In a recent decision, the Full Court of the Supreme Court of South Australia has again sounded a warning to company directors, who allow their business to trade on, "hoping against hope" that something will turn up to resolve its financial difficulties. The Full Court confirmed a decision of a single Judge of the Court that two company directors, Dr Fryer (a non-executive director) and Mr Perry (the managing director) were liable to pay sums totalling $340,000 (including interest) to the liquidators of Noelex Yachts Australia Pty Ltd, on account of insolvent trading.

Noelex Yachts Australia Pty Ltd ("Noelex") carried on the business of a manufacturer and wholesaler of yachts from 28 August 1987 to 2 April 1995 at Goolwa, in South Australia. The creditors of Noelex resolved to place the company into liquidation in June 1995.

In 1998, the then liquidators of Noelex sued Dr Fryer and Mr Perry, claiming that, between June 1993 and April 1995, the company incurred a series of debts, and that:

• it was insolvent at the time that each and every one of the debts was incurred
• at the time each of the debts was incurred there were reasonable grounds for suspecting that the company was insolvent
• at the time each of the debts was incurred, Dr Fryer and Mr Perry were aware that there were reasonable grounds for suspecting that the company was insolvent.

In those circumstances, sections 588G and 588M of the Corporations Law allow a liquidator of the company to recover from the directors an amount equal to the loss or damage suffered by creditors as a result of the insolvency of the company. The debts incurred included Sales and Group tax liabilities and penalties, trade debts and employee entitlements.

The Facts

Noelex’s financial position throughout its life was analysed in some detail by the liquidator, by an expert witness called by the directors, and by the Court itself.

Suffice it to say that:

• the company’s balance sheets regularly disclosed liabilities in excess of assets
• there were substantial accumulated trading losses, that grew to $690,390
• it was apparent to the directors that further working capital was needed as early as 1991,
• there was a special directors’ meeting in 1992, at which Noelex was described as "insolvent" and various options for salvaging the company’s position were canvassed
• in May and July 1992, attempts were made to salvage the company’s position by introduction of further capital
• in October 1992, one Mr Ironside resigned as a director, making adverse comments as to the company’s financial position
• there was a shareholders’ meeting in June 1993; the Chairman of the Board "pleaded" with shareholders to provide further financial assistance to allow the company to complete a restructuring, describing, as he did so, the company’s position as "desperate"; as at January 1993, approximately 59% of creditors were outstanding over 90 days and approximately 77% were outstanding over 60 days
• from at least September 1992, the company was making payments by post dated cheques; during early 1994, the company was defending winding up proceedings, and cheques for as little as $400 were dishonoured; Mr Perry’s evidence, however, was that he was always able to proceed on the basis that most creditors would not press for payment or that payment could be made via director’s loans to Noelex.

The Court concluded that the evidence disclosed endemic insolvency.

The directors defended the proceedings upon a number of bases; this led the Court to conclusively re-state the law of insolvent trading, and to put to rest a number of controversies that have surrounded the current insolvent trading regime since its enactment in 1993. In doing so, it confirmed the Courts’ tendency to impose stringent standards upon company directors; particularly when companies are in financial trouble.

Question 1: What is a Debt?

This question was not seriously in dispute, and was simply answered by the Court: "an obligation of one party to pay a sum of money to another".

Question 2: When is a Debt Incurred?

The directors argued that some of the obligations to which Noelex was subject were not debts "incurred" for the purposes of the Corporations Law; in particular, the directors argued that Sales and Group tax penalties, as well as Sales and Group tax itself, were imposed on the company, which, did not do any positive act to incur the debts.

The Court over-ruled the case of Castrios v McManus (1991) 9 ACLC 287, and held, consistently with Sands & McDougall Wholesale Pty Ltd (In Liq) v Commissioner of Taxation (1999) 1 VR 489, Hawkins v Bank of China (1992) 26 NSWLR 562, and a number of other cases, that the incurring of statutory taxes and impositions, even by "mere passive retention of existing staff or premises" constitutes "incurring a debt".

Question 3: What Constitutes Insolvency?

The test for solvency prescribed by the Corporations Law is notorious, and deceptively simple; a company is solvent if and only if it can pay all its debts as and when they fall due; a company that is not solvent is insolvent.

The Court re-stated several propositions from the cases relating to the definition of insolvency:

• solvency is a question of fact; in litigation, it is for the trial judge to determine from all the evidence
• solvency must be determined from the entirety of the company’s financial position, based upon commercial reality; temporary lack of liquidity is not, generally speaking, insolvency
• it is legitimate to take into account extended trading terms; but mere failure by creditors to enforce trading terms is usually ignored; what is required is a specific agreement to extend terms, usually with creditors generally
• it is not appropriate, when determining solvency, to consider whether the company might trade profitably in the future.

Question 4: What is "Loss or Damage"?

The directors argued that the "Loss or Damage" suffered by creditors in an insolvency is not simply the amount of their unpaid debts; rather, one needs to consider a whole series of other factors affect the loss actually suffered by creditors. These factors included:

• any dividend expected to be received in the liquidation
• the profit component of a trade debt, and whether the creditor had any one else to whom it could sell
• in the case of rates, any statutory charge imposed on the company’s land
• that tax penalties could never constitute "loss or damage" suffered; they are simply "penal exactions".

These arguments were described as "novel and extraordinary" and as "flying in the face of the plain intention of the legislation". The Court entertained no doubt that the relevant loss or damage is the amount of the unpaid debt due to the creditors in question.

Issue 5: The Defences

The directors sought to rely upon the defences provided by section 588H of the Corporations Law; that is, it is a defence if the director, at the time a debt was incurred, had reasonable grounds to expect, and did expect that the company was solvent at the time, and would remain solvent even if it incurred the debt, and any other debts incurred at that time.

The Court held, on the facts of this case, that the directors were merely hoping against hope that they would be able to retrieve the situation; Noelex was hopelessly insolvent and no reasonable person could have expected that its position was anything but hopeless.

Similarly, although section 1318 of the Law allows the Court to excuse directors who act "honestly" but are still guilty of insolvent trading, the Court held that that section had no application in this case; the directors did not act "honestly" in the relevant sense, rather, they acted "reckless[ly]" and "took advantage of indulgent creditors".

What It All Means

Since 1993, the Courts’ interpretation of the insolvent trading provisions of the Law has imposed, steadily more stringent obligations upon company directors. Whilst, in the circumstances of this case, it is difficult to see the Full Court coming to any conclusion other than the one it did, its approach to the legislation makes obvious the need for great caution on the part of directors whose companies are suffering liquidity problems.

Directors whose companies are in financial difficulty, whether through GST associated cash shortages, or otherwise, will need to give very careful consideration to their own positions and are at risk of significant personal liability if they are unable to retrieve the situation.