Overview
Financial distress for a company always places additional emphasis on governance—and on the duties of the directors of the company. The Australian legal system has a clear system of duties for directors—a period of financial distress adds different dimensions and points of emphasis to those duties, and can bring additional risk for the individual directors in the event of a subsequent formal insolvency appointment.
To govern well during a time of financial distress (and to minimize risk for the directors of breaching their obligations), it is important that directors are familiar with how these duties operate during that time. This overview provides that familiarity for directors. It is not intended to be exhaustive. If you require detailed advice on any of the topics outlined, please contact us so that tailored guidance can be provided.
Core duties of directors—issue during a time of financial distress
In Australia, directors’ duties arise from four main sources: (a) statutory duties under the Corporations Act 2001 (Cth); (b) general law duties; (c) the company’s constitution; and (d) in some instances, specific regulatory requirements. The following overviews the principal statutory and general law duties and liabilities of directors of Australian companies, as we experience them taking application in a time of financial distress for the company.1
Who owes the duties?
Statutory duties under the Corporations Act apply to acts or omissions of directors and other "officers" of Australian companies, regardless of the director’s residency or where the conduct occurred.
(a) "Officers" include those who make, or participate in making, decisions affecting the whole or a substantial part of the company’s business, or who can significantly affect its financial standing. In some specific cases, statutory duties can also extend to employees.
(b) A "director" under the Corporations Act includes not only those formally appointed, but also anyone acting as a director or whose instructions or wishes the directors are accustomed to follow.
General law duties are owed by directors and (broadly speaking) senior executive officers, arising from their position of trust and the duty of care owed by directors and other senior executives to the company. For senior executives who are not also, these duties may be modified by their service agreements.
Australian law recognizes “shadow” or “de facto” directors. This can be both individuals and also other group companies (e.g., a parent company)—it can also include third parties such as a domineering financier (whether shareholder or lender). A “shadow” director situation is risky for both the actual named directors and the “shadow director”—and so needs to be considered carefully. The detail is beyond the scope of this overview.
Duty to act with care and diligence
Directors must act with care and diligence under both general law and section 180(1) of the Corporations Act. This duty is assessed by comparing the director’s conduct to that expected of a reasonable person in a similar role and context, taking into account the company’s size, business, and the director’s responsibilities.
The “business judgment rule”
Under section 180(2) of the Corporations Act, a director who makes a business judgment is taken to have satisfied the duty of care and diligence under s180(1), and equivalent common law and equitable duties (but not other duties). A business judgment is any decision to take, or not take, action regarding a matter relevant to the company’s operations. The defense is available provided that the director:
(a) makes the judgment in good faith and for a proper purpose
(b) does not have a material personal interest in the subject matter
(c) informed themselves about the subject matter to the extent they reasonably believe appropriate
(d) rationally believe the judgment is in the best interests of the company. This belief is considered rational unless no reasonable person in the director’s position would hold it.
This defense is valuable for directors in a financial distress scenario—but does emphasize the importance of good “hygiene” steps for a board of a distressed company.
Practical “hygiene” steps in financial distress
In a financial distress scenario, these considerations emphasize the importance of some basic hygiene steps:
(a) Regular board meetings (and increased frequency of those meetings), with well organized agendas and materials
(b) Provision to the board of current and regular financial reporting and forecasting
(c) The engagement of suitable expert advisors to assist the board with issues confronting the business
(d) The maintenance of quality board meeting minutes.
Duty to act in good faith in the best interests of the company—s 181 Corporation Act
Directors must act in good faith and exercise their discretion honestly in what they consider to be the best interests of “the company”. While general law and statutory duties are not identical, they are similar in character, and directors must comply with both.
A subjective duty—with qualifications
The general law duty is primarily subjective—directors are required to act in good faith according to what they believe to be in the company’s best interests. However, courts may find a breach where a director’s decision is one that no reasonable director could regard as being in the company’s interests, even if the director believed otherwise at the time.
Whose interests to consider?
A time of financial distress, very importantly, throws into sharp focus what interests or stakeholders to think about when thinking of the best interests of “the company”.
During regular times—shareholders and group companies
Outside of financial distress, it is commonplace for shareholders to be top of mind for a board when considering best interests.
In a corporate group context, there is statutory provision for directors of a subsidiary being able to act in a manner that gives substantial weight to the holding company’s best interests.2 Additionally, the subsidiary must not be insolvent at the time the director acts, and the director’s actions must not cause the subsidiary to become insolvent, protecting the financial health of the subsidiary.
A shift to the interests of creditors—financial distress scenario
In a time of financial distress, however, considering the “best interests of the company” involve a shift toward inclusion of the interests of creditors. It has been explained that—while there is no direct duty owed to creditors—the “best interests of the company” involves an avoidance of prejudice to creditors. A failure to appreciate this shift in focus of the “best interests duty” is fertile ground for litigation against directors in the event of a formal insolvency.
Practical steps for a director
The essential practical step for a director approaching this duty in a time of financial distress is a mindset shift—considering creditors as part of decision-making. In our experience, this sees a greater focus on cash—through closer cash management, robust and regular cash-flow forecasting, engagement with key creditors (e.g., lenders, large suppliers), and deferral of non-essential or loss-making expenditure.
Duty to avoid conflicts
Broadly speaking, directors must not put themselves in a position where their duties to the company may conflict with duties owed to another party or their own personal interests. This finds expression in general law, and also in sections 182 and 183 of the Corporations Act—which provide that a director must not use their position3 or information acquired by the director as a result of holding that position4 to gain an advantage for themselves or someone else.
In a financial distress scenario, the conflicts duty is often critical in corporate groups—where directors may occupy board roles across financially distressed entities in a group and also entities not experiencing financial distress. Directors in those circumstances can easily slip into a position of conflict—wishing to prefer the interests of one entity (e.g., the “solvent” entity) over another (e.g., the distressed entity), but without properly identifying and managing that conflict.
There is no “silver bullet” for this issue in practice—the conflicts duty simply demands identification and careful consideration, with some practical mitigation measures, on a fact-driven basis. This might include board position changes across group members and the engagement of specialist directors to take up new positions on particular group company boards.
The duty to prevent insolvent trading
The duty itself
Section 588G of the Corporations Act imposes on directors a duty to ensure the company does not trade while insolvent. A director breaches this duty if:
(a) they were a director at the time the company incurred the debt
(b) the company was insolvent at that time, or became insolvent as a result of incurring the debt (or related debts)
(c) there were reasonable grounds to suspect the company was, or would become, insolvent when the debt was incurred.
Consequences of breach
A breach of this duty can result in both civil and criminal penalties—and may include an order that the directors be personally liable to compensate the company for a debt incurred in breach of the duty, should the company proceed into insolvent liquidation.
Defenses
There are several defenses to a civil claim of insolvent trading:
(a) A director is not liable if, at the time the debt was incurred, they had reasonable grounds to expect, and did expect, that the company was solvent and would remain so after incurring the debt.
(b) A director may rely on information provided by a competent and reliable person responsible for the company’s solvency, provided the director reasonably believed the company was solvent based on that information.
(c) Directors may be excused if they did not participate in management at the relevant time due to illness or another valid reason. This defense is rarely successful.
(d) A director can defend their actions by showing they took all reasonable steps to prevent the company from incurring the debt, such as appointing an administrator.
(e) The court may relieve a director from liability if it finds the director acted honestly and, considering all circumstances, ought fairly to be excused.
These defenses underscore the importance of directors maintaining a thorough and ongoing understanding of their company’s financial position and taking prompt action if insolvency is suspected.
The “safe harbor”
The “safe harbor” regime in section 588GA of the Corporations Act affords directors of distressed companies a further critical protection against insolvent-trading liability. It is not a formal restructuring tool—but rather a carve-out to insolvent trading liability if certain steps are followed.
After suspecting insolvency, a director who(with appropriate expert advice) formulates and diligently pursues a plan reasonably likely to yield a better result for the company than an immediate appointment of an administrator or liquidator will be excepted from personal liability for debts incurred while that plan is being developed and then implemented.
A plan for a “better outcome”
The protection endures only so long as the plan is actively progressed within a reasonable period, and remains viable—viability is determined objectively and by reference to reasonableness, and so hopeless optimism will not suffice. Illustrative measures that may satisfy the “better outcome” threshold include asset sales, halting further borrowing, renegotiating debt facilities, cutting expenses, undertaking a business review, initiating a formal restructuring, or appointing experienced directors. This is all often (and typically, in larger businesses) done with the assistance of expert restructuring advisors.
The essential hygiene factors
There are a number of essential hygiene factors that need to be met, in order to rely on safe harbor:
(a) Tax lodgments must be up to date.
(b) Employee entitlement payments (including superannuation) must be up to date.
(c) The company’s financial records must be in good shape.
(d) Measures must be in place to prevent officer/employee fraud (i.e. quality accounting control systems).
(e) While not mandatory, the engagement and involvement of an expert restructuring advisor is also relevant to determining if the “better outcome” plan requirement of safe harbor is being satisfied.
The safe harbor provisions have yet to be fully tested in the courts, and further judicial clarification is awaited. But reliance on safe harbor has now become a go-to tool for directors and their advisors in this market—bringing a quality governance framework to a financial distress scenario.
Considerations for holding companies
By section 588V of the Corporations Act, a holding company is liable for the insolvent trading of its subsidiary, if the holding company had the capacity to influence management and failed to prevent debts being incurred. This is obviously an important veil-piercing measure for group parents to be mindful of when dealing with financial distress of a subsidiary.
It is important to keep in mind that this duty can apply to joint ventures—where as low as (in effect) 51% is held in the joint venture entity. That is—the holding company insolvent trading obligation does not only apply to wholly-owned subsidiaries.
It is important to note that the same defenses and the “safe harbor” are also available in relation to this duty—and so should be carefully considered by holding companies facing the financial distress of a subsidiary.
Appointing a voluntary administrator—pulling the rip chord
If the company cannot be turned around, and the directors conclude that the company is insolvent (or likely to become insolvent)— then the “rip chord” is appointment of a voluntary administrator under Part 5.3A of the Corporations Act.
The Australian voluntary administration regime, this market’s core corporate rescue procedure, is beyond the scope of this overview—but see our other client publications on this topic. For present purposes, the regime is easy for a board to initiate—being done informally and out of court, by simple board resolution. Administration is a very well understood process in this market—with a good bench of expert practitioners available to assist.
Some other considerations in this market
In our experience, there are several other sources of director personal liability in a financial distress scenario—and also practical limitations on some insurance coverage—that merit consideration.
Director penalty notices (tax and superannuation)
In certain circumstances, the Australian Taxation Office (ATO) can issue a “director penalty notice”—rendering a director personally liable for certain of a company’s unpaid tax obligations, such as PAYG tax, GST (VAT), and superannuation guarantee charges. Directors have limited defenses to this personal liability.
While beyond the scope of this overview—this source of personal liability underscores the importance of good hygiene practices around tax lodgments and tax remittances during a time of financial distress
Indemnity to ATO for unfair preference clawbacks
If a company proceeds into insolvent liquidation, it is commonplace for a liquidator to pursue recovery of unfair preference payments made to creditors in the period before liquidation. The ATO is a common target for such recovery action.
Section 588FGA of the Corporations Act provides the ATO with a statutory indemnity from company directors if the ATO is required to repay amounts to a liquidator under an unfair preference claim. Where a court orders the ATO to repay a tax payment received from a company (typically PAYG withholding or superannuation contributions) as an unfair preference, the ATO may recover that amount from those who were directors at the time of payment. The ATO must show that the company was insolvent at the time of payment or became insolvent as a result, and that the director had reasonable grounds to suspect this. The courts have determined confirmed that directors remain liable for the indemnity even if they resigned before the liquidator’s claim.
Liabilities for transactions to avoid employee entitlements
Section 596AB of the Corporations Act criminalizes transactions intended to defeat employee entitlements. It applies to directors and officers who engage in asset stripping or phoenix activity, such as transferring assets to related entities before insolvency. The offense does not require a successful outcome; intention or recklessness to cause loss is sufficient. Contraventions may result in imprisonment for up to 15 years or civil penalties.
This provision underscores that great care is needed if restructuring is being considered during a time of financial distress where employee entitlements may be at risk.
Directors have no priorities in liquidation
Director entitlements enjoy no priority in a later liquidation of a company—and so are subordinated to non-director employees.
This sees director fees sit alongside the body of ordinary unsecured creditors in any liquidation.
Director and officer liability insurance
As a result of a vigorous litigation market for company liquidators against directors, the scope of director and officer liability insurance policies in this market can be narrow—at times excluding from cover liabilities in effect arising from the insolvency of a company. There is no uniform market practice and global policies often differ—but directors of Australian companies in a financial distress scenario should consult with their broker about the scope of cover available to them, should the company ultimately fail.
We hope that this overview is helpful for our director clients in getting across the key issues in this market when confronting financial distress. For more information, please contact David Walter, Michael Parshall, Simone Lowes, Michael Shepherd, Heather Sandell.
Footnotes
1. This document does not address constitution-specific duties, which require tailored advice.
2. See s187, Corporations Act. Note that the subsidiary's constitution must explicitly authorise the director to act in the best interests of the holding company. It is important that this is checked before relying on the statutory provision.
3. Section 182 of the Corporations Act.
4. Section 183 of the Corporations Act
