Under the Corporations Act, directors must act in the best interests of their company and cannot use their position to make undisclosed gains. These obligations do not change if the company is insolvent, as the directors also owe duties to creditors and external administrators.
Directors cannot make “creditor defeating dispositions”
These are translations where a director enters into a deal that involves property being sold for less than market or reasonably attainable value. The transactions must also hinder or significantly delay property being available to creditors in the event of liquidation.
Phoenix activity may constitute a “creditor defeating dispositions”. This is when a company facing liquidation transfers its activity and assets to a new company that continues the business of the old company. This activity is legitimate if the new company pays a fair market price for the assets of the old company and uses methods such as hiring an independent valuer. However, if the directors acted fraudulent or recklessly during this process, they may be liable under the Corporations Act for breach of duties and fraud. Penalties can be up to 15 years imprisonment.
In 2019, the ATO went after a property developer who used phoenix activity to absolve himself of tax debts. The property developer had liquidated entities six times in five years, leaving creditors, including the ATO with $160 million in debts. The Supreme Court ruled the developer had fraudulently falsified bank statements, hired directors and withdrawn funds. He was disqualified from being a director, lost his building license and ordered to pay $9.4 million to creditors.
Directors must keep accurate records of transactions and records
These records must accurately explain the company’s transactions, financial position and performance. If a company fails to keep such records, they can be presumed insolvent and directors could be liable for insolvent trading. As a result, directors should ensure that income statements, balance sheets and other financial documents are up to date-accurate and properly audited.
Directors cannot permit the company to trade or incur new debts during insolvency
Even if the directors did not know the company was insolvent they can still be liable for breaching this duty if there were reasonable grounds to suspect insolvency. Whether they are reasonable grounds is determined by considering the company’s cash flow and state of their balance sheet. Directors are expected to regularly assess the solvency of their company on a periodic basis and cannot solely rely upon end of year statements. They need to consistently assess the financial state of the company and should consult professional advisors when any discrepancies arise.
However, a director will not liable for insolvent trading if they were
- Absent due to sickness
- Appointed an alternate director who incurred debts in their absence
- Relied on the assessment of qualified and competent person who stated the company was solvent
- Incur debts in the process of implementing a restructuring plan that could result in a better outcome for the company. This restructuring plan requires the directors to ensure company accounts are in order and consult expert assistance.
If directors are found to have acted dishonestly or fraudulent while trading while insolvent, they could be liable for criminal penalties and be disqualified from being a company director
Summary:
Directors must not make creditor defeating transactions during insolvency. They should maintain accurate company records and not trade while the company is insolvent or suspected to be insolvent.
Phil is a director at OpenLegal. He has over 16 years experience working in private practice and in-house counsel in Sydney and London, giving him expertise in employment law, IP, finance, leases, dispute resolution, insurance and contracts.
