Professional Advice re Solvency of Business

Directors of a company are under a positive obligation to ensure that the company does not trade whilst it is insolvent. Should the company continue to trade whilst it is deemed insolvent directors may attract a personal liability for all unpaid debts incurred during the period of insolvency.

In a recent decision of the Federal Court¹, Goldberg J held that an accountant, who had been employed to provide advice to the director regarding the finances of the company (including the preparation of budgets, cashflow projections and projected financial statements) was not a person upon whom reliance could be placed pursuant to the provisions of Section 588H(3) of the Act as a defence to a claim against a director.

Background
The director (Mr Carroll) had taken certain actions to expand his business by the purchase of new plant and implementation of new processes. The new plant was required to be installed and commissioned by a third party. The installation and commissioning of the plant encountered a number of difficulties and delays. These delays caused a substantial cashflow deterioration to the company.

The director employed an external accountant (Mr Bright) to provide financial advice. In addition, Mr Bright was required to undertake the preparation of cashflow projections and projected financial statements which would enable the director to arrange further financing.

The further financing was to be used to assist in payment for the new plant and to provide working capital to assist the company through the period of commissioning of the new plant and until the new production processes were properly established.

The external accountant advised the director on a number of occasions that he considered that the company remained solvent based upon the projections which the accountant had prepared.

The director arranged further financing although the company continued to trade at a substantial loss whilst continuing its efforts to successfully install and commission the new plant.

When it was determined that the company may not be solvent the director was referred to an insolvency practitioner who at that time advised him that he should seek an investor or consider the sale of the business.

Although at that time the director considered the company was still solvent it was hoped that the new plant would shortly commence fulltime operation and resolve the cashflow crisis which the company faced.

The company continued to incur losses and it was eventually placed in Voluntary Administration and subsequently Liquidation.

The Act
Section 588G of the Corporations Act, 2001 (“the Act”) provides that if:

“(a) a person is a director of a company at the time when the company incurs a debt; and
(b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and
(c) at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent as the case may be; and
(d) that time is at or after the commencement of this Act.

2. by failing to prevent the company from incurring the debt, the person contravenes this Section if:
(a) the person is aware at that time that there are such grounds for so suspecting; or
(b) a reasonable person in a like position in a company in the company’s circumstances would be so aware.”

Where a director contravenes Section 588G a Liquidator may commence action to recover any debt incurred by the company during the period which it was insolvent. A creditor may also pursue a director for insolvent trading for the loss they suffer. (Section 588R)

A director may attempt to defend an insolvent trading action where he relied upon information provided to him. (Section 588H(3) of the Act). This Section provides that:

“It is a defence if it is proved that, at the time when the debt was incurred, the person:

(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 adequate information about whether the company was solvent; and
(ii) that the other person was fulfilling that responsibility; and
(iii) expected, on the basis of the information provided to the first mentioned person 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.”

The Liquidator commenced an action against the director for insolvent trading. The director defended the action relying upon the provisions of Section 588H(3) of the Act together with a request for relief pursuant to Section 1317S(2) of the Act.

Decision
It was held by Goldberg J that “the evidence does not satisfy me that Mr Bright was specifically given the role or task of providing Mr Carroll adequate information about whether the company was solvent……. that information was given as part of the general accountancy and advisory work which Mr Bright was undertaking for the company ……it follows that the defence available to Mr Carroll under Section 588H(3) of the Act is not made out”

Although the director was found to have breached the provisions relating to insolvent trading and had not made out a case for a defence pursuant to Section 588H(3) of the Act, the Court in this instance granted relief pursuant to the provisions of Section 1317S(2).

The facts of this case are unique in relation to the granting of relief which is only granted by the Court in exceptional circumstances.

Lessons
Accountants/advisors should require specific instructions prior to providing advice including advice on solvency.
The case further highlights the necessity to employ an appropriately qualified and experienced person to advise on the solvency of a company and the options available to officers following receipt of that advice.

Failure to adequately deal with these issues may result in your client director being held personally liable for company debts.

If you have a client that is in financial difficulty, we would be pleased to have the opportunity to undertake a solvency assessment to assist in determining the most appropriate way forward.

1 The Stake Man Pty Ltd v Carroll (2009) FCA 1415