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Focus: Insolvent trading – June 2003

In this issue: We look at two recent court rulings that deal with the issue of directors' responsibilities when a company is trading while insolvent.

Non-executive directors – turning a blind eye is not a defence

In brief: Recently in the Victorian Supreme Court, a non-executive director was found to have breached the Corporations Act, in circumstances where he was said to have turned a blind eye to the company's liquidity crisis. Partner Paul Meadows and Special Counsel Anne Ferguson analyse this decision and explain some of the lessons that non-executive directors can learn from it.

Insolvent trading provisions

In ASIC v Plymin, Elliott and Harrison, Justice Mandie of the Victorian Supreme Court found that John Elliott as a non-executive director had failed to prevent a company from incurring debts at a time when it was insolvent and had contravened section 588G of the Corporations Act.

The Water Wheel companies were placed into voluntary administration in February 2000. ASIC commenced civil proceedings against the managing director, chairman of the Board and Elliott (as a non-executive director) for orders that they had contravened the insolvent trading provisions.

To succeed, ASIC had to establish on the balance of probabilities that:

  • the companies were insolvent at the time debts were incurred;
  • at that time there were reasonable grounds for suspecting that the companies were, or would, become insolvent; and
  • the directors were, or a person in a like position would have been, aware that there were reasonable grounds for suspecting insolvency.
Test for insolvency

Justice Mandie confirmed that the test of whether a company is insolvent is the 'cash flow test', ie can the company pay its debts as and when they fall due? In this case, the judge's view was that the company was insolvent, as alleged by ASIC, from 14 September 1999 onwards. On that date the ANZ Bank informed the managing director that funds from the sale of part of the business must be paid to the bank in reduction of the debts owed, that the bank had decided to end its relationship with Water Wheel and that its credit facilities were repayable on demand. The judge also pointed to the fact that throughout 1999 Water Wheel was not paying (and never did pay) many of its debts.

Reasonable grounds for suspecting insolvency

Whether there are reasonable grounds for suspecting insolvency is judged according to the (objective) standard of reasonableness appropriate to a director or non-executive director, as the case may be, of reasonable competence and diligence. In relation to a non-executive director Justice Mandie noted:

A non-executive director is expected to take steps to put himself in a position to monitor the company and to exercise and form an independent judgment and to take a diligent and intelligent interest in the information either available to him or which he might with fairness demand from the executives or other employees and agents of the company.

The Court confirmed that if a director was aware of facts that would support the suspicion of insolvency it did not matter whether or not the director had an actual suspicion. That is, the director's own state of mind may not relevantly assist him. Alternatively, if it cannot be shown that the director was aware of such grounds, but a reasonable director in a like position would have been aware of them, then it does not matter that the particular director lacked that awareness.

Here the Court held that Elliott was aware of facts and matters that gave rise to reasonable grounds for suspecting insolvency. These matters included:

  • concerns that the financial controller had raised that the company might be insolvent;
  • the audited loss for the year ending 3 December 1998 was $879,000 and losses for the half year to 3 June 1999 were $2.135 million;
  • Deloitte was engaged to investigate whether the 1998 loss could be attributed to unrecorded flour sales due to a new computer system. By April 1999, Deloitte had not found any evidence of unrecorded sales;
  • creditors were not being paid in accordance with normal trading terms and the company had worsening liquidity problems;
  • by April 1999 it was known that off-balance sheet finance was unlikely to come from existing financiers and no replacement financiers could be found;
  • at an April Board meeting a co-director expressed concern about the lack of financial results and information for the first three months of the year and asked about the solvency of the companies. That director resigned two days later without explanation;
  • the ANZ Bank appointed an investigative accountant in June 1999 and, by August 1999, the bank indicated the company was in default of its credit facility arrangements and had placed all facility arrangements on demand; and
  • by August 1999 it was known that creditors were owed $10.4 million, the ANZ Bank debt was $5.7 million and that current assets were $12.3 million.

Justice Mandie considered that Elliott had turned a blind eye to Water Wheel's financial difficulties and this was no defence to the claim against him.

Preventing debts from being incurred

In considering whether the directors had failed to prevent the company trading or incurring debts, the Court held that:

Inactivity or the failure to attempt to prevent the company from trading or incurring the debt will be sufficient to constitute a failure to prevent the company from incurring the debt within the meaning of s588G(2).

In this case, the Court found that the directors took no steps to prevent Water Wheel from continuing to trade.

When is a debt incurred?

The Court also held that whether a debt has been incurred or not:

does not depend on strict legal analysis [of the relevant contract] but turns on when, in substance and commercial reality, the company is exposed to the relevant liability.

Justice Mandie concluded that in the case of a sale of goods, a debt will often be incurred on each occasion when a delivery is ordered.

Lessons learned

This case is an example of the application of the insolvent trading provisions and what facts might be held to be grounds for suspecting insolvency. These include:

  • the unexplained resignations of co-directors;
  • the withdrawal of support by the company's banker;
  • the lack of other available avenues for raising finance;
  • the inability to raise further equity capital;
  • mounting creditors who are not being paid in accordance with trading terms and the commencement of legal proceedings by some;
  • continuing liquidity problems, including a mismatch in the timing of debts due to creditors and moneys owed by debtors;
  • relatively large and continuing trading losses;
  • the issuing of post-dated cheques, some of which were dishonoured;
  • placement of orders by suppliers on COD terms;
  • the inability of the company to issue accurate historical financial information or forecasts; and
  • overdue payroll and group tax.
Non-executive directors should be aware of...

The case is also illustrative of the need for non-executive directors to be able to show that in cases of financial distress they have a sufficient (objective) basis to conclude that the company is not, and is not likely to become, insolvent. Among other things, this may require non-executive directors to establish that:

  • there has been sufficient questioning by them of the company's financial position;
  • they have been sufficiently informed by competent and reliable managers of that position (which involves among other things that a director have a reasonable measure of comfort that the level of information provided is adequate and that the managers providing the information are competent);
  • external advice has been sought where necessary or appropriate from an expert insolvency practitioner; and
  • proper consideration to the appointment of an administrator has been given.

In summary, if actual insolvency is established, a director, to make out a defence, will need to show that he or she took all reasonable steps practicable to prevent the company from incurring debts after insolvency. In such cases, if the director cannot persuade a majority of other directors that the company should not continue to trade, the director should resign.

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What is a 'good reason' not to participate in the management of a company?

In brief: A recent decision of the NSW Court of Appeal emphasised the importance of active participation of directors in the affairs of a company. The Court decided that a total failure to participate, for whatever reason, should not be regarded as a 'good reason' under the statutory defence present in s588FGB(5) of the Corporations Act 2001. Lawyer Joanne Little looks at the case and its implications.

Deputy Commissioner of Taxation v Clark

The Court of Appeal's decision in Deputy Commissioner of Taxation v Clark1 is supported by an analysis of the legislative change and judicial decisions, which indicate that the expectation that directors will participate in management has intensified over time. The Court also indicated that a director's duty of care and diligence is a core, irreducible requirement of participation in the management of the company and this requirement is one of the factors underlying the scheme for insolvent trading.

This case revolved around Southern Cross Interiors Pty Limited (in liquidation) (SCI) paying $208,737.44 (the monies) to the Australian Tax Office between 22 May 1997 and 19 August 1997 by way of group tax and the prescribed payments scheme. The liquidator of SCI was successful in bringing an action against the Deputy Commissioner of Taxation (DCT) to repay the monies by proving that the payments were an unfair preference. The DCT, under a statutory right of indemnity, sought declarations that the two directors of SCI were liable to indemnify the DCT for the repayment of the monies.

The directors of SCI were a married couple, Mr and Mrs Clark. Mrs Clark became a director when one of the directors resigned and, according to the evidence, Mr Clark asked Mrs Clark to become the second director because it was a legal requirement that a company have two directors. As summarised by Chief Justice Spigelman, the evidence at first instance was that (at para 10):

Mrs Clark has never been a director of any other company. Nor did she have any business experience. Her time was taken up as a housewife and mother. She said that when requested to become a director, she thought she had to accept as a wife. She agreed, from time to time, she signed company documents, but that they were not explained to her and signature occurred in situations which - 'I would often have a frying pan in one hand and be signing with the other'.

The decision of the Supreme Court of NSW

Justice Palmer made the declaration that Mr Clark was liable to repay the DCT for the repayment of the monies; however, a declaration was not made for Mrs Clark, as it was held that Mrs Clark's non-participation came within the defence available to a director in proceedings against the director for indemnity provided by s588FGB(5) of the Corporations Act 2001. Section 588FGB(5) is in the following terms:

It is a defence if it is proved that, because of illness or for some other good reason, the person did not take part in the management of the company at the payment time.

It was therefore held that Mrs Clark because of her lack of understanding; her husband's failure to explain the nature of the responsibilities of directorship; her belief that she was not required to participate in the management of the company, and the fact that these beliefs were induced by her husband's statements constituted 'some other good reason' for the purposes of s588FGB(5).

The decision of the NSW Court of Appeal

The issue before the Court of Appeal was whether Mrs Clark 'did not take part in the management' of SCI 'for some other good reason' at the times of the payments. The court analysed the following:

  1. the statutory interpretation of the statutory defence in s588FGB(5).
  2. the risk of reinforcing gender stereotypes; and
  3. the approach to statutory interpretation.
1. Non-participation of a director in the management of a company s588FGB(5)

The Court of Appeal analysed the case law, amendments to the Corporations Act 2001 and the policy underpinning the legislation, and held that the focus of attention in interpreting a 'good reason' for a director not to participate in management for the purposes of the corporations law requires:

  • consideration of the duties of a director, particularly in, but not limited to insolvent trading; and
  • a recognition that it is a fundamental structural feature of Corporations legislation in Australia that directors are expected to participate in the management of the corporation.

The Court concluded that the statutory defence operates on the assumption that every director will be involved in the management of the company. This is supported by the fact that the sections are constructed in such a way to infer that the explanation for a failure to participate is focused on a particular point in time and in considering the duties expressly imposed upon directors at the time the monies were paid in 1997, as well as the history of the case law, statutory reform and textual context, the words 'good reason' must be read down so that they do not conflict with the obligation of directors generally to participate in the management of the company. In this way, reasons that cause a director never to participate in the management of a corporation are not capable of constituting a 'good reason'.

2. The risk of reinforcing gender stereotypes

The court analysed the alternate arguments in relation to gender stereotypes and the interpretation of the statutory defence, namely:

  • that gender neutral rules ignore the actual experience of many women who assume subordinate roles in both the public and private spheres; and in the alternate,
  • the adverse consequences on the ability of women to participate equally in commercial life if the legal system permits women to rely upon stereotypes embodied in special rules.

The Court concluded that the recognition of complete abdication of responsibilities as a director as a 'good reason' for purposes of the statutory defence, carries with it the risk of reinforcing gender stereotypes and undermining the confidence with which potential creditors will deal with small companies in which women participate with their husbands.

3. The approach to statutory interpretation

When phrases of generality are used in statutory provisions, those phrases 'must take [their] colour from [their] surrounding'. The contemporary approach to statutory interpretation is literal but not literalistic, and requires words to be construed in their total context. However, with specific reference to the ejusdem generis rule, which gives the immediate verbal context determinative weight in the process of construing general words, the court held that the application of this rule is rarely justified. Rather, whether or not general words ought to be read down is to be determined by the whole of the relevant context, including other provisions of the statute and the scope and purpose of the statute.

Additionally, where Parliament has chosen a formulation that is of indeterminable scope and of a high level of generality, a court should interpret the provision on the basis that the intention of the original enactment was that the particular application of the provision may vary over time. This is particularly evident in constitutional interpretation; however, in the Corporations context, it will be changes in the principles establishing duties of directors that determine whether there has been any relevant change in the context which justifies a differing interpretation to be given to a provision.

Implications of this decision

The Court held that Mrs Clark's total reliance on her husband in the management of SCI was not a 'good reason' for her non-participation in the management of the company at the times when payment was made to the DCT. Mrs Clark was therefore unable to resist her liability as a director.

The Court of Appeal's decision effectively limits the ambit of possible arguments to justify non participation by a director in the management of a company. While the Court of Appeal did not specifically exclude the availability of arguments based upon duress, non est factum, undue influence, deceit, misleading and deceptive conduct or unconscionable conduct, it limited the ambit of the statutory defence by deciding that the words 'good reason' must be read down so that they do not conflict with the obligation of directors generally to participate in the management of a company. It also decided that an argument attempting to justify why a director has never participated will not succeed and will never constitute a 'good reason'. This decision indicates the strict stance that the Court of Appeal has taken on the responsibilities of directors and reinforces the importance and absolute nature of directors' duties.

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References
  1. Deputy Commissioner of Taxation v Clark [2003] NSWCA 91 (May 2003)

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