INSOLVENT TRADING - University of Sydneysydney.edu.au/lec/subjects/insolvency/Winter 2010/Lect…  · Web viewThe relevant provisions of the Corporations Act regulating insolvent

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INSOLVENT TRADING

(Notes from the Law of Associations Course)

Introduction to sections 588G-588Z

When a company has a liquidity crisis its directors and officers need to take special care in their dealings with those outside the company. Directors need to consider their company's ability to pay all its debts as and when they become due. This is particularly so when the company is in financial difficulty and some form of financial management structure is in place. If a reasonably competent director would conclude that the company lacks that capacity or would lack that capacity after incurring the debt, they should not cause the company to incur further debts.

The relevant provisions of the Corporations Act regulating insolvent trading are contained in sections 588G-Z. Those provisions contain a complete code for the regulation of such trading. Sections 588G-588Z of the Corporations Act are provisions which commenced operation on and from the 23 June 1993. These sections were designed to replace the insolvent trading provisions contained in sections 592-593 of the Corporations Law1. However these latter provisions will continue to apply to debts incurred prior to 23 June 1993 in circumstances amounting to insolvent trading.

The duty

Section 588G(1) imposes a duty upon directors to prevent a company from engaging in insolvent trading. The heading to Division 3 of the Corporations Act refers to this duty and this heading is regarded as part of the Corporations Act because of the operation of sec 109D.

Section 588G(1) applies if:

(a) the director was a director of the company at the time when the company incurs a debt; and

1 It should be noted that sections 592(6) and 593(2) of the Corporations Act also deals with conduct known as fraudulent trading. These provisions have not been replaced and this means that these parts of sections 592 and 593 are still operative in regards to fraudulent trading notwithstanding that the debts were incurred after the 23 June 1993. However with regards to insolvent trading, a preliminary issue of ascertaining the date the debt was incurred must be made. If debts were incurred after 23 June 1993 in these circumstances sections 588G-588Z will apply. For debts incurred prior to this date in similar circumstances, sections 592(1)-(5),(7),(8), 593(1) and (4)-(8) apply.

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(b) the company is insolvent at the time of the incurring the debt or becomes insolvent by incurring that debt or by incurring at that time debts including that debt; and

(c) at the time there are reasonable grounds for suspecting the company was insolvent or would become insolvent as a result of the transaction; and

(d) that time is at or after the commencement of this Part, that is 23 June 1993.

Section 588G(3) provides that by failing to prevent the company from incurring the debt, the person will contravene the section if they were aware at the time that there are such grounds for so suspecting or a reasonable person in a like position in a company in the company circumstances would be so aware.

Further, section 588G(3) provides that a person commits an offence if:

(a) the company incurs a debt at a particular time; and

(b) at that time, the person is a director of the company; and

(c) 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

(d) the person suspected at the time when the company incurred the debt that the company was insolvent or would become insolvent as a result of incurring that debt or other debts; and

(e) the person’s failure to prevent the company incurring the debt was dishonest.

(a) If either section 588G(2) or (3) is satisfied, then section 588M can be used to enable a creditor to recover compensation for loss resulting from insolvent trading as long as section 588R or section 588S are satisfied.

It should be noted that both those who contravene the section and those "involved in the contravention" (section 79) can be caught.

Relevantly, section 588M provides that if:

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(a) a person (director) has contravened section 588G(2) or (3) in relation to the incurring of a debt by a company; and

(b) the person (creditor) to whom the debt is owed has suffered loss or damage in relation to the debt because of the company’s insolvency; and

(c) the debt was wholly or partly unsecured when the loss or damage was suffered; and

(d) the company is being wound up,

then a creditor may, if they have satisfied either section 588R or section 588S, recover from the director, as a debt due to the creditor, an amount equal to the amount of the loss or damage.

Section 588R enables a creditor to commence proceedings with the written consent of the company’s liquidator.

Section 588S enables a creditor to sue for compensation without the liquidator’s consent but only after giving notice to the liquidator.

Section 588M(4) provides that proceedings under section 588M may only begun within six years after the beginning of the winding up. Further, section 588M has the effect in addition to, and not in derogation of, any rule of law about the duty or liability of a person because of the person’s office or employment in relation to the company and does not prevent proceedings from being instituted in respect of a breach of such a duty or in respect of such a liability (section 588P).

According to para 1229 of the Explanatory Memorandum which accompanied these provisions:

"[A] court would be expected to look at two separate issues when considering whether the duty had been breached. The first matter would be what circumstances that particular company was in, including the size of the company, the type of the company, the nature of its enterprise, the provisions of its articles, the composition of its board and the distribution of work between the board and other officers. The second matter that a court would be expected to look at would be, in the light of the circumstances referred to, what would a reasonable person in the position of director normally be expected to do to ensure that he or she would be aware of any

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insolvency problem. In particular a court might expect the following:

that directors of a large company would ensure that among their number there should be one or more who are talented in the field of corporate financial management;

that directors of a large company should read, be able to understand and seek any necessary clarification of the key financial information put before the board, such as a balance sheet and a profit and loss statement;

that the board ensure that appropriately skilled people are engaged to carry out the company's accounting functions;

that the board would require relevant accounting information to be supplied ahead of regular board meetings at which key financial decisions are to be made, and that, where a significant borrowing is to be undertaken, the management should supply the board with a statement of the company's current financial position as well as the particulars of the way in which the principle, interest and other charges are to be serviced over the anticipated term of the loan;

that the board make arrangements for monitoring the use of any authorisation granted in relation to the use of the company seal, the entering into contracts with financiers or the signing of cheques and bills of exchange; and

where the nature of the business may expose the company to a high risk of sudden liquidity restriction, or the company is known by the director to be in a delicate financial position, that extra care and more rigorous safeguards may be adopted."

Importantly, there is nothing in section 588G which necessitates the winding up of the company as a precondition to activating the section, however it can be argued that the heading to Part 5.7 (including Part 5.7B in which sections 588G-588Z is located) of the Corporations Act makes it clear that section 588G is part of particular legislation concerned with the recovery of property or compensation after a winding up has begun. Furthermore some of the sections related to section 588G, such as sections 588M and 588R, reinforce the view that they operate only where the company is being wound up. In contrast, other related sections such as sections 588J and 588K, are not expressed to be contingent upon winding up occurring and it is arguable that these particular sections are not confined to winding up situations.

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Taking each of the elements in section 588G(1) in turn, the following can be stated:

(1) Directors

With respect to `directors', section 9 of the Corporations Act provides that a "director" would include any person occupying or acting in the position of director by whatever name called and whether or not validly appointed or authorised and any person in accordance with whose directions or instruc-tions the directors are accustomed to act - so called "defacto" directors. See Taylormaid Marine Industries Pty Ltd v Beaurepaire & Ors (1987) 5 ACLC 253. Further persons dealing with a company can assume that a person is a director in certain situations [sec 129].

The definition may also include alternate directors if called upon to act. See Playcorp Pty Ltd v Shaw & ors (1993) 11 ACLC 641.

(2) Incurring of a “debt”

Another requirement to found a cause of action under section 588G(1) is proof that "the company incurred a debt." This involves an examination of two requirements. First, what qualifies as a `debt' for the purposes of the section and secondly, what is involved in the `incurring' of a debt.

(a) The meaning of `debt'

The meaning of the word “debt” is not defined in the legislation. However it has been interpreted to bear its ordinary technical meaning as something recoverable by an action for debt and thus must be ascertained or capable of being ascertained: Ogden’s Ltd v Weinberg (1906) 95 LT 567; Hussein v Good (1990) 1 ACSR 710. Therefore, a “debt” refers to an obligation for the payment of money or money’s worth and there is authority to suggest that the obligation must be for an ascertained liquidated sum: 3M Australia Pty Ltd v Watt (1984) 9 ACLR 503; Jelin v Johnson (1987) 5 ACLC 463.

In CAC v Shapowloff (1974) CLC 27,964, the defendant, by telephone, allegedly ordered 5,000 shares from a broker on behalf of his company. The terms were that the company would pay for them only when the broker received the scrip. In other words, the liability remained contingent until the scrip was received. The broker obtained these shares in 29 transactions and 29 contract notes were forwarded to the company. The shares were not paid for and the company was wound up. The defendant was charged with knowingly being a party to contracting a debt provable in the winding up of that company having, at the time the debt

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was contracted, no reasonable or probable ground of expectation of the company being able to pay.

A declaration was sought from the Supreme Court. Before any evidence was taken, as to the meaning of the word `debt' in the section, Jacobs P in the Court of Appeal (1974) CLC 27,974 declared at 27,977:

"[T]hat for the purposes of sec 303(3) of the Companies Act where a series of contracts is made from time to time which result in a liability on behalf of the company to pay in respect of each of them, then each such liability constitutes a debt; and the time when each such debt is contracted is the time when each respective liability arises, and not the time or times when the balance is declared or computed."

The Magistrate, believed that contingent debts should be included within the meaning of the word "debt". Here liability arose when the contract notes were delivered to the company. This view was affirmed by Cantor J in the Supreme Court and by Mahoney JA in the Court of Appeal.

Notwithstanding these comments on contingent debts, it appears that some divergence of opinion has developed because of the lack of clarity in the section as to whether these debts are "debts" within the meaning of sec 592 Corporations Law. The section does not expressly state whether "debt" includes a contingent debt and this omission could lead to unsatisfactory results. Illustrative of these concerns is the Victorian Supreme Court decision in Hussein v Good (1990) 8 ACLC 390. In this case the defendant, a director of a clothing retail company ordered a range of clothing from the plaintiff, a manufacturer. The date of delivery was originally to be March 1988 but this, by agreement, was changed to 3 May 1988. Payment was to be made upon delivery.

Part of the total goods were delivered on 3 May 1988 but no payment was made. A few days later money was collected by the plaintiff, however one of the cheques used for payment was dishonoured. Before notice of dishonour was given, the remainder of the goods were delivered. No further payment was made.

On 16 May 1988 the defendant's accountant advised the defendant to put the company into voluntary liquidation. The company was placed under the control of a liquidator. The company was placed under the control of a liquidator. The plaintiff claimed against the defendant pursuant to section 556 of the Companies Code (now section 588G Corporations Act).

The Court held that the date to determine whether there were reasonable grounds to expect that the company could not pay all its debts as and when they became due was in May 1988 and that at that date the defendant did

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not expect the debt would be paid. A debt it was held,2 meant "what is owed, state of owing something". Here nothing was owed until the delivery of the manufactured garments.

According to Southwell J, Shapowloff was distinguishable from the present case:

"I see some difficulty in drawing an analogy between the particular circumstances surrounding transaction between a purchaser of shares and his agent, the broker, where the creation of a contingent liability can usually be expected to become a present indebtedness very quickly, perhaps upon the same day, and a case where, as in the present case, a trader in goods places an order with a manufacturer in circumstances where any contingent liability, if there was one, would not become a present indebtedness until some months thereafter."

The defendant unsuccessfully argued that the date on which the debt was incurred was November 1987, when the goods were ordered.

In Standard Chartered Bank v Antico (1995) 131 ALR 1 at 57 Hodgson J stated that:

“a company incurs a debt when, by its choice, it does or omit something which, as a matter of substance and commercial reality, renders it liable for a debt which it otherwise would not have been liable.”

Further, in ASIC v Plymin (No 1) (2003) 46 ACSR 126 Mandie J noted at 247:

“the weight of authority shows that a debt can be incurred when the contract giving rise to the debt is entered into, even if contingencies affect the debt or the debt is a future debt. In the case of a future debt, it may be incurred at the time of entering the contract if it is then an ascertained or an ascertainable amount. By the same token, a debt may in appropriate circumstances be incurred within the meaning of the section at a time later than the entry of the contract under which the debt arises or may arise. Although it is necessary to consider the terms of the relevant contract, the question when the debt is incurred within the meaning of this section does not depend on strict legal analysis but turns on when, in substance and commercial reality, the company is exposed to the relevant liability.”

In Australian Securities and Investments Commission v Edwards (2005) 2 (1990) 8 ACLC 390 at 397.

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220 ALR 148; 54 ACSR 583; [2005] NSWSC 831 Barrett J stated that incurring, a debt involves any "act, omission or other circumstance which causes the company to owe the debt”.

In Hawkins & ors v Bank of China (1992) 10 ACLC 588, it was held that "debts" can include a contingent liability3. According to Gleeson CJ:

"`Debt' is capable of including a contingent liability. The word was used in that sense in sec 291 of the Companies Act 1961, which referred to `debts payable on a contingency'. That expression did not involve a contradiction in terms. Dictionaries define `debt' as a liability or obligation to pay or render something. Such a liability may be conditional as well as present and absolute.

Likewise a contractual obligation to supply goods even after they have been paid for, will not constitute a debt for the purposes of the section. This is because as at the time of the contract all that could be claimed if the goods were not supplied would be an action for damages. "A potential liability for damages does not constitute the incurring of a debt for the purposes of sec 592."4

In Deputy Commissioner for Corporate Affairs v Abbott & Anor (1980) CLC 34,428 it was held that5:

"The word `debts' means something recoverable by an action for debt and nothing can be recovered in an action for debts except that which is ascertained or can be ascertained.; see Ogden's Ltd v Weinberg (1906) 95 L.T. per Lord Davey at p.567".

This view was accepted and followed by Master Seaman in Jelin Pty Ltd v Johnstone & Anor (1987) 5 ACLC 463 and it appears that the word is used in its ordinary sense6 and therefore claims for unliquidated damages7 and outstanding interest would be excluded8. In addition taxes which are due and payable and which may even be deemed to be debts owing to the crown are not `debts' for the purposes of section 588G9. However, claims for outstanding workers compensation premiums are debts within the 3 (1992) 10 ACLC 588 at 595. Kirby P also agreed at 599 with this

conclusion.4 Reed International Books Australia v King (1993) 11 ACLC 935 at

938.5 (1980) CLC 34,428 at p 34,430.6 See 3M Australia Pty Ltd v Watt & Anor; NEC Home Electronics

Australia Pty Ltd v White & Anor (1984) 2 ACLC 621.7 See Jelin Pty Ltd v Johnstone & Anor (1987) 5 ACLC 463.8 See BL Lange & Co v Bird (1991) 9 ACLC 1015.9 See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC

287.

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meaning of the section.10 Finally, the fact that a company's liability to pay a debt has been extinguished (subject to proofs of debt) upon a winding up, does not mean that directors and management will avoid liability11 as creditors have a vested right to sue the officer.

(b) The meaning of “incurring” a debt

Section 588G(1A) contains a “debt” table which is designed to assist ascertain the point in time when a debt was incurred. It is non-exhaustive.

Predecessor legislation covered situations where the defendant was knowingly a party to the contracting of a debt by the company. For example, the purchase of shares via a telephone order12; purchase of goods and services13; entering into contracts to help build project homes14; arranging for advances to be made to the company. The question is, is section 588G of the Corporations Act restricted to debts which have been contracted15?

In Jelin Pty Ltd v Johnson & Anor (1987) 5 ACLC 463, the plaintiff sought to recover damages from the defendant because it had been deprived of a judgment debt. This judgment debt was given by the Federal Court in relation to misleading statements made by servants of the company. The plaintiff submitted that the relevant debt was incurred either when the plaintiff introduced funds into the business on the faith of the misleading statements of the servants or agents or when the Federal Court gave its judgment. Master Seaman QC said that neither on the day on which the misrepresentations were made, nor on the day when judgment was given by the court awarding damages, nor on any day between these two days, did the company `incur a debt'16.

"The incurring of a liability in damages is not the same as `incurring a debt' under the section".

10 State Government Insurance Corp v. Pollock (1993) 11 ACLC 839.11 See Ross McConnel Kitchen & Co. Pty Ltd (in liq) v Ross & Ors

(1985) 5 ACLC 326 at 329.12 Shapowloff v Dunn (1981) ACLC 33,127.13 Deputy Commissioner for Corporate Affairs v Abbott & anor (1980)

CLC 34,428 and DeRossi v Hamilton (1982) 7 ACLR 40 and Flavel v Day (1985) 3 ACLC 320.

14 Southern Highlands Building Co. Pty Ltd (in liq) and the Companies Act (1979) ACLC 32,074.

15 Metal Component Industries Pty Ltd (in liq) v Clark & Anor (1980) ACLR 862.

16 (1987) 5 ACLC 463 at 465.

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A similar conclusion was reached in relation to a liability to pay taxation17.

In Hawkins & ors v Bank of China (1992) 10 ACLC 588 it was held that the giving of guarantee constituted the incurring of a debt. The liability incurred under the guarantee was to pay an already-accrued sum which was a liquidated amount. Even though it was unusual to say that the company may not have incurred a debt at the time when it had given the guarantee, nevertheless according to Gleeson CJ and Sheller JA it was proper to say that the company incurred a debt to the bank at some stage. Their Honours noted:

"[T]hat the words `incurs' and `debt' are not words of precise and inflexible denotation. Where they appear in sec 556 they are to be applied in a practical and commonsense fashion, consistent with the context and with the statutory purposes."

According to Gleeson CJ18:

"the word `incurs' takes its meaning from its context and is apt to describe, in an appropriate case, the undertaking of an engagement to pay a sum of money at a future time, even if the engagement is conditional and the amount involved is uncertain. Once it is accepted that `debt' may include a contingent debt then there is no obstacle to the conclusion that, in the present context, a debt may have been taken to have been incurred when a company entered a contract by which it subjected itself to a conditional but unavoidable obligation to pay a sum of money at a future time."

Kirby P adopted a similar view and held19 that:

"The act of `incurring' happens when the corporation so acts as to expose itself contractually to an obligation to make a future payment of a sum of money as a debt. The mere fact that such a sum of money will only be paid upon a future contingency does not make the assumption of the obligation any less `incurring' a `debt'."

Associated with ascertaining whether a company has incurred a debt is the concomitant task of being able to specify the particular time when the debt was incurred.

In Russell Halpern Nominees Pty Ltd v Martin & Anor20, the plaintiff company agreed to lease premises to two other companies. Rent was not 17 See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC

287 at 296.18 (1992) 10 ACLC 588 at 595.19 (1992) 10 ACLC 588 at 598.20 (1986) 4 ACLC 393.

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received and it was found that immediately before and at the time of entering into the agreement for lease, both tenants were unable to pay their debts as and when they fell due. A writ based upon sec 556 was struck out on the basis that it did not disclose a reasonable cause of action. The Supreme Court by majority, dismissed the appeal.

According to Burt CJ.21:

"[W]hatever the expression `incurs a debt' might mean, it is clearly descriptive of an act which when done by the company in the stated circumstances exposes a director of the company and a person who took part in the management of the company when the debt was incurred, [sic] when the act was done, to a criminal liability. The incurring of the debt by the company in the stated circumstances is the act which constitutes the offence created by the subsection and that act is done at a particular and identifiable point of time, [sic] `when the debt was incurred.' ... To hold otherwise would be to say that if a company when in all respects financially sound were to enter into a lease for a term of years and at some time thereafter and for reasons which could not be anticipated it were to fall on bad times and be unable to pay its debts, the directors would thereafter and on every rent day within the remainder of the term be guilty of an offence for the reason that on the rent day the company `incurs a debt'. I am unable to accept that".

(3) “Insolvent” at the time of the incurring the debt or becomes insolvent

The definition of “insolvency” is central to the operation of the insolvent trading provisions. Liability is not triggered under the insolvent trading provisions unless the company was insolvent at the time the particular debt was incurred, or became insolvent by incurring that debt or other debts: section 588G(1)(b).

Prior to 23 June 1993, no statutory definition of insolvency existed. However the Corporations Act now contains section 95A which provides definitions of both solvency and insolvency. Those definitions have been argued22 as representing:

“a particularly important reform … in relation to Part 5.7B because it refines and partly codifies the complex law surrounding the situation which arises when a company is insolvent.”

21 (1986) 4 ACLC 393 at 396.22 Pollard SM., “Fear and Loathing in the Boardroom: Directors

Confront New Insolvent Trading Provisions” (1994) 22 ABLR 392.

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Under section 95A(1) a person is deemed solvent, “if and only if, the person is able to pay all the person’s debts as and when they become due and payable.”

Under section 95A(2) a person who is not solvent is insolvent.

It has been held that the definition contained in section 95A suggests that a cash flow test is intended rather than a simple balance of assets over liabilities: Leslie v Howship Holdings Pty Ltd (1997) 15 ACLC 459. This was reinforced by Prior J in Powell v Fryer (2000) 18 ACLC 480 at 482 where his Honour stated that the primary cash flow test of insolvency was as follows:

“The commercial solvency of the company is not proved by merely looking at its accounts and making a mechanical comparison of its assets and liabilities. Insolvency is a question of fact falling to be decided as a matter of commercial reality in the light of all the circumstances with things being viewed as it would by someone operating in a practical business environment. The statutory focus is on solvency, not liquidity. Thus it is appropriate to consider the terms of credit or financial support available to the company with which to defray any debts owed to creditors. The question is not to be answered merely by looking at the financial statements.”

Similar views were expressed by Palmer J in Hall v Poolman (2008) 65 ACSR 123 and in Lewis v Doran (2004) 50 ACSR 175.

The definition of insolvency contained in section 95A differs from the pre-existing law which had developed around its predecessors in insolvency legislation as those predecessor provisions defined insolvency as an ability to pay the debtor’s debts “from his own monies”: see, for example, section 122 of the Bankruptcy Act 1966 (Cth) and section 451 of the Companies (NSW) Code 1981. However, those sections have had some influence over what is required to be satisfied to prove solvency. Cases such as Sandell v Porter (1966) 115 CLR 666 held that a debtor’s ability to pay “from his own monies”, as required by section 95 of the Bankruptcy Act 1966 (Cth), included an ability to raise money by its sale, pledge or mortgage of his assets. However, money obtained by unsecured borrowings was not treated by the Courts as the debtor’s “own money”: see Armour; Ex parte Official Receiver v Commonwealth Trading Bank (1956) 18 ABC 69 at 74; Kyra Nominees Pty Ltd (in liq) v National Australia Bank Ltd (1986) 4 ACLC 400 at 405; Norfolk Plumbing Supplies Pty Ltd v Commonwealth Bank of Australia (1992) 6 ACSR 61 at 615.

It appears to be the case that the Courts, prior to the enactment of

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section 95A of the Corporations Act were heavily in support of the view that the requirement that a debtor be able to pay “from his own money” in order to demonstrate solvency excluded from consideration the debtor’s ability to obtain unsecured loans.

The Exposure Draft Bill of the Corporate Law Reform Bill (Cth) published in February 1992, in the clause that ultimately became section 95A, defined insolvency as a debtor’s inability to pay his or her debts as they became due and payable “from his or her own money”. In the light of that, Palmer J noted in Lewis v Doran (2004) 50 ACSR 175 at 193-194, “it is legitimate to assume that the inclusion of those words was intended to convey that the case law which had developed around those words in prior insolvency legislation was to continue to be applicable”. However, when the Bill became law, the words “from his or her own money” were dropped and no explanation of why those words were omitted from section 95A as enacted is to be found in the Harmer Report or in the Explanatory Memorandum.

In Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation , (2001) 39 ACSR 305; (2001) 53 NSWLR 213 at [54] Palmer J summarised the law in this area by setting out the following principles23:

“i) whether or not a company is insolvent for the purposes of CA ss.95A, 459B, 588FC or 588G(1)(b) is a question of fact to be ascertained from a consideration of the company’s financial position taken as a whole: Sandell v Porter, Pegulan Floor Coverings Pty Ltd v Carter (1997) 24 ACSR 651 and Powell v Fryer;

ii) in considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable: Sandell v. Porter, Taylor v. ANZ, Newark and Sheahan v. Hertz.

iii) in assessing whether a company’s position as a whole reveals surmountable temporary illiquidity or insurmountable endemic illiquidity resulting in insolvency, it is proper to have regard to the commercial reality that, in normal circumstances, creditors will not always insist on payment strictly in accordance with their terms of trade but that does

23 Although Palmer J’s decision in that case was overturned on appeal, it was done so on grounds not impacting on the statements quoted.

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not result in the company thereby having a cash or credit resource which can be taken into account in determining solvency: Bank of Australasia v. Hall [1907] HCA 78; (1907) 4 CLR 1514, at 1528; Norfolk Plumbing at 615; Taylor v ANZ at 784; Guthrie v. Radio Frequency Systems Pty Ltd (2000) 34 ACSR 572, at 575;

iv) the commercial reality that creditors will normally allow some latitude in time for payment of their debts does not, in itself, warrant a conclusion that the debts are not payable at the times contractually stipulated and have become debts payable only upon demand: Antico at 331; Hall v Aust-Amec (supra); Melbase (supra) at 199; Carrier (supra) at 253; Cuthbertson & Richards Sawmills Pty Ltd v Thomas (supra) at 320; Lee Kong (supra) at 112;

v) in assessing solvency, the Court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the Court’s satisfaction, that:

• there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; or

• there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; or

• there has been a well established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors’ terms of trade or are payable only on demand:

vi) it is for the party asserting that a company’s contract debts are not payable at the times contractually stipulated to make good that assertion by satisfactory evidence: Powell v Fryer (supra) at 600; Melbase (supra); Cuthbertson & Richards Sawmills Pty Ltd v Thomas (supra).”

In Lewis v Doran (2004) 50 ACSR 175 Palmer J reiterated the above views by stating at 198:

“I think that I must approach the application of s.95A [of the

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Corporations Act] with two considerations in mind. First, the words of s.95A must be construed as they stand, without addition or subtraction. Second, the law both before and after the enactment of s.95A is unequivocally and emphatically clear that insolvency is, first and last, a question of fact “to be ascertained from a consideration of the company’s financial position taken as a whole. In considering the company’s financial position as a whole, the Court must have regard to commercial realities. Commercial realities will be relevant in considering what resources are available to the company to meet its liabilities as they fall due, whether resources other than cash are realisable by sale or borrowing upon security, and when such realisations are achievable.”

His Honour added at 199:

“In my opinion, the omission of the words “from its own monies” from the definition of insolvency in s.95A now leaves the Court free to determine the question of retrospective insolvency free of a qualification which might well be appropriate to determine only prospective insolvency. The omission leaves the Court free to determine insolvency, whether retrospective or prospective, as a question of commercial reality having regard to the particular facts of the case.”

Later in his judgment Palmer J stated (at 200)24:

“I conclude that section 95A of the Corporations Act has changed the pre-existing law as to the definition of insolvency as stated in cases such as Sandell v Porter, and that it is no longer necessary in order to assess solvency to ascertain whether the company is able to pay all of its debts “from its own monies”, in the sense discussed in those cases. In my opinion, section 95A requires the Court to decide whether the company is able, as at the alleged date of insolvency, to pay all of its debts as they become payable by reference to the commercial realities. If the Court is satisfied that as a matter of commercial reality the company has a resource available to pay all its debts as they become payable that it will not matter that the resource is an unsecured borrowing or a voluntary extension of credit by another party.”

Therefore it is the case that all cash resources available to a company 24 This was confirmed on appeal: see Lewis (as liquidator of Doran

Constructions Pty Ltd) v Doran (2005) 219 ALR 555; 54 ACSR 410. Special leave to appeal was refused by the High Court. The case was also approved in Reynolds v Neumedix Biotechnology Pty Ltd [2006] QSC 302.

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including credit resources are to be taken into account when assessing solvency: See Metropolitan Fire Systems Pty Ltd v Miller (1997) 23 ACSR 699. This would include promises of financial support: see Dunn v Shapowloff [1978] 2 NSWLR 235 and should include unsecured borrowings or voluntary extensions of credit. It could also be argued that it would include the anticipated proceeds of a fully underwritten equity raising.

It is to be noted however that the "commercial realities approach" appears to carry greater weight in New South Wales than it does in other states: see Emanuel Management Pty Ltd v Foster's Brewing Group Ltd (2003) 178 FLR 1, [2003] QSC 205; Powell v Fryer (2001) 159 FLR 433; 37 ACSR 589; [2001] SASC 59.

The test of insolvency in section 95A is directed towards paying all its debts as and when they become due and payable. The inquiry under section 95A, and consequently the inquiry under section 588G(1)(b), concerns the company’s ability to discharge all its debts rather than merely particular debts, on their respective dates of payment, at the time when a particular debt is incurred. It is therefore the case that liability can be established under section 588G(1)(b) without reference to the particular debt incurred if, at the time the particular debt was incurred, the company was unable to pay other debts.

In Fliway transport Pty Ltd v Soper (1988) 21 NSWLR 19; 14 ACLR 690; 7 ACLC 129, it was held that for a debt to fall due it must at least be recoverable by legal action and, it would appear, that mere inaction by a creditor in enforcing its rights against a debtor is not usually influence whether or not the debt has become due: Pioneer Concrete Ltd v Ellston (1985) 10 ACLR 289 at 301. However, if the creditor has allowed, or created a reasonable expectation for a period of grace for repayment, this may impact upon the determination of whether the debt has become due: Re Newark Pty Ltd (in liq) [1993] 1 Qd R 409 and therefore impact upon the debtor company’s insolvency. Thus it may be permissible to take into account a course of dealing between the parties: see also Manpac Industries Pty Ltd v Ceccattini (2002) 20 ACLC 1304; See also Southern Cross interiors Pty Ltd (in liq) v Deputy Commissioner of Taxation , (2001) 39 ACSR 305; (2001) 53 NSWLR 213.

Further, the inclusion of the words “as they become due” also indicates that insolvency must be determined with reference to a consideration of the company’s position over a period of time and not a particular instance: Re Universal Management Ltd (in liq) (1981) NZCLC 95-026. A temporary lack of liquidity does not always mean that the company is insolvent: see Hymix Concrete v Garrity (1977) 13 ALR 321. The Courts have recognized that the ability of the company to procure funding from other sources to meet its liabilities can be taken into account to

17

determine that the company is in fact solvent. However the authorities suggest that directors will need to prove that there was a legitimate basis for the belief that funds would become available.

In ASIC v Plymin (No 1) (2003) 46 ACSR at 386 a number of common indicators of insolvency were identified including the following:

(a)Continuing losses;

(b)Liquidity ratios below 1;

(c)Overdue Commonwealth and State taxes;

(d) Poor relationship with primary bank, including inability to borrow further funds;

(e)No access to alternative finance;

(f) Inability to raise further equity capital;

(g) Suppliers placing the company on cash- on-demand terms, or otherwise demanding special payments before resuming supply;

(h) Creditors unpaid outside trading terms;

(i) Issuing of post-dated cheques;

(j) Dishonoured cheques;

(k) Special arrangements with selected creditors;

(l) Solicitor’s letters, summonses, judgments or warrants issued against the company;

(m) Payments to creditors of rounded sums which are not reconcilable to specific invoices;

(n) Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

(a) Rebuttable presumptions of insolvency

A major difficulty in finding directors liable under the insolvent trading provisions has been proof of insolvency on the day that the particular

18

debt was incurred. It is sometimes the case that the financial records of the company are inadequate or they enable proof of insolvency on dates other than the one required. According to the Australian Law Reform Commission in its General Insolvency Inquiry25, in many situations,

“the liquidator is a stranger to the past business operations of the company, and is often confronted with considerable difficulty in affirmatively establishing that a company was insolvent at a time prior to the winding up, even though there may be every indication that this was the case.”

In order to overcome the problem and to assist in determining whether or not a company was insolvent at the time a debt is incurred or becomes insolvent by incurring that debt or by incurring at that time debts including that debt, section 588E(3) and 588E(4) of the Corporations Act contain two rebuttable presumptions of insolvency in civil recovery proceedings and, if applicable, reverse the onus of proof. Thus section 95A will only be relied on where the statutory presumptions of insolvency are unable to be relied upon or are able to be rebutted.

Section 588E relevantly provides:

Presumptions to be made in recovery proceedings (1)  In this section:

"recovery proceeding" , in relation to a company means:

…

a) proceedings for a contravention of subsection 588G(2) in relation to the incurring of a debt by the company including proceedings under section 588M in relation to the incurring of the debt but not including proceedings for an offence); or    

(2) …

(3)  If:

(a) the company is being wound up; and

(b) it is proved, or because of subsection (4) or (8) it must be presumed, that the company was insolvent at a particular time during the 12 months ending on the relation-back day (bold added);

it must be presumed that the company was insolvent

25 See Report number 45, volume 1 (1988), [290].

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throughout the period beginning at that time and ending on that day.

(4)  Subject to subsections (5) to (7), if it is proved that the company:

(a) has failed to keep financial records in relation to a period as required by subsection 286(1); or

(b) has failed to retain financial records in relation to a period for the 7 years required by subsection 286(2);

The company is to be presumed to have been insolvent throughout the period.

(5) …

(6) …

(7) …

(8) …

(9) A presumption for which this section provides operates except so far as the contrary is proved that the purposes of the preceding concerned.

Section 9 of the Corporations Act defines "relation-back day", (referred to above in section 588(3)(b)) in relation to a winding up of a company or Part 5.7 body, as meaning: (a) if, because of Division 1A of Part 5.6, the winding up is taken to

have begun on the day when an order that the company or body be wound up was made - the day on which the application for the order was filed; or

(b) otherwise - the day on which the winding up is taken because of Division 1A of Part 5.6 to have begun.

Division 1A of Part 5.6 of the Corporations Act sets out when a winding up is taken to begin. Section 513A within that Division deals with a winding up ordered by the Court under sections 233, 459A, 459B or 461. Section 513B within that Division however deals with a voluntary winding up and relevantly provides that where a company resolves by special resolution that it be wound up voluntarily, the winding up is taken to have begun or commenced:

“if, immediately before the resolution was passed, the company was under administration – on the section 513C day in relation to the administration.” (underlining added) (section 513B(b))

The “section 513C day” in relation to an administration of a company is

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the day on which the administration begins (see section 513C(b)). Therefore, under the presumption in section 588E(3), where it is proved that a company which is being wound up was insolvent at a particular time during the 12 months prior to the relation-back day, it is presumed that the company was insolvent from that time until the relation-back day.

(b) Reasonable grounds to suspect insolvency

Section 588G(1)(c) provides that a director of an insolvent company is exposed to liability for insolvent trading if, at the time the debts are incurred:

“… there are reasonable grounds for suspecting that the company is insolvent or would so become insolvent .”

The test described by section 588G(1)(c) is an objective one (Powell v Fryer (2001) 37 ACSR 589, at [76]-[77]) per Olsson J (with whom Duggan and Williams JJ agreed):

“… the state of knowledge of a particular director and any assessment which he may have made as to the ability of the company to pay its debts is irrelevant. The court must make its own judgment on the basis of facts as they existed at the relevant time and without the benefit of hindsight.

By reason of section 588G(2)(b) it is sufficient that a reasonable person in a like position in a company in the company's circumstances would be so aware. Regard is to be had to the facts and circumstances that the director ought to have known, as well as to the facts and circumstances that were actually known to him: Credit Corp Australia Pty Ltd v Atkins (1999) 30 ACSR 727 at 769.”

See also Hall v Poolman (2008) 65 ACSR 123 and Metropolitan Fire Systems Pty Ltd v Miller (1997) 23 ACSR 699; [1997] FCA 399.

According to Kitto J in Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266; 40 ALJR 13 at 303:

“A suspicion that something exists is more than a mere idle wondering whether it exists or not; it is a positive feeling of actual apprehension or mistrust, amounting to `a slight opinion, but without sufficient evidence' ... Consequently, a reason to suspect that a fact exists is more than a reason to consider or look into the possibility of its existence.”

Kitto J’s comments were endorsed by Palmer J in Hall v Poolman (2008)

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65 ACSR 123 at [234], where his Honour held that a suspicion of insolvency falls somewhere between a belief that insolvency exists, on the one hand, and a mere wondering whether it exists, on the other. Suspicion is a positive feeling of apprehension, an admittedly tentative belief, without sufficient evidence to form a concluded and supportable opinion.

Aligned with demonstrating whether there are reasonable grounds for suspecting that the company is insolvent or would so become insolvent, section 588G(2) provides for two distinct ways in which a director can be found to have had the requisite suspicion:

Actual awareness, that is if the person is aware at that time that there are such grounds for so suspecting; (section 588G(2)(a)) or

Where a reasonable person in that position would have been so aware (section 588G (2)(b)).

The test set out in section 588G(2)(a) is a subjective test. The test set out in section 588G(2)(b) is an objective test26.

Thus, if it cannot be established that the director had actual awareness of reasonable grounds for suspecting insolvency, a director can still be liable if a reasonable person in their position would have been aware. Whether a reasonable person in the director’s position would have been aware is assessed by the objective standard of a director of ordinary competence. According to Einfeld J in Metropolitan Fire Systems Pty Ltd v Miller (1997) 23 ACSR 699 at 703:

“[the test is] one of objectively reasonable grounds which must be judged by the standard appropriate to a director of ordinary competence… Questions of knowledge of and participation in the incurring of the relevant debt are now relegated to the status of factual matters which may arise should the directors seek to establish one of the statutory defences afforded by the legislation. The establishment of liability is therefore not contingent on elements personal to the respondents.”

26 A number of cases have reiterated this view in relation to predecessor legislation. See Shapowloff v Dunn (1981) ACLC 33,127 at 33,133 - 33,134; Pioneer Concrete Pty Ltd v Ellston (1985) 10 ACLR 289 at 301; 3M Australia Pty Ltd v Kemish (1986) 4 ACLC 185 at 187 and 191; Statewide Tobacco Services Ltd v Morley (1990) 8 ACLC 827 at 831; Commonwealth Bank of Australia v Friedrich & Ors (1991) 9 ACLC 946 at 953; State Government Insurance Corp v Pollock (1993) 11 ACLC 839 at 846; Rema Industries & Services Pty Ltd v Coad (1992) 10 ACLC 530 at 536-537; Carrier Air Conditioning Pty Ltd v Kurda (1992) 10 ACLC 773 at 775.

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In Australian Securities and Investments Commission v Plymin (No 1) (2003) 175 FLR 124; 21 ACLC 700; 46 ACSR 126 Mandie J held at [426]:

“What s 588G(2)(a) requires is proof of a subjective awareness by the director of grounds, whether or not the director had a "subjective suspicion" of insolvency, which grounds may be objectively be characterised as "reasonable grounds" for suspecting such insolvency.”

In the same case, his Honour held at [325] that:

“It would seem to follow ... the essence of a failure by a director to prevent a company from incurring a debt is a failure by that director to take all reasonable steps within his power to prevent the company from incurring such debt. The effect of the provisions, shortly stated, is that if the requirements of s 558G(1) are proved in circumstances where either subsection (a) or subsection (b) of s 588G(2) is also proved, a director will be taken to have failed to prevent the company from incurring the debt, unless it is proved that the director- took all reasonable steps to prevent the company from incurring the debt.”

In Elliott v Australian Securities and Investments Commission (2004) 10 VR 369; 22 ACLC 458; 48 ACSR 621; [the Victorian Court of Appeal considered at length the requirements of section 588G(2)] and held at [116]:

“It is in our view clear that the effect of s 588G(2) is that a director contravenes the section "by not preventing" or "by failing to prevent" a company from incurring a debt, and that a director will be taken to have so failed if debts are incurred by a company at a time when there are reasonable grounds for suspecting that the company is insolvent.”

At [117] the Court in Elliot said that section 588G(2) does not require proof that an individual director failed in his or her duty to take a step which would have been effective to prevent the company incurring the debt.

The inclusion of the term “in a like position in a company in the company’s circumstances” allows the court to have regard to a wide range of factors including, the size of the company; the type of business conducted by the company; the composition of the board; whether the director was an executive or non-executive director; the delegation of

23

functions and responsibilities between directors; the distribution of work between board members and management and professional qualifications and special expertise held by the director: see Commonwealth Bank of Australia v Friedrich (1991) 5 ACSR 115.

The time that awareness of the director is assessed is immediately before the particular debt was incurred: Metropolitan Fire Systems Pty Ltd v Miller (1997) 23 ACSR 699: 3M Australia Pty Ltd v Kemish (1986) 10 ACLR 371; 4 ACLC 185.

As noted above, the issue of whether or not there existed reasonable grounds to expect that the company can pay all its debts is determined objectively. Continuing in business at the risk of creditors or taking no steps to save the company from insolvency27, when the person knows that there is no objectively reasonable expectation of the company being able to meet its obligations, could bring about personal liability. This will be despite the fact that the director or person involved in management is working long hours so as to rehabilitate the company and that the reasons for the collapse of the company's business were substantially beyond their control28.

In Commonwealth Bank of Australia v Friedrich (1991) 9 ACLC 946, Eise was the honorary and part-time chairman of the National Safety Council of Australia Victorian Division (NSC), a non-profit company limited by guarantee. Friedrich was the chief executive officer of the NSC. The State Bank of Victoria lent money to the NSC at a time when its liabilities exceeded assets. However the NSC's accounts showed an excess of assets over liabilities. This was due to the fraudulent activities of Friedrich. The annual accounts for two successive financial years were the subject of qualified auditor's reports, which Eise had not seen and the directors' reports had been signed by Eise on the day of the annual general meeting and were purportedly approved by the board. In fact the board had not considered the matter. Subsequently the State Bank lent large sums of money to the NSC and through its legal successor, the Commonwealth Bank, lodged a claim against each member of the NSC board under sec 556(1) Companies Code 1981. All of the directors except Eise settled.

One of the three issues29 in contention was whether immediately before 27 Deputy Commissioner for Corporate Affairs v Caratti (1980) ACLC

34,155 at 34,158.28 Southern Highlands Building Co. Pty Ltd (in liq) and the Companies

Act (1979) CLC 32,074.29 The other two issues in contention were first, whether at the time

when the debts were incurred Eise did not have reasonable cause to expect that the company would not be able to pay all its debts as and when they became due and secondly, whether Eise could obtain relief under section 535(1) (now section 1318 Corporations Act)?

24

the time when each of the debts were incurred there were reasonable grounds to expect that the company would not be able to pay all its debts as and when they became due?

According to the Victorian Supreme Court, the existence of "reasonable grounds" for the purposes of sec 556(2) [sec 592(2) Corporations Law] is to be determined by a wholly objective test. Tadgell J stated30, that "the sub-section does not require proof that anyone would not have reasonable grounds to expect and it does not refer to the defendant's state of knowledge." The Judge added that31:

"[T]he plaintiff must prove facts which, immediately before the time when the company incurred the relevant debt, gave a person seeking properly to perform the duties of a non-executive director of that company reasonable grounds to say: `I expect that the company will not be able to pay all its debts as and when they become due'."

The situations where a defendant would have no reasonable or probable ground of expectation of the company being able to pay the debt can be summarised as follows:

1. Where an officer has not adverted to the matter and there exists an objective belief that there is no reasonable or probable ground of expectation.

2. Where the officer has a subjective expectation but there is no objective ground for this expectation.

3. Where the officer has a subjective expectation that the company cannot pay but there exists an objective expectation of being able to pay.

4. Where the officer does not care whether the debt will be paid and objectively there was no ground of expectation.

Statutory defences available to directors

Under predecessor legislation to section 588H, there were only two defences which were available to directors or managers to enable them to escape liability for insolvent trading. Those defences were: first, the debt was incurred without their authority or consent; or second, at the time when the debt was incurred, they did not have reasonable cause to expect that the company would not be able to pay its debts. The required

30 (1991) 9 ACLC 946 at 954.31 (1991) 9 ACLC 946 at p 955.

25

standard of proof of the defences provided by the predecessor section was on the balance of probabilities.

In Metal Manufactures Ltd v Lewis (1988) 6 ACLC 725, Mr and Mrs Lewis were the only directors of Primary Metals and Resources Pty Ltd (the company). In September 1993 the company had agreed to buy goods from the plaintiff and later it breached this contract resulting in an award of damages being made against it. However in September 1984, Primary Metals and Resources Pty Ltd was ordered to be wound up. The plaintiff thereupon sued Mr and Mrs Lewis under the then insolvent trading provisions contained in section 556 of the Companies (NSW) Code.

Mr and Mrs Lewis were the only directors of the company. Mr Lewis was its managing director and it was he who entered into the contract on behalf of the company with the plaintiff in his capacity as managing director. The court noted that it was not clear how or when Mr Lewis became managing director. At the time the contract was made the company could not pay its debts, but at no stage was Mrs Lewis involved in the day to day running of the business and was in fact only regarded as a "director for signing purposes only". Mrs Lewis had no knowledge of the particular debt to the plaintiff and whenever she made inquiries with Mr Lewis about possible difficulties of the company she was told not to concern herself. In particular Mrs Lewis did not know or even address the issue of whether the company could pay its debts.

Mr Lewis did not contest liability under section 556 of the Companies (NSW) Code and consented to the judgment, however Mrs Lewis raised the defence in sec 556(2)(a) and was successful before the trial judge. The plaintiff appealed. The Court of Appeal in a two to one majority dismissed the plaintiff's appeal. Kirby P was in dissent.

The question arose as to the liability of silent directors for contracts entered into by a managing director of their company. The trial judge, Hodgson J32, held that the defence in sec 556(2)(a) would be satisfied if a defendant proved first, that they did not participate in the incurring of the debt and secondly that none of the actual participants in incurring the debt had the defendant's express or implied authority or consent to incur the debt. On the issue of "inaction" by a defendant, the Judge said, if a defendant's inaction implies authority or consent, then the defence is not available, however this was not the case here. In the New South Wales Court of Appeal, McHugh JA described the giving of consent by a director as equivalent to the signifying of `approval or assent' to the incurring of debt whether that is done expressly or by implication. Furthermore his Honour described the concept of "authority" as involving both the knowledge or reason to suspect that a debt would be 32 (1986) 4 ACLC 739.

26

incurred and the power to prevent it from being incurred. Integral to this view was that "authority", had to relate to the specific debt incurred and not merely be an authority to incur debts generally. Knowledge or reason to suspect that a particular debt would be incurred had to be disproved on this view. Here it was said that Mrs Lewis could not have assented and furthermore she had no power to prevent the debt from being incurred.

Mahoney JA held that the word "without" in sec 556(2)(a) did not mean that Mrs Lewis had to forbid the making of the contract. What the word meant, his Honour said33, was simply "the absence of the relevant authority or consent." Importantly the judge rejected the view that liability could attach to a person simply because they let someone else act as managing director and therefore anything which the managing director did was done with that other person's authority or consent. In these circumstances Mrs Lewis did not consent or give her authority to the incurring of the debt.

In contrast to Metal Manufactures Ltd, is the Victorian Supreme Court decision in Statewide Tobacco Services Ltd v Morley (1990) 8 ACLC 827 (Supreme Court) and (1992) 10 ACLC 1233. In this latter case the critical question again was whether a silent director who left the conduct of the business entirely to another director could make out the defence under the then section 556(2)(a) of the Companies Code. The defendant also raised the defence under sec 556(2)(b) of the Companies Code.

The facts of Morley's case were as follows. KM Trading Pty Ltd was a small family company which ran tobacco kiosks in Melbourne. For the first twenty years of the company's existence it was controlled by Keith Morley, the company's governing director who was appointed pursuant to the articles. However in 1978 Ian Morley, who was Keith Morley's son, took over management of the business temporarily at the request of Mrs Morley, Ian Morley's mother. Keith Morley died in 1979 and soon afterwards there was an informal meeting between Mrs Morley, Ian Morley and his sister Jan Sloan. These three were now the only shareholders and directors of the company with Mrs Morley holding the majority of shares. At the request of Mrs Morley and her daughter, Ian Morley was asked to take control of the management of the company. Ian Morley agreed to this. Neither Mrs Morley or her daughter involved themselves in the day to day running of the business and Ian Morley did not keep them informed or provide them with annual reports. Ian Morley continued to run the business until the company was placed in liquidation in 1988.

Mrs Morley signed some returns, including the annual return and she made a directors' statement. At some stage whilst her son was in control Mrs Morley also signed a guarantee to the bank so as to secure overdraft facilities for the company. No directors' meetings were held and no formal 33 (1988) 6 ACLC 725 at 732.

27

dividends were paid although for a period of time Mrs Morley did receive $300 per week described as her living expenses. Mrs Morley knew that the company sold tobacco and like products to customers and that suppliers of these products sometimes extended time for the company to pay. She saw no invoices, statements or books of account and she did not ask to be provided with relevant financial information. As a result she was unaware of the company's inability to pay its debts.

A supplier of tobacco products supplied goods to the company at a time when the company was insolvent and this supplier was owed in excess of $165,000. This amount was still outstanding when the company went into liquidation. The supplier instituted proceedings against Mrs Morley for the recovery of this amount under section 556 of the Companies Code. Mrs Morley sought to avoid liability by reliance upon each of the statutory defences in section 556(2). Success in either would enable her to escape responsibility for the debt. The trial judge found that neither defence was made out. Ormiston J stated34:

"The conclusions I have reached may be summarised as follows. Where:

(1) a director, such as the defendant, takes no effective part in the management of a company which continues to trade while insolvent and, in particular, that director does not seek to obtain regular trading accounts of the company; and

(2) that director has participated in the conferring of general authority upon an executive director, employee or agent incurs debts to a creditor on behalf of the company in the course of the insolvency;

then the director will have committed an offence and may be liable to that creditor for those debts of the company pursuant to s.556(1) of the Code and is not entitled to rely on any of the defences under s.556(2)."

"In the context of this section, which requires proof of want of `authority', the authority in question is that which is conferred by the act of one or more directors, whether participating in the grant of the company's authority as a member of the board of directors or in his role as managing or executive director. If a director did not so participate in the conferring of authority, whether express or implied, only then can it be said that the particular debt was incurred `without his express or implied authority'. To conclude otherwise would ignore the realities of the day-to-day management of companies."

34 (1990) 8 ACLC 827 at 837.

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The judge noted that Ian Morley had not been appointed managing director pursuant to the articles, that Mrs Morley had power to determine her son's employment and knew that in the ordinary course of his duties her son was incurring debts of the very nature which were now under consideration. Ian Morley, it was held, had no more power than any other member "of the board who had the functions of management delegated to him by his fellow directors. He held no formal office under the articles and was dependent upon the continuation of the authority informally given by the other two directors. They were therefore jointly responsible and thus acted for this purpose as joint `principals'. If either of these directors, including Mrs Morley, changed their minds and acted accordingly to withdraw his authority, his authority would thereupon cease." In these circumstances she gave authority to her son to incur the debts35.

The Appeal division of the Supreme Court of Victoria agreed with this finding36. Mrs Morley gave her implied consent and therefore could not avail herself of the defence in sec 556(2)(a).

A similar decision occurred in Group Four Industries Pty Ltd v Brosnan (1992) 10 ACLC 1437. In this case Mr and Mrs Brosnan, were the only shareholders and directors of a company called Madras Pty Ltd (Madras) which acted as the trustee for the Brosnan Family Trust. The trust was a trading trust and its business was the sale and distribution of airconditioners. The plaintiff supplied airconditioning equipment between November 1985 and March 1986 to Madras and at the end of that period a balance of approximately $72,000 was owing to the plaintiff. Madras was wound up in April 1987. The plaintiff claimed that the defendants were jointly and severally liable for the amount by virtue of section 556 of the Companies (SA) Code.

At the time of these purchases from the plaintiff, Madras was insolvent. The trial judge37 found that Mr Brosnan was liable for payment of the debt but dismissed the case against Mrs Brosnan. The plaintiff appealed against this and the Full Court of the South Australian Supreme Court allowed the appeal.

Mr Brosnan ran the company although there was no formal appointment of him as managing director. He appeared to just take de facto control. Mrs Brosnan was sometimes involved in taking delivery of goods, she signed some cheques and did occasional banking. Every year she signed the 35 Ormiston J distinguished Metal Manufactures on this point because

in that case Mr Lewis was the managing director and there was no evidence that Mrs Lewis appointed or participated in the appointment of him.

36 (1992) 10 ACLC 1233 at 1241.37 (1991) 9 ACLC 1181.

29

company's annual return. Although Mrs Brosnan knew that the company was having financial difficulties at the time it incurred the debt to the plaintiff, she claimed that she did not know that it was insolvent at that time.

The Full Court approved of Morley's case and held that she could avail herself of the defence in section 556(2)(a) as she had consented to her husband incurring the debt. According to Olsson J, Mrs Brosnan had to show that she bore no relevant responsibility for the authority given to incur the debt and this could only be shown if the director did not participate as a member of the board or as managing or executive director, in the conferring of authority upon the person who incurred the debt. Debelle J noted that she took no step to attempt to prevent the incurring of the debt and by acquiescing, she gave implied authority or consent.

As a result of the decisions in Lewis, Morley and Brosnan it is apparent that the position in New South Wales is in conflict with the Victorian and South Australian position. The second defence which was previously available to directors appeared in section 592(2)(b). Pursuant to that section it must be proven that the defendant did not have a reasonable expectation that the company would not be able to pay its debts. The want of reasonable expectation needed to have been shown.

In Metal Manufactures Ltd v Lewis (1986) 4 ACLC 73938, the interpretation of section 556(2)(b) was argued in detail before the trial judge although not on appeal. In this case, Hodgson J held that the defence under sec 556(2)(a) had been established but not that under sec 556(2)(b). With regard to sec 556(2)(b), Hodgson J considered that, in determining whether a defendant has made out a reasonable cause within the meaning of the subsection, it was relevant to consider facts and circumstances known to the defendant and also facts and circumstances which, by reason of the defendant's duties, ought to have been known to the defendant. His Honour pointed out that in determining a defendant's state of knowledge39:

"... [O]ne can have regard to matters such as illness and absence of a person in order to decide whether or not he has reasonable cause to expect something, but I do not think one can have regard to a person's complete ignorance of his duties as a director of a company and his complete neglect of such duties."

Ormiston J in Statewide Tobacco Services Ltd v Morley (1990) 9 ACLC 827 took a similar approach. The question of a director's reasonable cause of 38 On appeal, the only question raised was the application of the first

defence.39 (1986) 4 ACLC 739 at 749.

30

expectation was, according to the Court, related to the extent of the inquiries that the director has made and should have made about the company's solvency. Ormiston J made it clear that director's should not be able to hide behind ignorance of the company's affairs which are of their own making, or, which has been contributed to by their failure to make further necessary inquiries. The judge went on to state that although directors are not required to have omniscience, each director is expected to take a diligent and intelligent interest in the information either available to them or which they might with fairness demand from the executives or other employees and agents of the company. The Full Court agreed with this interpretation.

In Group Four Industries Pty Ltd v Brosnan (1992) 10 ACLC 1437, Mrs Brosnan could not rely on the sec 592(2)(b) defence and emphasis was placed upon what a director ought to know and the facts which were known to Mrs Brosnan would have led any reasonable, intelligent person of average competence to suspect that all was not well with the company and to seek information. According to Olsson J "she was not entitled merely to sit back in self-imposed ignorance and then to seek relief based on that ignorance."

The above decisions still have relevance for the defences now contained in section 588H of the Corporations Act. This Act provides four defences to allegations of insolvent trading which, if established, would excuse a director from the consequences of insolvent trading. The defences are contained in section 588H(2), section 588H(3), section 588H(4) and section 588H(5) and are as follows:

First, it is a defence if it is proved that, at the time when the debt was incurred, the person had reasonable grounds to expect, and did expect, 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 (section 588H(2)).

Second, section 588H(3) 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

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B. expected, on the basis of 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.

Third, if the person was a director of the company at the time when the debt was incurred, it is a defence it is proved that, because of illness or for some other good reason, he or she did not take part at that time in the management of the company (s 588G(4)).

Fourth, it is a defence if it is proved that the person took all reasonable steps to prevent the company from incurring the debt (s 588G(5)).

Further, section 1317S enables the court to relieve a person wholly or partly from a liability to which the person would otherwise be subject where they have acted honestly and having regard to all the circumstances of the case, the person ought fairly to be excused from the contravention.

Section 1318 is a similar provision to section 1317S and it enables the court to relieve a person wholly or partly from liability where, in civil proceedings for negligence, default, breach of trust or breach of duty, it appears to the court that the person has acted honestly and having regard to all the circumstances of the case the person ought fairly be excused for that negligence, default or breach.

Looking at two of these defences the following can be said:

Section 588H(2)

It is a defence if it is proved that, at the time when the debt was incurred, the person had reasonable grounds to expect, and did expect, that the company was solvent at that time and would remain solvent even giving incurred that debt and any other debts that it incurred at that time.

There are therefore two essential elements to establishing that defence:

(a) The requirement that there be reasonable grounds to expect the company will remain solvent; and,

(b) That the director did, in fact, have that expectation.

In determining whether a director had reasonable grounds to expect the company was solvent, an objective standard is applied to the facts known

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to the defendant.

The word “expectation” is taken to mean a higher degree of certainty than a mere hope possibility or suspicion: 3M Australia Pty Ltd v Kemish (1986) 10 ACLR 371; 4 ACLC 185. According to Austin J in Tourprint International Pty Ltd (in liq) v Bott (1999) 32 ACSR 201, at [67] an “expectation” of solvency, as required by the section, means:

“… a higher degree of certainty than ‘mere hope or possibility’ or ‘suspecting’. The defence requires an actual expectation that the company was and would continue to be solvent, and that the grounds for so expecting are reasonable. A director cannot rely on a complete ignorance of or neglect of duty and cannot hide behind ignorance of the company's affairs which is of their own making or, if not entirely of their own making, has been contributed to by their own failure to make further necessary inquiries.”

Einfeld J made a similar point in Metropolitan Fire Systems Ply Ltd v Miller (1997) 23 ACSR 699 at 703. In that case his Honour held (at 703) found that the phrase requires that the directors have reasonable grounds for being confident that the company is solvent.

Therefore the defence requires the director to establish not only an expectation that the company was and would continue to be solvent, but that the grounds that that expectation were reasonable. In practical terms this means that the expectation of solvency must outweigh any factors which would give rise to a suspicion of insolvency.

In order for the defence to succeed, there must be an expectation, held on reasonable grounds, that recourse to assets will enable debts to be paid, not at some indefinite time in the future, but so as to keep the companies solvent according to the definition in section 95A, namely, as the debts fall due for payment. According to Palmer J in Poolman v Hall, it is not appropriate to base an expectation of solvency:

“… upon the prospect that [the company] might trade profitably in the future thereby restoring its financial position. … The question is whether the company at the relevant time is able to pay its debts as they become due not whether it might be able to do so in the future if given time to trade profitably …”: Sheahan v Hertz Australia Pty Ltd (1995) 16 ACSR 765, at 769; Powell v Fryer (supra) at [75].”

Palmer J also stated the following in Poolman:

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“The law recognises that there is sometimes no clear dividing line between solvency and insolvency from the perspective of the directors of a trading company which is in difficulties. There is a difference between temporary illiquidity and “an endemic shortage of working capital whereby liquidity can only restored by a successful outcome of business ventures in which the existing working capital has been deployed”: Hymix Concrete Pty Ltd v Garritty (1977) 2 ACLR 559, at 566; Re Newark Pty Ltd (in liq); Taylor v Carroll (1991) 6 ACSR 255. The first is an embarrassment, the second is a disaster. It is easy enough to tell the difference in hindsight, when the company has either weathered the storm or foundered with all hands; sometimes it is not so easy when the company is still contending with the waves. Lack of liquidity is not conclusive of insolvency, neither is availability of assets conclusive of solvency: Expo International Pty Ltd (in liq) v Chant [1979] 2 NSWLR 820, at 837.

Where a company has assets which, if realised, will pay outstanding debts and will enable debts incurred during the period of realisation to be paid as they fall due, the critical question for solvency is: how soon will the proceeds of realisation be available: see the authorities cited at para 187 above. Bearing in mind the commercial reality that creditors will usually prefer to wait a reasonable time to have their debts paid in full rather than insist on putting the company into insolvency if it fails to pay strictly on time, I think it can be said, as a very broad general rule, that a director would be justified in “expecting solvency” if an asset could be realised to pay accrued and future creditors in full within about ninety days.

The position becomes murkier the less certain are the outcomes. The market value of the asset may not be ascertainable until the market is tested, so that it is not certain that the realisation will pay in full both existing debts and those to be accrued during the realisation period. The time at which the proceeds of realisation become available may depend upon the state of the market and the complexity of the transaction.

There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors: “How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than

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not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?

If the honest and reasonable answer is “certain” or “probable”, the director can have a reasonable expectation of solvency.

If the honest and reasonable answer is anywhere from “possible” to “no way of knowing”, the director can have no reasonable expectation of solvency.

If the honest and reasonable answer is “more likely than not”, the director runs the risk that a Court will hold to the contrary in an insolvent trading claim.

If the honest and reasonable answer is “no way of knowing yet, we need more information”, the director must then ask: “How long before we have the information so that we can give a final answer?”

If the honest and reasonable answer to that question is: “By a definite date which will not extend the realisation period (if there is to be one) beyond three months”, the director may reasonably say: “Let’s wait until then before deciding”.

If the honest and reasonable answer is “there is no way of knowing yet when we will have the information to make a decision”, the director must say: “Then there is no way that we can now have a reasonable expectation of solvency and there is no way we can reasonably justify continuing to trade without knowing when we will know whether the company is insolvent. Call the administrators”. By this series of questions and answers I do not mean to lay down some pro forma test of directors’ liability for insolvent trading. Each case depends on its particular facts. These questions and answers merely serve to illustrate that when a company is struggling to pay its debts, the directors must face up to the issue of insolvent trading directly and with brutal honesty: they must not shirk from asking themselves the hard questions and from acting resolutely in accordance with the honest answers to those questions.”

Section 588H(3)

The defence in section 588H(3) allows a director to escape liability under the insolvent trading provisions if he or she expected that the company was solvent at the time the debt was incurred as a result of relying on

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information provided by a competent and reliable person who was responsible for providing information pertaining to the solvency of the company. According to the Australian Law Reform Commission40, the defence is intended to encourage directors to ensure that proper and adequate financial management systems are in place and thus promote legal compliance.

This defence has two limbs, each of which must be satisfied. Section 588H(3)(a) requires a director to establish his or her belief in the existence of a proper and adequate system for managing and monitoring the financial status and solvency of the company. It also requires a belief that the delegate responsible for those matters was continuing to fulfil that responsibility. These beliefs must be based on reasonable grounds. The focus of this limb is not on ascertaining whether the delegate is in fact competent and reliable, but that the director actually believed on reasonable grounds that this was the case.

Section 588H(3((b) requires the director to establish their expectation of continuing solvency on the basis of information provided by the delegate.

If it is accepted that any of the defences in section 588H have been made out, than the applicant’s claim in so far as it is based on insolvent trading will fail.

Section 1317S and 1318

Thus if the Court rejects the application of both of the pleaded defences contained in section 588H, then directors may need to rely on section 1317S and 1318 to avoid liability.

Section 1317S provides a basis for relief from liability under a civil penalty provision where the person has acted honestly and the person ought fairly to be excused in the circumstances of the case.

Section 1318 allows the court to relieve certain persons from liability in civil proceedings for negligence, default, breach of duty or breach of trust, if the person establishes that he or she acted honestly, and that he or she ought fairly to be excused for the negligence, default, breach of duty or trust having regard to all the circumstances of the case. And application pursuant to section 1318 was rejected in Kenna and Brown Pty Ltd (in liq) v Kenna (1999) 32 ACSR 430.

An order under either section is discretionary.

40 Australian Law Reform Commission, General insolvency Inquiry (1988), Vol 1, [307].

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CONSEQUENCES FOR INSOLVENT TRADING WHERE THE STATUTORY DEFENCES DO NOT APPLY

Criminal penalty

A breach of the duty to prevent insolvent trading will constitute a criminal offence only if the director has permitted insolvent trading knowingly and with a dishonest intention (section 1317FA).

Civil penalty order

As section 588G is expressed to be a civil penalty provision under section 1317DA, an application for a civil penalty order may be made to the Federal Court or Supreme Court (sec 1317EA) by any one of the following entities (sec 1317EB):

(a) ASIC;(b) a Commission's delegate; or (c) some other person authorised in writing by the Minister.

If the Court finds on the balance of probabilities (section 1317ED (1)) that a person has contravened section 588G, the Court must declare that the person has contravened the provision (section 1317EA (2)) and, in addition, it has a discretion to make an order prohibiting the person from managing a corporation for a specified time and or requiring the person to pay the Commonwealth a pecuniary penalty not exceeding $200,000 (sec 1317EA (3)(a) and (b)). Where an order is made that a person is not to manage a corporation this order must be complied with (section 1317EF) and any penalty is payable to ASIC and is enforceable by ASIC or the Commonwealth as if it were a judgment of the Court (section 1317EG).

An application for a civil penalty order cannot be made more than six years after the contravention (sec 1317EC).

Compensation

When ordered by the Court when a civil penalty has been applied for:

Whether or not a Court makes a civil penalty order, the court can order a person against whom a civil penalty order is sought to pay compensation to the company (section 588J (1)). The Court can do that when satisfied on the balance of probabilities (section 1317ED) that:

(1) the person committed a contravention of section 588G in relation to the incurring of a debt by a company; and

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(2) the debt is wholly or partly unsecured: and

(3) the person to whom the debt is owed has suffered loss or damage in relation to the debt because of the company's insolvency.

Compensation is set at equal to the amount of loss or damage suffered by the person and is payable to the company rather than the person who suffered the loss or damage which gave rise to the liability.

An application for a civil penalty order would normally be made by ASIC (section 1317EB (l)), however the liquidator has an entitlement to be heard only if the court is satisfied that the person committed a contravention of section 588G and only on the question whether the Court should order compensation to the company (section 588J (3)).

It must be emphasised that compensation is payable to the company not to the person who has suffered the loss or damage.

When ordered by a court of criminal jurisdiction:

If a Court finds a person guilty41 of an offence by contravening section 588G of the Corporations Act in the circumstances set out in section 1317FA (1) that is, knowingly, intentionally or recklessly and either:

dishonestly and intending to gain an advantage; or

intending to deceive or defraud someone,

the Court may order the person to pay compensation to the company if it is satisfied that the debt is wholly or partly unsecured and the person to whom the debt is owed has suffered loss or damage in relation to the debt because of the company's insolvency (section 588K). The amount of compensation will be equal to the loss or damage and it may be ordered whether the Court imposes a penalty. The time limit for criminal proceedings is five years from the act or omission constituting the offence unless the Minister extends the period (section 1316).

When ordered by a Court after a liquidator applies:

A person may be liable to pay compensation in the circumstances set out in 41 Finding a person guilty of an offence will occur, if and only if, the

court convicts the person or where the court finds the offence proven but does not proceed to convict (section 73A).

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section 588M when proceedings are commenced by the company's liquidator. Under this provision:

where a director has contravened section 588G; and

the creditor to whom the debt is owed has suffered loss or damage in relation to the debt because of the company's insolvency; and

the debt was wholly or partly unsecured when the loss or damage was suffered; and

the company is being wound up;

then whether or not the director has been convicted of an offence in relation to the contravention or whether or not a civil penalty order has been made against the director, the liquidator may recover from the director an amount equal to the amount of the loss or damage, as a debt due to the company. Proceedings under this section may only be begun within six years after the beginning of the winding up.

When ordered by a Court on application of the creditor:

In addition to liquidators having rights against directors in these circumstances, creditors may also be able to claim compensation. The Act provides that creditors of companies that are being wound up, may, with the consent of the liquidator, begin proceedings in relation to the incurring by the company of a debt that is owed to the creditor (section 588R). Such creditors may give to the company's liquidator written notice within six months of winding up indicating that they intend to bring proceedings under section 588M in relation to a specified debt and requesting the liquidator's consent (section 588S). Where consent by the liquidator has not been given within three months of a request from a creditor, the creditor may apply to the Court for leave to commence the action under section 588M (section 588T).

However a creditor of a company that is being wound up cannot begin proceedings under section 588M if:

(a) the liquidator has applied to the Court in relation to the debt being a voidable transaction under section 588FF; or

(b) the liquidator has commenced proceedings under section 588M; or

(c) the liquidator has intervened in an application for a civil penalty order against a person in relation to the incurring of the debt in relation to a contravention of section 588G. (section 588U).

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It should be noted that there cannot be double recovery by both a creditor and the liquidator (section 588N).

Compensation ordered by the Court in all these circumstances is not available to pay secured debts unless all the unsecured debts have been paid in full (section 588Y(1)).

HOLDING COMPANY LIABILITY

Liability is also imposed upon holding companies for insolvent trading committed by subsidiaries42. Where a holding company permits one of its subsidiaries to trade while insolvent, then the subsidiary's liquidator may recover from the holding company amounts equal to the amount of loss or damage suffered by the unsecured creditors of the subsidiary.

Under Division 5 of Part 5.7B of the Corporations Act, a company contravenes section 588V if:

the company is a holding company at the time when the subsidiary incurs a debt; and

the subsidiary is insolvent at that time, or the subsidiary becomes insolvent by incurring that debt or by incurring at that time debts including that debt; and

there are reasonable grounds at the time for suspecting that the subsidiary is insolvent or will become insolvent; and

that either the holding company or one or more of its directors were aware of these grounds or, having regard to the nature and extent of the corporation's control over the subsidiaries affairs, it is reasonable to expect that a corporation in the holding company's circumstances would have been aware of those grounds or that one or more of the holding company's directors would have been aware of those grounds; and

that time is at or after the commencement of this Part, that is 23 June 1993.

The test involves an assessment both of whether reasonable grounds exist and whether the holding company or one of its directors should have been aware of those grounds. A corporation which contravenes the section is 42 Liability of a holding company for the insolvent trading of a

subsidiary is set out in section 588V of the Corporations Act. Recovery of compensation is contained in sections 588W, 588Y and 588Z.

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not guilty of an offence but civil penalties can be imposed (section 588V(2).

A liquidator of a subsidiary can take proceedings against the holding company to recover for the benefit of the unsecured creditors of the subsidiary, loss or damage suffered. The limitation period for these proceedings is six years (section 588W(2)).

Holding company defences

A holding company does have defences to an action commenced under section 588V. These defences are contained in section 588X of the Corporations Act and provide:

(a) if it is proved that when the debt was incurred the holding company and each relevant director had reasonable grounds to expect, and did expect, that the company was solvent at the time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time, then a defence will have been made out (section 588X(2)).

(b) it is a defence if it is proved that, at the time when the debt was incurred, the holding company, and each relevant director:

had reasonable grounds to believe, and did believe:

that a competent and reliable person was responsible for providing to the holding company adequate information about whether the subsidiary was solvent; and

that the person was fulfilling that responsibility; and

expected, on the basis of the information provided to the holding company by the person, that the company was solvent at the time and would remain solvent even if it incurred that debt and any other debts that it incurred at that time (section 588X(3)).

(c) if it is proved that, because of illness or for some other good reason, a particular relevant director did not take part in the management of the holding company at the time when the company incurred the debt, the fact that the director was aware is to be disregarded (section 588X(4)).

(d) it is a defence if it is proved that the holding company took all reasonable steps to prevent the subsidiary from incurring the debt (section 588X(5)).

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