Tread with caution

The onerous insolvent trading and related provisions of the Corporations Act does not provide directors with much room for comfort, writes Professor Bob Baxt.

When I discuss questions of what are the most pressing legislative rules that impact on the life of a director on a day-to-day basis, it does not surprise me that the insolvent trading regime and the related provisions in the legislation dealing with insolvency and the rights of liquidators and others to recover property from directors in certain circumstances, comes top of the list. Directors express continued concern that section 588G of the Corporations Act 2001 (the Act) presents one of the most difficult provisions that they must make sure they do not fall foul of in their day-to-day administration and running of their relevant companies. (It is interesting to note that the Australian insolvent trading provisions are regarded as the toughest in the western world).

While this particular sentiment is probably more often repeated in relation to smaller companies, rather than large companies whose shares may be listed on the ASX or equivalent, the reach of the insolvent trading provisions and the ability of the liquidator (or creditors when given the power to sue on behalf of the company) to seek remedies against directors, continues to pose significant problems for all companies.

It is rare to find courts exercising any kind of discretion to excuse directors from liability where a claim is brought against them by relying on the operation of section 588G of the Act (which prohibits insolvent trading). Directors may seek some kind of relief from the courts (as they can do under section 1317S of the Act), but the courts are very reluctant to grant relief in this context. If the insolvent trading allegation is linked to one that alleges that the directors have not acted with appropriate care and diligence, then the directors in question will also find it is equally difficult, if not impossible, to rely on the statutory business judgment rule in section 180(2) of the Act as a defence.

Featherstone case

The recent decision of the Queensland Court of Appeal in Featherstone v David James Hambleton as Liquidator of Ashala Pty Ltd (In Liquidation) [2015] QCA43 is a useful illustration of just how tough it is to turn around a verdict given in favour of the liquidator (or creditors) against directors in an insolvent trading scenario. It also emphasises how futile it is to seek relief by reliance on the court exercising relevant discretion in favour of the directors.

In the Featherstone case, the facts that the Queensland Supreme Court at first instance and the Court of Appeal had to consider were relatively straightforward. The company Ashala Bar Café and Restaurant Pty Ltd became insolvent and the liquidator sought payment of $198,151.14 (plus interest) from Featherstone, who was in effect the company’s controller. This amount arose out of alleged insolvent trading engaged in by the company whilst run by Featherstone and those associated with him. While the initial litigation was for a larger sum than the amount eventually ordered to be paid, the judge in first instance ruled that

Featherstone conducted the affairs of the company in such a way to make him responsible for the relevant debt, which was incurred while the company was insolvent. Featherstone argued that he was not formally appointed as a director, however the court felt that the relationship between him and the company was such that he was in effective control of the company and its day-to-day affairs and management and thus, although there were others involved, he was primarily responsible for the insolvent trading allegations that were made.
Featherstone appealed the decision of the trial judge and argued that he had made errors in law in a number of his decisions. He argued that the company was not insolvent; he argued that he had not been appointed formally as the director; and that it was not clear that he had reasonable grounds to believe that the company was insolvent when the debts were incurred (as well as other related grounds which relied on certain principles in law which are not of relevance to the discussion in this case). Featherstone also argued that some of the evidence called in support of the liquidator’s case could not be, and should not have been, relied on by the trial judge.

It is unnecessary for our purposes to delve into the relevant evidence and arguments that were raised with respect to the allegations. It is sufficient to note that the judgment of the Court of Appeal, after outlining the critical assertions made by Featherstone, as well as the provisions of the legislation, made it clear that it would be a rare case where an appeal court would overturn a finding of insolvent trading.

This was especially so where evidence was presented in a cogent and reasonable fashion to the trial judge and the trial judge would have had no basis upon which to find the relevant evidence unacceptable. In effect, the appeal court ruled that the trial judge had good reason to rule that the company was insolvent at the relevant time, that the relevant director (being Featherstone) did have the responsibility for the activities that took place, and that there was no basis upon which to reject the findings of the trial court.

In addition to this decision, two decisions of the High Court of Australia, in Fortress Credit Corporation (Australia) Pty Ltd and Anor v Fletcher and Barnett as Liquidators of Octavia Ltd (Receivers and Managers Appointed) [2015] HCA 10 and Grant Samuel Corporate Finance Pty Ltd v Fletcher and Barnett as Liquidators of Octavia Ltd (Receivers and Managers Appointed In Liquidation) [2015] HCA 8 illustrate that there would be little room for for liquidators and others to argue that they should be given greater discretion in seeking remedies against persons who had received payments made by a company when it was insolvent, and where the relevant payments amounted to what are generally described as voidable transactions. The law enables the liquidator or a creditor to “reach back in time” to recover payments made if the payments that were made at a time that the company was not solvent or for fraudulent reasons.

High Court ruling

The High Court, in effect ruled in these cases that it would be rare for it (or for other appeal courts) to depart in a significant way from the structure of the rules written into the Act, especially if this reading would interfere with an efficient and speedy administration of insolvent companies and the powers of the liquidators. The language of the court in the Fortress Credit Corporation case, referred to above, makes this clear. Statutory provisions, which enable the liquidator (or other administrators) to seek recovery from third parties where payments have been made or property transferred by directors to those persons when the company may have been insolvent, should be read strictly. This was based on the landmark Harmer Report on insolvency, handed down in 1988, which recommended a stricter interpretation of these rules than had occurred in the past.

The High Court further noted in the Fortress Corporation case that the discretion under section 588FF(3), (which enables the liquidator in special cases to seek to recover property from third parties may seek an extension of time from the stated three year period set out in the section), would only be exercised in rare circumstances. However, the court would not state a general proposition that a liquidator (or other administrator) would never be given the right to seek a recovery against such third parties; rather the court again recognised that there may be situations where a discretion may be allowed to permit some variation in the way in which the administration is to take place.

As the three cases discussed in this note suggest, variation in the time-frame, or the remedies that may be sought and obtained, have not been interpreted in a way so as to provide comfort to directors or the persons against whom the liquidator may move.

The fear that directors have of the impact of the insolvent trading provisions (and related legislation) is not an unjustified one. Care needs to be taken to ensure that compliance with the law is a primary focus of attention for directors at times when a company is in some financial difficulty. Too reckless an attempt to rescue the company may expose the relevant directors and others to greater risks than are clearly warranted in the circumstances.