News

Guidance on director duties and insolvent trading

The Federal Court in the case of Smith v Boné, in the matter of ACN 002 864 002 Pty Ltd (in liq) [2015] FCA 319 has provided some fresh judicial guidance on what can be considered the proper exercise of director duties as companies approach the point of insolvency.

The facts of this case are typical of most insolvencies we see in our office:

• a company traded successfully and then fell into arrears with creditors and the ATO;
• the director negotiated a payment plan with the ATO and tried to cut costs and juggle other creditors; and
• ultimately the plans failed and the company was wound up.

The director was pursued for liability for trading whilst insolvent pursuant to section 588G of the Corporations Act (“Act”) and the director sought relief from liability under sections 1317S or 1318 of the Act claiming it would be unjust and oppressive to find him liable.

The Court, therefore, had to consider whether the director “acted honourably, fairly, in good faith and in a common sense manner, as judged by the standards of others of a similar professional background”.

While the Court was satisfied that the director did not conduct himself dishonestly, the Court did not excuse him from liability because he:

• did not actively seek professional advice about the company’s solvency;
• was never advised during the relevant period that his company was solvent; and
• was advised that the company had previously engaged in insolvent trading, albeit with the support of creditors, and may engage in insolvent trading if it continues to trade.

Most significantly, with respect to payment arrangements entered into with the ATO, the Court was not satisfied that a reasonable, commercially experienced director would have made the arrangements without a clear plan as to how the company would meet its obligations.

With respect to the payment arrangements, the Court considered that the director’s conduct strongly suggested an attitude that he was entitled to decide what was in the best interests of the creditors and that, in the case of the ATO, the company was entitled to negotiate multiple repayment plans, even if full repayment would take years.

In matters we are appointed to, we often see examples of actions taken by directors that mirror very closely the above circumstances; in particular the manner in which payment arrangements are proposed to the ATO.

The learning that we draw from the above is that when solvency pressure mounts:

• take expert insolvency advice early;
• act in the best interests of the company and its creditors and try not to be swayed by the personal interests of the directors (which might be in sharp contrast to the creditors);
• only commit to a reliable and realistic payment plan with all creditors where outcomes demonstrate a turnaround is feasible; and if a turnaround is not feasible, seek an external administration to avoid the risk of being found guilty of insolvent trading.

Considerations when seeking to stay or terminate a winding up

With an increase in the number of winding up applications being filed in Court, we thought it may be useful to reflect on the recent decision in Re Avenue Investment Capital Pty Ltd (in liq) [2015] NSWSC 1919 giving guidance on the matters that a party seeking to stay or terminate a winding up of a company need to establish.

Applications to stay or terminate a winding-up usually occur when a company in liquidation has paid off or otherwise satisfied all of its debts and wishes to resume trading, or where some form of restructure is to be pursued.

However, we are often asked to consider these applications where directors tell us they were not aware of the winding up application being brought and they consider their business is definitely solvent. In such circumstances, an application must be brought swiftly by a shareholder/director of the company seeking an order to stay or terminate the winding up.

When considering such applications, the Court is concerned about the evidence of solvency of the company and its proposed future commercial activities. In the case of Re Avenue Investment Capital Pty Ltd, the Court was not satisfied on the evidence before it that the winding up should be terminated.

The judgement emphasised that when making an application to stay or terminate a winding up:

• the applicant bears the burden of providing the evidence to Court;
• it is the Court’s discretion to make the order and their view will be shaped by:
• the demonstrated solvency;
• the attitude and interests of creditors (including future creditors);
• the liquidator’s opinion;
• the public interest; and
• an explanation for the circumstances leading to the winding up.

In our experience, such applications are costly and time-consuming and the evidence of solvency that must be produced by the director is significant. Also, while it is happening, the company is still under the control of the liquidator and costs continue to mount and become payable. As a result, such applications are generally only appropriate where the company that has been wound up is clearly solvent.

Corporate structuring – lessons to be aware of

Like many of our readers, we have been very interested to hear stories about the failure of Clive Palmer’s troubled Queensland nickel refinery in early January and as events have transpired, hearing the anguish of many creditors who have found themselves as creditors of a company that has limited assets.

It is reported that the refinery operated using various subsidiary companies; the objective of which is to separate trading risk from asset wealth and to assist in profit sharing.

Arrangements whereby businesses employ group structures intended to separate risk from asset ownership are quite common (particularly with larger companies) and are not illegal. With that in mind, suppliers trading with such groups need to be smarter and ensure they employ strategies that help them address the increased risk of trading they are exposed to.

Such strategies will include:

• when opening trade accounts, conduct due diligence with intended trading partners to identify asset-less trading structures and implement risk management strategies when identified;
• limit the amount of credit extended to risky trading partners;
• consider taking out credit insurance to share the risk of trading;
• seek guarantees from the directors of the company and the holding company; and
• ensure goods supplied on credit are covered by retention of title terms and have those terms of trade registered on the Personal Property Securities Register (“PPSR”).

Each of the above steps seeks to ensure that the risks of supply are supported by other avenues of recovery in the event of insolvency.

When these style of entities are wound up, they are interesting matters from the liquidator’s perspective as there are many avenues of review that the liquidator can pursue with the aim of identifying assets to be realised for the benefit of the creditors. Such reviews include:

• review the trading arrangements between the asset-owning company and the asset using company to ascertain whether the arrangement constitutes a PPS lease that may give rights to the assets if the lease is not registered on the PPSR;
• ascertain whether the payment of rent between the asset owning and the asset using companies is fair, or an uncommercial transaction that could be voided;
• assess the liability of the directors and/or parent company for possible breaches of the insolvent trading provisions; and
• determine if there has been a breach of section 596AB of the Act by parties entering into a transaction or agreement to avoid the payment of employee entitlements.

Our advice is that prudent financial structuring of businesses is not illegal and often makes very good commercial sense. But just as there are risks for suppliers in dealing with group structures, there are also risks from the group as well if the structuring is uncommercial or deliberately established to defeat creditors.

When are you hanging on too long?

As advisers to businesses at or close to insolvency, we regularly meet with directors of companies in trouble to outline the risks and obligations when making the difficult decision to continue to trade or not.

It has never been our firm’s practice to pressure a director into a decision they are not comfortable with, however often our role in such meetings is to draw into the spotlight key facts that help directors understand and accept the true financial position of their business.

As business owners ourselves, we understand that objectivity can be clouded by our emotional attachment to our business, but as in the case of Smith v Boné discussed above, the Court will not find kindly on directors who have placed their personal interests above creditors.

Businesses can fail for many reasons, but the most common cause of failure is prolonged unprofitable trading. When the depths of a financial problem are highlighted to directors, we are often surprised that the first reaction is for the directors to agree to pump more money into the business. Often we see the source of money being from redrawing on the home mortgage and via credit cards. In reality, that solution is only to replace one class of creditor for another.

We advocate that before a decision is made to reinvest in a struggling business, two questions must be answered:

1. How did the business get into the problem it is in?
2. How can the business return to profit in the short term?

Only when these answers can be found, should the decision to reinvest in the business be considered.

The answers to these tough questions can be confronting to the directors and are typical of the answers financiers require from customers when they are asked to provide increased facilities.

Sometimes, due to the impact of globalisation, changing consumer tastes, or a poor strategic business decision, a business that was once strong cannot be turned around and trade profitably going forward. It is often the directors of businesses with a profitable past that are the first to leap into the decision to reinvest more into the failing business; a decision more clouded by emotional attachment than financial logic.

The trusted business advisers to the company have a role to play in helping guide a sensible, rational decision by directors. Often the rational decision can be drawn out by a dispassionate discussion concerning risk, weighed up against return, and drawing a comparison of investing into a sound asset vs. the return of reinvesting into the struggling business.

Our Director Mark Lieberenz has produced a very informative staff training paper concerning insolvency, advisor liability and restructuring options that will be a useful further reminder of how to advise responsibly to businesses that are struggling financially.

Please contact Mark if you would like him to visit your firm to deliver the paper to you and your staff.