In the present essay we will be discussing the concept of insolvent trading and the director’s duty to prevent insolvent trading given under section 588G of the Corporations Act 2001. Under this corporation law assignment we will also discuss the relevant case laws and legal notions related o the concept of director’s duties and we will also discuss the concept of the veil of incorporation and the lifting the veil of incorporation and we will also discuss the difference between the piercing of the veil of incorporation and the lifting of the veil of incorporation and finally we will try to find a solution to the case scenario provided to us.
PART A-Why the Director’s duty to prevent insolvent trading exists?
Under the Corporations Act 2001 (Cth) the director of a company have many duties and one of the most important duties that a director has is his duty to prevent insolvent trading of the company in which he is a director (RAMSAY, Ian M, 2000).
The Duty to prevent insolvent trading is provided in the “section 588G of the Corporations Act 2001 ”. The duty to prevent insolvent trading is imposed only on the directors of the company and this duty does not apply to other officers. The director is defined in the section 9 of the Corporations Act 2001 and it also includes the “de facto directors and shadow directors”, a de facto director is a person who acts as a director even when the person is not officially appointed as a director and a shadow director is a person who instructs the director of a company and the director work according to the directions of the shadow director (RAMSAY, Ian M, 2000).
A company can incur two types of debts where one is “deemed debts” and the other debts are a debt for a “specified amount or a debt which is voluntarily incurred” by the company (RAMSAY, Ian M, 2000).
The above mentioned debts must have been incurred when the company has become insolvent or when the company will become insolvent after incurring the debts in question. Section 95A of the Corporations Act 2001 has defined the word insolvency and according to this section “a company is considered to have become insolvent when the company is not able to pay all its debts when the debts have become due for payment” (RAMSAY, Ian M, 2000).
The main requirement for a director to become liable under the 588G section of the Corporation Act 2001 is,
“The director was aware at the time the debt was incurred that there were reasonable grounds for suspecting that the company was insolvent; or
A reasonable person in a similar position in a company in the company’s circumstances would have been aware that there were grounds for suspecting that the company was insolvent.” (RAMSAY, Ian M, 2000)
DEFENCES FOR THE DIRECTOR:
Section 588H of the Corporations Act 2001 provides the defences when a director has breached the duty under section 588G and these defences are as following:
- “Reasonable grounds to expect solvency;
- Reasonable reliance on information provided by others;
- Absence from management; or
- Reasonable steps to prevent incurring of debt”
The director’s duty to prevent insolvent trading has been fixed because the director is the person who has all the information regarding a company and no decision is taken without his approval therefore it is his duty to see that his company does not incur any debt which may make it insolvent or when the company is already insolvent then to make it incur any new debt as when the company becomes insolvent then the money of the creditors gets lost and they have to incur a big loss, so prevent this loss in the business the director is made liable so that if there is any breached then the Director will have to “pay compensation and he will be banned from becoming a director for a specific period of time when civil penalty is imposed on the director and under the criminal penalties the director may have to pay a criminal penalty which can be till $200,000 or an imprisonment for a period of five years, or both the fine and the imprisonment can also be imposed on the director by the ASIC” (RAMSAY, Ian M, 2000).
Leading cases on director’s duty to prevent insolvent trading:
Woodgate v Davis, (2002): In this case “The sole director of two companies that carried on business in partnership attempted to argue that the insolvent trading provisions did not apply to companies that operated via a partnership. When that argument failed he was left facing a $3.37m claim, under section 588G of the Corporations Act 2001.”
What are the circumstances and consequences of the “veil of incorporation” being lifted for insolvent trading?
In the case Salomon v Salomon & Co, (1897), the House of Lords acknowledged “the legal principal affirmed the legal principle that, upon incorporation, a company is generally considered to be a new legal entity separate from its shareholders. The court did this in relation to what was essentially a one person company”. After this case the courts also held in differnt cases that the coprorate veil of a company may be pierced or lifted to refuse the shareholders the protection which a limited liability company provides to its shareholders (RAMSAY, Ian M and Noakes, David B, 2001).
Atlas Maritime Co SA v Avalon Maritime Ltd (No 1) , (1991), in this case the phrases “piercing the corporate veil and lifting the corporate veil was stated by Staughton LJ”, “To pierce the corporate veil is an expression that I would reserve for treating the rights and liabilities or activities of a company as the rights or liabilities or activities of its shareholders. To lift the corporate veil or look behind it, on the other hand,should mean to have regard to the shareholding in a company for some legal purpose” (RAMSAY, Ian M and Noakes, David B, 2001).
There are some circumstances that would lead to the lifting of veil of incorporation and they are; “Agency: this implies that a company cannot become an agent for its shareholder and when a company works as an agent for a shareholder then the court can lift the veil like in the case (Barrow v CSR Ltd , 1988).
Fraud: this implies that when a company is incorporated only for evading any legal obligation and this was held in the case (Re Edelsten ex parte Donnelly , 1992).
Sham or façade: this implies that the company when used as a camouflage to conceal the actual purpose of the company like in the case (Sharrment Pty Ltd v Official Trustee in Bankruptcy , 1988).
Group enterprises: when a parent company hides behind a subsidiary company then also the veil of incopration can be lifted (Taylor V. Santos. Corporate Law Electronic Bulletin. No. 13, 1998).
Unfairness or injustice: When the company behaves in an unfair manner then the court can lift the veil like in the case (RMS Glazing Pty Ltd v The Proprietors of Strata Plan No 14442, 1993) ”.
When the veil of incorporation is lifted then the shareholder becomes liable to the creditors and their assets can be used for paying the debts of the creditors.
PART B- Whether any of the directors may be about to breach or have already breached their duty to prevent insolvent trading?
To come to the conclusion that whether any directors may be about to breach or may have already breached their duty as a director to prevent insolvent trading, we need to discuss the legal position of each director and similar case laws related to insolvent trading, which we have discussed below:
There are many different kinds of directors in a company and they have been discussed below:
Managing director: the most important director in the executive board of director is known as the managing director of the company and in the case of Shirlaw v Southern Foundries ltd, (1939), the concept of managing director was discussed where it was said that “[A] director to whom the board, being empowered to do so by the [replaceable rules or coporate constituion] delegates its powers of management, or some of them, and this delegation is usually, if not invariably, made subject to the overriding authority of the board”(TOMASIC, Roman et al., 2002).
Non-executive director: the non-executive directors are also known as outside directors and they are appointed by the board and this appointment is done from outside of the corporation, so that the board can have independent opinion and honest judgement from the director (TOMASIC, Roman et al., 2002)
Executive director: a director who also works as a full time employee for the company in which he is the director and generally the post, on which the executive director works is a senior or higher management level, is known as executive directors. The executive directors are appointed because they have specialised knowledge of their field and this helps the board of directors in having better knowledge and better understanding about the status of the company legally and financially (TOMASIC, Roman et al., 2002).
Chief financial director: the chief financial officer is a professionally qualified person who deals with all the finance related work of the corporation and he does all the financial planning and keeps an update about all the accounts of the corporation.
The director of a company also has the following duties:
- “The duty to exercise due care and diligence;
- The duty to act in good faith, and for proper purposes; and
- The duty to avoid conflicts of interest” (BRIEN, Paul O’, 2008)
The facts of the present case:
Now in the present case we see that there four directors in the company and they are as following:
- Managing Director – Des
- Finance Director – Emma (non executive)
- Director – Satish (executive – employed also to run the technological side of the business)
- Director – Ying (non executive) – a friend of Des’ and director of Support Pty. Ltd. (Support Pty. Ltd. has gone guarantor for a $50,000 loan from the Business Bank Ltd. to OHS Solutions)
Issue of the present case:
The issue is whether the directors of the OHS Company have breached their duty as a director to prevent insolvent trading as given under section 588g of the Corporations Act 2001.
In the present case the most important director was the managing director who is Des, according to the given facts Des had the highest responsibility to prevent any insolvent trading of the company therefore he should have shown the highest level of diligence but he believed Satish who was also the executive director and did not check whether his claims were true or not, so he will be liable under section 588G for breaching his duty to prevent insolvent trading and he will be liable under civil penalty as he was not fraudulent.
Secondly, Satish was the executive director who had the technological skills but he gave wrong information to the board of directors and also to the managing director he gave misleading information, therefore Satish will also be liable under section 588G and he will be liable under criminal penalty because he gave fraudulent and misleading information to the board where as an executive director he had the duty to give correct technical information.
Thirdly, Emma, who as the financial director will not be liable under the section 588G of the act because she was not provided with complete financial information and when she got the information she found out that a large account from Trouble Shooters was overdue.
Fourthly, Ying, who was the non-executive director would also be liable under the section 588G of the act because he also did not prevent the company from insolvent trading in fact, the insolvency of the OHS company would give Ying’s company an option to buy the OHS company, so we can assume that Ying did not stop the insolvent trading for his own benefit therefore he may also be liable under section 588G of the act.
To conclude we can say that all the directors except Emma seems to have breached their duty as a director prevent the OHS Company from insolvent trading where Des showed lack of diligence, Satish was fraudulent, Emma did not had the resources and Ying seems to have let OHS company to do insolvent trading so that he can buy the company at a cheap price. So we see that in the present case there was fraud, agency and unfairness, so the veil of incorporation can be lifted to check the insolvent trading by the company and all the directors have breached their duties provided under section 588G of the Corporation Act and according to the provided facts they will have to pay the debts of the creditors from their personal assets. Also to reach this conclusion we have discussed the relevant case laws like the (Woodgate v Davis, 2002), (Atlas Maritime Co SA v Avalon Maritime Ltd (No 1) , 1991), (Barrow v CSR Ltd , 1988), (Re Edelsten ex parte Donnelly , 1992), and (RMS Glazing Pty Ltd v The Proprietors of Strata Plan No 14442, 1993). Also according to the facts of the case we can also assum that Troouble shooterss was a company owned by satish because he has said that the dues are clear but he had taken huge dues from the company OHS and he was fradulent in all his disclosures about the staus of the IT problems in the OHS company, so this means that Satish will be liable under the criminal penalty of 588G of the Corporation Act 2001.
- ASIC v Adler and Ors  NSWSC 171.
- Atlas Maritime Co SA v Avalon Maritime Ltd (No 1)  4 All ER 769..
- Barrow v CSR Ltd  (Unreported, 4 August 1988, Supreme Court of Western Australia, Rowland J).
- BRIEN, Paul O’. 2008. DIRECTORS’ DUTIES TO CREDITORS. [online]. [Accessed 16 JANUARY 2015]. Available from World Wide Web: <http://www.ypol.com.au/pdfs/DirectorsDutiesCreditorsAndForCorporateSolvency.pdf>
- CRS. 2014. Insolvent Trading. [online]. [Accessed 16 JANUARY 2015]. Available from World Wide Web: <http://crsinsolvencyservices.com.au/wp-content/uploads/2014/10/CRS-InsolventTrading.pdf>
- RAMSAY, Ian M. 2000. COMPANY DIRECTORS’ LIABILITY FOR INSOLVENT TRADING. MELBOURNE: CCH Australia Limited.
- RAMSAY, Ian M and David B NOAKES. 2001. Piercing the Corporate Veil in Australia. Company and Securities Law Journal. 19, pp.250-271.
- Re Edelsten ex parte Donnelly  (Unreported, Federal Court, Northrop J, 11 September 1992).
- RMS Glazing Pty Ltd v The Proprietors of Strata Plan No 14442  RMS Glazing Pty Ltd v The P (Unreported, Supreme Court of New South Wales, Cole J, 17 December 1993).
- Salomon v Salomon & Co  AC 22.
- Sharrment Pty Ltd v Official Trustee in Bankruptcy  (Unreported: Federal court, 3rd June 1988).
- Shirlaw v Southern Foundries ltd  2 All ER 113.
- Taylor V. Santos. Corporate Law Electronic Bulletin. No. 13  September 1998.
- TOMASIC, Roman, Bottomley STEPHEN, and Rob MCQUEEN. 2002. Corporations Law in Australia. Federation Press.
- Woodgate v Davis  55 NSWLR 222.