Understanding Section 588G Of Corporations Act And Legal Remedies For Insolvent Trading

Requirements for a pass/good mark

The issues as identified in the case study pertaining to the advise being given to the liquidator if the unpaid amount of $251,000 can be recovered from its members and if the liquidator shall succeed or not in recovering the amount.

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Section 9 of the Corporations Act 2001(Cth), the director can be defined as the person who is authentically appointed as a director or an alternate director. A person though not appointed as a director, he can act in the position of the director i.e. de facto director. Lastly, even a person is not appointed as a director, the directors are accustomed to act in accordance with the instructions or wishes of that person. He can be termed as a shadow director.

As per section 588G of the Corporations Act (Cth), the directors of the company can be held personally liable in case the company has incurred a debt when it is insolvent and there have been reasonable grounds to suspect that it has remained insolvent. As a result, criminal and civil sanctions can be imposed on the directors who have violated Section 588G. The directors breach this section if they fail from avoiding the company from incurring the debts provided if:

  1. They are aware regarding the grounds of suspecting that the company is insolvent.
  2. A reasonable person in a similar situation in the position of a director must be aware of such circumstances.

Section 588G (3) illustrates that a person has committed an offense if:

  1. A company has incurred a debt at that particular point.
  2. He was a director when the debt was incurred.
  3. The company is insolvent at that time or becomes insolvent as the debt was incurred.
  4. The person has suspected at that time as the debt was incurred due to which the company became insolvent or would become insolvent because of incurring of debts by the company.
  5. The failure of the person in preventing the company from incurring the debt was dishonest.

In reference to this, the test of solvency has been established under section 95A of the Act which states that a person is a solvent if he is able to repay all the debts of the other person as and when they become due and are liable to be paid. It has also declared that a person who is not solvent is insolvent.

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The indications of potential insolvency are that a prudent director must discharge his duties taking note about the commercial position of the company. As per ASIC Regulatory Guide, 217 which states the duties to prevent insolvent trading illustrates that a company can be declared insolvent if there is a history of continuous losses and a company is unable to produce appropriate financial information. It has defaulted or is about to default regarding its financial activities. Lastly, a legal action has been threatened against the company. So the director has a positive duty to avoid insolvent trading as per section 588G of the Corporations Act 2001.

This duty applies to the directors who have been appointed as an alternate director and who have been acting in that capacity. Contravention of the section 588G (3) of the Act attracts a civil penalty which authorizes the Australian Securities and Investments Commission (ASIC) to impose pecuniary penalties over the directors. As per section 588G(2), a provision of a civil penalty is applicable to a director who fails to avoid the debt being incurred when they were aware of the grounds of suspecting illiquidity of the company or where a reasonable person in the same position would suspect the insolvency of the company.

Definition of Director and De Facto Director

In the given case, although it is not mentioned explicitly that Bill and Sue are the directors it is implicit according to section 9 of the Corporations Act (Cth) that they both are not validly appointed as directors but they act in the position of directors of the company i.e. they are shadow directors.

Secondly, Bill has lied to Sue that the creditors have been paid the amount of $230,000 and that the company was struggling to pay off its debts since January 2018. Also, the company has also exceeded the credit limit of $20,000 on its credit card so it was unable to pay its telephone bill of $1000.   In this regard, the liquidator will succeed in recovering the amount of $251,000 from Bill and Sue.

 As according to section 588 G, it is the duty of the directors to prevent the company from incurring debts if it is already insolvent at the time of incurring of debts or of it incurs further debt including that debt, it shall become insolvent. Also, this section also applies when there are reasonable grounds of suspecting that the company has become insolvent or would become insolvent if it would incur more debts.

As per section 588G(2), a civil penalty is attracted when the director fails to prevent the debt being incurred even if they are aware regarding the grounds of insolvency or when a reasonable person in the same position would suspect the position of insolvency. As per section 588G (3), a criminal offense is set out when it is the failure of the dishonest director to avoid the company from incurring of debts. A director had suspected the company to be insolvent at the time when the company was incurring debts or it would become insolvent due to the company has incurred debts.

As a result of section 588G, the liquidator would succeed in recovering the unpaid amount from the directors as they knew at the time of incurring the debts that the company has become insolvent. Furthermore, Bill lied to Sue that he had paid the amount to the creditors although he already knew that the company has been struggling to trade well and repay its debts since January 2018.

Conclusion 

Hence to conclude, it can be said that liquidator would succeed in recovering the debts from both the directors Bill and Sue under section 588 G.

The issue pertains to the relevant provisions of Corporation Act to be enforced by ASIC in the context of receipts of complaint from its creditors and legal remedies it may seek against Bill and Sue and its chances of success.

Implications of Section 588G on Directors’ Liability

If a director has been found to contravene the provisions of the Section 588G (2), then ASIC may seek the legal remedies as under:

  1. Pecuniary penalty order: The court may order the directors to pay a pecuniary penalty to the Commonwealth up to $200,000 if it is found that the directors fail to prevent the insolvent trading of the company. Moreover, if it is also found that there is a serious and material prejudice to the affairs of the company or its inability to pay its creditors, then the directors are liable under this provision.
  2. Compensation order: The directors may be ordered to pay the compensation to the company which would be equal to the amount of loss suffered due to the failure of the directors to prevent the company from incurring of debts as per section 588J and section 1317H.
  3. Disqualification from managing the affairs of the corporation: The court may disqualify the director from managing the affairs of the company for a considerable period, provided it is justified.

With regards to the criminal penalty, if a director has committed a criminal offense under section 588G (3), the court may make either of the following orders:

  • Imprisonment of a director for up to five years.
  • The director would be penalized for paying up to 2000 penalty units which are equal to $220,000.

In this reference, Salomon v A Salomon was passed in a ruling that the company is a separate legal entity and which is distinct from its members, so Salomon who was the founder of A. Salomon and Company Ltd. was protected from his personal liability to the creditors of the company. This is the general rule in the case of a company that it is an artificial person which is separate and distinct from its shareholders and directors.

However, the company is a separate legal entity may be misused by some individuals for their own benefit, hence it may be used for committing frauds and illegal acts as held in Pioneer Concrete Services Ltd v Yelnah Pty Ltd. Since a company is an artificial person does not have the capability to do anything fraudulent and illegal, so the façade of corporate personality should be removed to recognize the persons who are guilty in the real sense. It is termed as the doctrine of lifting the corporate veil as held in Jones v Lipman 

 As per the case law of Peate v Federal Commissioner of Taxation, in case of  winding up of the company, if it appears that the  business is carried out in a fraudulent manner to defraud the creditors of the company , then the court may hold such persons to be liable personally for any liability incurred by the company .   

As per section 588G (2), ASIC can seek the legal remedies against Bill and Sue. If the directors are found to be contravening the provisions of section 588G (2), then the court may direct one of the following orders:

The court may disqualify the directors from managing the affairs of the company. It may also direct them to pay a pecuniary penalty to Commonwealth up to the sum of $200,000 if it finds that the directors have failed to prevent the insolvent trading and the intensity is of serious nature. It would cause material prejudice to the interest of the company or its capability to pay off its creditors.

The court may also instruct the directors to pay a compensation which is equal to the loss suffered by the company in monetary terms because the directors failed to prevent the company from incurring the debts at the time when it was insolvent.

As per section 588G(3), if the directors are found to be have committed the criminal offense, it may make the orders instructing the directors to pay a penalty of up to 2000 penalty units equals to $220,000 or the directors can be imprisoned for five years.

Although it has been stated that the company is a separate legal entity from the directors and members.But as per Atlas Maritime Co SA v Avalon Maritime Ltd (No 1) and with the application of the doctrine of the lifting of the corporate veil, the directors would be held liable for the acts of the company.  

Conclusion 

ASIC would be successful in seeking the legal remedies according to section 588G (2) and section 588G (3).

References

ASIC , Directors’ liabilities when things go wrong(28 September 2016)< https://asic.gov.au/for-business/your-business/tools-and-resources-for-business-names-and-companies/asic-guide-for-small-business-directors/directors-liabilities-when-things-go-wrong/#personal>

French Derek, Mayson Stephen, Mayson Stephen W. and Ryan Christopher L.  ,Mayson, French & Ryan on Company Law(Oxford University Press,2014)

Clarke Frank, Dean Graeme and Egan Matthew, The Unaccountable & Ungovernable Corporation(London :Routledge,2014)

Anderson Helen,’ Challenging the Limited Liability of Parent Companies: A Reform Agenda for Piercing the Corporate Veil’ (2012)22 Australian Accounting Review 129.

Salomon v A Salomon [1896] UKHL 1

Hameed Irshad,The Doctrine of Limited Liability and the Piercing of the Corporate Veil in the Light of Fraud: A Critical Multi-Jurisdictional Study(21 June 2013)< https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2282306>

Pioneer Concrete Services Ltd v Yelnah Pty Ltd[1986] 5 NSWLR 254

Jones v Lipman [1962] 1 WLR 832

Peate v Federal Commissioner of Taxation  [1964] 111 CLR 443

Harris, Hargovan  and Adams, Australian Corporate Law (LexisNexis, 2018)

ASIC ,RG 217 Duty to prevent insolvent trading: Guide for directors(29 July 2010)< https://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-217-duty-to-prevent-insolvent-trading-guide-for-directors/>

Matolcsy Zoltan , Tyler Jonathan and Wells Peter ,’Is continuous disclosure associated with board independence?’(2012) 37  Australian Journal of Management .

Kershaw David, Company Law in Context: Text and Material (OUP Oxford,2012)

Atlas Maritime Co SA v Avalon Maritime Ltd (No 1) [1991] 4 All ER 769