commissioning and operation of the kilns, the sale of the business as a going concern was problematic;
  • there was no basis throughout the relevant period to believe that the kilns would be fixed so as to enable the cashflow of the company to improve;
  • the bank statements during the relevant period showed a deterioration in the company’s cashflow position;
  • the company’s debts were not being paid over longer and longer periods; and
  • the company’s tax liability and trade creditors had significantly increased throughout the relevant period.

Defences

His Honour rejected Mr Carroll’s defence under s588H(2). According to Justice Goldberg, the extent of the outstanding and unpaid debts of the company and the extent to which future debts would be incurred were such that it was not reasonable for Mr Carroll to expect that the company’s stock could be sold within a sufficiently short timeframe to enable all the company’s debts to be discharged as and when they fell due.

Nor did his Honour consider that the defence available to Mr Carroll under s588H(3) was made out. Though Mr Bright gave advice about whether the company was solvent, the evidence did not demonstrate that he was specifically given the role of providing Mr Carroll with ‘adequate information about whether the company was solvent’. The advice Mr Bright provided was given as part of the general accountancy and advisory work that Mr Bright was undertaking for the company.

Despite his Honour’s findings, Justice Goldberg was satisfied that Mr Carroll acted honestly and, having regard to all the circumstances of the case, ought fairly to be excused for contravention of the insolvent trading provisions under s1317S. His Honour adopted the criteria for determining such honesty, as set out by Justice Palmer in Hall v Poolman, in the following terms:

In my view, when considering whether a person has acted honestly for the purposes of a defence under ss 1317S(2)(b)(i) or 1318 of the CA, the court should be concerned only with the question whether the person has acted honestly in the ordinary meaning of that term, that is, whether the person has acted without deceit or conscious impropriety, without intent to gain improper benefit or advantage for himself, herself or for another, and without carelessness or imprudence to such a degree as to demonstrate that no genuine attempt at all has been to carry out the duties and obligations of his or her office imposed by the Corporations Act or the general law. A failure to consider the interests of the company as a whole, or more particularly the interests of creditors, may be of such a high degree as to demonstrate failure to act honestly in this sense. However, if failure to consider the interests of the company as a whole, including the interests of its creditors, does not rise to such a high degree but is the result of error of judgment, no finding of failure to act honestly should be made, but the failure must be taken into account as one of the circumstances of the case to which the court must have regard under ss 1317S(2)(b)(ii) and 1318 of the CA.

Applying the above criteria to the case before him, Justice Goldberg held:

  • although Mr Bright did not formally satisfy the description of a person ‘responsible for providing…’ for the purposes of the defence available in s588H(3)(a)(i) of the Act, Mr Bright was providing advice to Mr Carroll throughout the relevant period upon which it was reasonable for Mr Carroll to rely, notwithstanding his suspicions and knowledge as to the company’s solvency;
  • Mr Carroll took active steps to expand sales and persisted in trying to get the kilns operational;
  • stock sales were increasing throughout the relevant period and Mr Carroll was monitoring stock levels and the amount of daily production;
  • Mr Carroll sought advice from an insolvency practitioner, whose advice he acted upon;
  • Mr Carroll took active steps to seek out investors who could provide further capital for the company and took steps, though it was ultimately not proceeded with, to factor book debts; and
  • following correspondence with the ATO as to the company’s tax liabilities, Mr Carroll spoke to Mr Bright the following day and arranged to meet with Mr McLellan three days later.

Justice Goldberg concluded that, though Mr Carroll permitted the company to incur debts in circumstances giving rise to contravention of s588G, he did so against the background of all of the circumstances referred to above. Mr Carroll did not profit personally from permitting the company to trade in this way, was not disregarding advice and, indeed, actively sought advice from Mr Bright and others throughout the relevant period. His Honour acknowledged the difficult decisions that Mr Carroll faced throughout the relevant period.

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