Corporations Law - Directors Duty to Prevent Insolvent Trading, Defenses for Directors - Case Study Example

Corporations Law Name Tutor Institution Course Date Introduction The Australian corporate law defines a limited company as a legal entity, separate from its directors and it is formed through legislation. It therefore has a right to own property, it can enter into contracts and has the ability to sue and be sued as an entity separate from its directors. Most people are motivated to form companies because of the limited liability that it allows its shareholders. The shareholder can in case of any thing only lose what he or she has contributed to that corporate entity as shares. This is referred to as the corporate veil. However, there are circumstances that may lead into lifting of this veil of corporation. The lifting of the veil is known as piercing the veil. In such circumstances, the shareholders will be held responsible for the obligations of the company. Such circumstances include insolvent trading where the company is not in a position to pay its debts1. Directors’ duty to prevent insolvent trading According to Corporations Act 2001 - Sect 95A, a company is said to be insolvent if it is not able to pay its debts when they are due for payment. At such situations, the directors should not allow the company to continue trading as it is required of them by the Corporations Act. Trading under such circumstances is referred to as insolvency trading and it has legal consequences. Directors of a company that continues with insolvent trading may be held personally responsible for all the debts that the company incurs from all the transactions done during the time of insolvency2. According to Section 588G of the Corporations Act, a company is accused of insolvent trading when it continues to incur debts while still at the state of insolvency. The claims of insolvency trading are usually made against the directors for the breach of the Corporations Act since it is considered that the directors knew that the company is not in a position to pay debts but knowingly allowed it to continue incurring other debts. Section 588G of the Corporations Act states that it is duty of the directors to prevent the company from engaging in insolvent trading if at all the person is a director during the time that the company incurs the debt, or the company is insolvent during that particular time, or incurring that debt will make it insolvent or where the director reasonably suspects that the company is insolvent or the debt may render it insolvent if incurred3. In case the directors contravene the section, section 588M states that they should settle all the claims made against the company and offer the necessary compensation4. However, there are various defense options available for the directors who had reasonable grounds to expect and indeed they expected that the company was solvent, the director had received information from a competent and reliable subordinate that had made him believe that the company was not solvent, or if the director was sick or was not involved in the management of the company during that time or he took all the necessary steps to prevent insolvent trading. Defenses for Directors OHS being a limited company, it means that the directors have been enjoying the corporate veil. A corporate veil is a legal provision that separates the company from the shareholders such that the directors cannot be held liable for the debts incurred by the company and its other obligations. However, under certain circumstances, the corporate veil can be lifted through a court process. Some of the reasons that may lead to lifting of the veil include a situation where the directors could have suspected that the company was insolvent at the time of incurring the debt or that incurring that debt would render it insolvent. However, the court must establish reasonable grounds to indicate that the company was in such a state. In Credit Corp Pty Limited & Ors v Atkins & Anor ((1999), a number of creditors laid claims against the director of a company Mrs Atkins, that had failed to settle their debts wanting them to be held personally responsible for those unpaid debts. Justice O’Loughlin looked at the case from the point that Mrs Atkins was not the one who personally incurred the debts, she also did not have reasonable knowledge on the situation of the company but she had a reasonable belief5. Referring to Group Four Industries v Brosnan (1992), Justice O’Loughlin declared that there are those facts about the company that Mrs Atkins ought to have known. These include the company’s financial affairs such as its relationships with the creditors if at all she was carrying out her director duties well6. Lifting the corporate veil affects both the executive and non-executive directors. Executive directors are that director who are full time engaged in an organization’s day-to-day activities of the company and is involved in decision making. Non-executive director is not part of the day-to-day management of the company but takes part in planning and policy making. In ASIC v Plymin, Elliott and Harrison, the presiding judge Justice Mandie ruled that one of the non-executive directors John Elliot had failed in his duty to prevent the company from incurring further debts while it was insolvent. He was found to have contravened section 588G of the corporations Act7. Lifting the corporate veil means that the directors should take the responsibility over the debts incurred by the company. The creditors have a right to go after the personal properties of the directors in order to settle their debts. However, the court can impose the responsibility on those directors found responsible. The directors are however required to compensate the creditors an amount equal to the incurred debts and for the losses that may have resulted from insolvent trading. PART B OHS directors and Duty to prevent insolvent trading Section 588G of the Corporations Act states that it is the duty of the directors and other officers in the company to prevent insolvent trading. Section 9 of the Corporations Act defines that the “director” includes those who have been appointed, those acting in the director’s position, called de facto directors, and those accustomed to act according to the wishes or instructions from the directors of the company, called the shadow directors8. The duty under section 588G therefore applies to the appointed directors, those that they appoint, and those acting in the capacity of the director or who act in accordance to the director’s instructions9. Requirements of the duty According to section 588G, the duty of the directors to prevent insolvent trading applies to the persons who were already directors by the time the debt was incurred by the company, the company incurs the debt while it is already in an insolvent state or the incurred debt leads the company into becoming insolvent, by the time that the company incurred the debt, the directors had reasonable grounds to suspect that the company is insolvent or would become insolvent, and also if the director or a reasonable person in a similar position is aware of the insolvent situation of the company by the time the debt is being incurred10. Consequences of breaching the duty If the court finds that a director has contravened the provisions of the Act, there are three orders that the court can make. The fist one is the compensation order which requires that the director be held personally liable for the debts. He is therefore required to compensate the creditors an amount equal to the losses that they suffered in the act of insolvent trading. The second one is the pecuniary penalty order which is imposed to the director if the court finds that director’s failure is serious or it brings material prejudice to the interests of the company. This order requires the director to pay $200,000 to the Commonwealth. The third order is disqualification of the director from managing the company for a period that the court considers appropriate11. Insolvent trading in OHS Solutions Pty. Ltd In the case of OHS solutions, insolvent trading happened when Des, the managing director of the company entered into an advertising contract with Promotions Plus Pty. Ltd while the company had not yet fulfilled the contract it had signed with Troubleshooters. The company had a large account from Trouble Shooters that was long overdue. The company also had not advertised for two other companies and the two were threatening to sue for the breach of contract. Therefore the company had already incurred debts from Troubleshooters, there were two companies reported by Satish whose contract had not been fulfilled and on top of that, Des had gone ahead to sign a $10,000 advertising contract with Promotions Plus Pty. Ltd. All this amounts to insolvent trading because the company already had due and unpaid debts but has continued to trade and sign new contracts with other clients. In ASIC v Plymin, Elliott and Harrison, the presiding judge, Justice Mandie declared that the test for a company’s insolvency is the cash flow test. That is, ability of the company to pay debts when they are due. OHS therefore had an overdue debt from troubleshooters that had not been paid12. Roles of OHS directors in breaching the Duty to prevent insolvent trading Looking at the various roles played by OHS directors in this case, they had failed in their duties to prevent insolvent trading. Below is an analysis of the roles played by each director, their duties and the defense available for them. Des: He was the managing director of the company during that time. He had signed a $10,000 advertising contract with Promotions Plus Pty. Ltd following assurance by Satish that the IT problems had been fixed since the company had engaged Troubleshooters. Being a director of OHS by the time it incurred the debts, S588G of the Corporation’s Act gives Des a duty to prevent it from engaging in insolvent trading. Following s588G(2), Des could face a civil penalty because there were grounds for suspecting that the company was insolvent, and that there were reasonable persons in a position to suspect that the company was insolvent. In Quick v Stoland, the case involved finding out whether there were reasonable grounds to suspect that the company was insolvent during that period. The court used the company accounts as evidence which indicated that the company could not have been able to pay its debts at that moment. It therefore declared that a direct must continuously monitor the financial affairs of the company13. Considering this ruling, Des therefore failed in his duty to prevent insolvent trading which he could have suspected by looking at the company’s books of accounts which had an overdue account from Troubleshooters. The only defense available for Des is s588H(3) that the person responsible provided information that made him believe that the company was solvent, that is, Satish. However, the court could dispute that because Satish was in charge of IT and not the company’s finances. Emma: she was a non-executive director of the company’s finance. According to s588G(2), a civil penalty could be applied to Emma because she was aware of grounds for suspecting that the company was insolvent since she was the finance director. Emma was also aware that there were two businesses that had paid to advertise on their website but this had not been fulfilled and that they were threatening to sue for breach of contracts. This was following the reports that had been given by Satish. In this case, Emma may not qualify for any of the defense options that are provided by section 588H. Being a non-executive director, she is supposed to monitor the company and exercise independent judgment based on the information availed to her or which she has demanded from employees of the company. This is according to Justice Mandie’s ruling in ASIC v Plymin, Elliott and Harrison. In the ruling, Justice Mandie stated that an executive director has a duty ensure that he/she has adequate and competent information regarding a company’s financial position. The court may find her to have contravened the civil penalty provisions and may hold her personally responsible. She may be required to compensate the creditors or the court may also disqualify her from managing the company14. Satish: he was an executive director in the company and was also employed to run the technological side of the business. He was therefore at the centre of the problem that led to insolvent trading in OHS solutions because he should have reported that the technological problems had not been fixed. Satish had also told Des that the IT problems had been fixed after engaging Troubleshooters. Therefore Des went ahead to sign a $10,000 advertising contract with Promotions Plus Pty. Ltd. This is what amounted to insolvent trading at OHS Ltd. S588G(3) of the Corporations Act states that it is a criminal offence where a director acted in dishonesty in failing to prevent insolvent trading. Following this section, Satish acted in dishonest by assuring Des that the problems had been fixed. His contravention being a criminal offence, Satish may not have any defence for his case and may therefore take the three possible orders from the court. Ying: he is a non-executive director of OHS Ltd and a friend of Des. He is the director of Support Pty. Ltd, a company that owns equal amount of shares as other directors. The company has acted as a guarantor for a $50,000 loan from the Business Bank Ltd. to OHS Solutions. Section 9 of the Corporations Act mentions a “close associate” of a director of the company whom it defines as a relative or a spouse of the director who may have caused the company to enter into an unreasonable transaction15. This however rules out Ying in OHS Ltd’s case of insolvent trading because he was not involved when the company was carrying out those various transactions. According to the Corporations Act, a guarantor is a separate entity between the creditor and the director. There is therefore no action that may make a creditor hold a guarantor liable. Even if the company is in a state of insolvency or liquidation, this cannot hinder guarantee to be exercised. Conclusion The Corporations Act has shed enough light on the issues of insolvent trading and the consequences that it attracts if the directors let it to happen in their companies. The act has explained the veil of incorporation as treating the company as a separate legal entity from its directors. However, it is the responsibility of the directors to ensure that the company does not get engaged in unlawful transactions that may lead to lifting or piercing of this veil. Insolvent trading is one of the unlawful operations that a company may engage in that may lead to lifting of the corporate veil. Section 588G of the Corporations Act outlines the duties of the company directors in preventing the company from engaging in insolvent trading. Each type of a director, both executive and non-executive and also some offices of the company have a duty in protecting the company from engaging in insolvent trading. The Act also outlines the consequences that each person faces by breaching the requirements. In the case of OHS Solutions Pty. Ltd, majority of the directors had failed in their duties to prevent insolvent trading and face either civil penalty or criminal penalty. However, the Act also gives defense for various contraventions. References Corporations Act 2001 Sect 95A Corporations Act 2001 S588G Corporations Act 2001 s588M Credit Corp Pty Limited & Ors v Atkins & Anor ((1999) 17 ACLC 756) Group Four Industries v Brosnan (1992) 10 ACLC 1 ASIC v Plymin, Elliott & Harrison (No 2) [2003] VSC 230; Corporations Act 2001 Section 9 Quick v Stoland Pty Ltd (1998) 87 FCR 371, 373–4 ASIC. (2010). Regulatory Guide 217: Duty to prevent insolvent trading: Guide for directors. Retrived from http://download.asic.gov.au/media/1241384/rg217-29july2010.pdf Salim, M. (2004).‘Corporate Insolvency: Separate Legal Personality and Directors’ Duties to Creditors’ 90(2) UiTM Law Review, 1. Read More