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The ‘Safe Harbour Defence’ to insolvent trading

Friday, March 20, 2020

The ‘Safe Harbour Defence’ to insolvent trading

 

Incorporating a company is a popular choice for many businesses. The key advantage, not granted under other structures, is that the company directors are insulated from the company’s debts in a winding up.

 

Put simply, except in very limited circumstances, if the company’s business fails and the company becomes unable to pay its debts, the assets of the directors are not available to creditors of the company to satisfy those debts.

 

This ‘general rule’ of limited liability does not apply where a director allows the company to continue trading (thus incurring debts) whilst the company is insolvent. Insolvency occurs when a company cannot pay its debts as and when due.

 

Insolvent trading claims are commonly used by a company’s creditors to pursue the directors personally for those debts incurred whilst the company was insolvent.

 

Company directors have a duty under the Corporations Act to avoid trading whilst insolvent. Insolvent trading is an offence of strict liability, meaning it is not necessary to show a director knew the company was insolvent. The Act imposes a duty on directors to manage the financials of their company and stay constantly appraised of them, so if the company begins trading while insolvent, the law presumes that the directors were aware and acquiesced to that behaviour.

 

There are very few defences available to directors who allow a company to trade whilst insolvent. One such defence was added to the Corporations Act recently; the ‘safe harbour’ defence.

 

The safe harbour defence is designed to incentivise company directors who, faced with an insolvency question, grab the wheel and steer the company towards safety rather than abandoning ship.

 

To successfully argue the safe harbour defence and avoid liability, the director must be able to demonstrate the following:

 

  1. the director must know or suspect that the company is or will become insolvent;

 

  1. the director must start developing one or more courses of action reasonably likely to lead to a better outcome for the company than an immediate liquidation.

 

 

As the legislation remains largely untested in the courts it is impossible to make a list of the full scope of courses of action and better outcomes the court might place within the limits of the defence, but good examples of steps the director might take include:

 

  1. Obtaining advice from an appropriately qualified professional to properly inform the director of the company’s financial position;

 

  1. Preventing misconduct by other directors;

 

  1. Ensuring the company is keeping appropriate financial records;

 

  1. Developing a restructuring plan for the company.

 

 

For directors, the general rule is to take steps sooner rather than later and always record your decisions. Directors who fail to turn their mind to the company’s financial issues will not be able to access the safe harbour defence.

 

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