Insolvent trading is one of the most serious risks faced by a company carrying the potential for substantial civil and criminal penalties. When a business continues to incur debts while unable to meet existing financial obligations, directors may be held personally liable.
In this article, we explain what insolvent trading is, outline the risks involved, and share practical strategies to help you or your clients avoid and manage this critical issue.
What is Insolvent Trading?
Pursuant to the Corporations Act 2001(“the Act”), a company is considered insolvent when it is unable to pay its debts as and when they fall due. Insolvent trading occurs when a company continues to incur debts despite being insolvent or becoming insolvent as a result of incurring those debts.
Section 588G of the Act imposes a duty on directors to prevent insolvent trading. A director may be held personally
liable if:
- They are aware that the company is insolvent;
- There are reasonable grounds to suspect insolvency; or
- A reasonable person in their position could be expected to be aware of the company’s position.
While determining whether a company is insolvent is complex, courts typically consider the following factors when determining whether a company is insolvent:
- Overall financial position;
- Future and pending financial prospects;
- Cash flow, by conducting a detailed cash flow assessment; and
- Balance sheet, by conducting a balance sheet assessment.
Consequences of Insolvent Trading
For directors, failing to prevent insolvent trading can result not only in financial consequences, but also in legal and reputational damage.
Importantly, directors can be made personally liable for debts incurred by their company after it has become insolvent. Pursuant to Section 588G of the Corporations Act 2011 (Cth), personal compensation proceedings may be instigated by ASIC, a Liquidator, or Company Creditors if a director fails to prevent insolvent trading.
In addition to personal the liability risks, there are also civil and criminal penalties which include the following:
- Criminal fines of up to 2,000 penalty units;
- Imprisonment for up to five (5) years;
- Civil fines of up to $200,000; and
- Disqualification from acting as a director of a company.
How to Prevent Insolvent Trading
Preventing insolvent trading requires a proactive and vigilant approach from both directors and their advisors. The most effective strategy involves closely monitoring the company’s financial health, seeking timely advice from trusted professionals, and taking decisive action at the earliest signs of financial distress.
To actively prevent insolvent trading, company directors and their advisors should proactively:
- Maintain Accurate Financial Records – Reliable, up-to-date accounts allow directors to assess the company’s position quickly. Accountants and Bookkeepers play a vital role in ensuring financial records reflect reality.
- Monitor Cash Flow Closely – Cash flow forecasting is critical. Regularly reviewing short- and medium-term liquidity helps identify whether the business can meet obligations as and when they fall due.
- Communicate With Creditors – Early communication with creditors is crucial for trust and company reputation. Ignoring creditor demands only escalates risk and can cause key suppliers to exit.
- Obtain Professional Advice Early – When insolvency is suspected, directors should seek advice from qualified insolvency professional, such as one of our expert team members. Early intervention provides more options for restructuring and recovering the company.
- Not Delay Difficult Decisions – Delaying action is one of the most common mistakes we see directors making. If insolvency is likely, directors should act quickly to ensure they are not trading whilst insolvent.
The Role of Advisors in Preventing Insolvent Trading
Advisors play a critical role in helping clients avoid personal liability and improve the likelihood of business continuity. Their unique position enables them to offer objective, honest insights into a company’s financial health. Directors should seek guidance from trusted advisors during periods of financial uncertainty, and advisors, in turn, should consult with experienced insolvency specialists when signs of insolvency or insolvent trading begin to emerge.
When to Involve an Insolvency Professional
Insolvent trading poses a serious risk to directors, with potentially severe financial, legal and reputational consequences. However, with accurate financial management, timely professional advice, and early intervention, it is a risk that can be effectively mitigated.
Early engagement with an Insolvency professional can significantly improve outcomes for directors, employees, and creditors. If you have concerns about your client’s solvency, we encourage you to reach out for a confidential, obligation free consultation with a member of our expert team.