A draft Australian Securities and Investments Commission (ASIC) guide on the duty of directors to prevent insolvent trading1 is relevant here given the similarity in our respective laws. In addition, the Australian Government has released a discussion paper which signals the possible introduction of a limited “safe harbour” for directors in trade out situations.
This Brief Counsel summarises the contents of these papers and comments on the applicability of the ASIC advice to New Zealand.
Australian and New Zealand regime very similar
Our Companies Act 1993 (the Act) requires directors to avoid trading recklessly, defining recklessness as carrying on business in a manner likely to create a substantial risk of serious loss to the company’s creditors. The Act also prohibits directors from allowing the company to incur an obligation unless they have reasonable grounds for believing that it will be able to perform the obligation when called upon to do so.
Section 588G in the Australian Corporations Act 2001 requires directors to ensure the company does not incur a debt if the company is insolvent, or if incurring the debt will make the company insolvent. Civil claims for compensation or criminal prosecution can result. There are defences available when directors believed on reasonable grounds that the company was solvent or that a competent and reliable person was providing information about the solvency of the company.
Key principles to guide behaviour
ASIC identifies four key principles for directors:
a director must keep informed about the financial affairs of the company, and regularly assess the company’s solvency
immediately upon identifying concerns about the company’s financial viability, a director should take positive steps to confirm the company’s financial position and realistically assess the options available to deal with the company’s financial difficulties
a director should obtain appropriate professional advice, and
a director should consider and act appropriately on advice received, in a timely manner.
These principles are also relevant to directors of New Zealand companies, and are a useful reminder of the care that must be taken in respect of insolvent trading.
The ASIC report contains the following practical measures directors can take to ensure they are informed as to the financial affairs of the company:
being involved in or overseeing the preparation of profit and cash flow budgets and regular management accounts, and monitoring actual results against budget expectations
regularly reviewing the company’s ability to collect debts owed to it and to realise other current assets, including stock
monitoring when creditors are due to be paid and the company’s ability to comply with normal terms of trade, and
reviewing bank debt levels and the ability to source additional funding if required.
In cases such as Mason v Lewis2, the New Zealand Court of Appeal has made it clear that directors have a positive duty to be informed of, and be involved in, the affairs of the company so as to ensure that it does not trade recklessly.
The key message in the ASIC report is that if it becomes apparent that a company is experiencing financial difficulty, directors should properly investigate the company’s affairs and seriously consider obtaining professional advice as to the solvency of the company. Directors should use this advice to assess the options available to the company, including whether any new obligations can be incurred.
The New Zealand Companies Office echoes this advice on its website under the heading "My company is in financial trouble...what are my options?" The overriding message is to seek professional assistance.
ASIC sets out the factors relevant to assessing whether a director is liable for a breach of his or her duty to prevent insolvent trading, and highlights the importance of keeping proper records.
Without proper financial records, directors cannot have a proper appreciation of the company’s ability or inability to pay its debts and the line between legitimate and illegitimate business risks can easily become blurred.
Record keeping is also addressed in section 300 of our Companies Act which defines proper accounting records as those which:
record and explain the transactions of the company
enable at any time the financial position of the company to be determined with reasonable accuracy
enable the directors to comply with the Financial Reporting Act, and
enable the financial statements to be readily and properly audited.
The appendix to the ASIC guide sets out a list of 16 criteria that a reasonable person would take into account when determining whether a company is in financial difficulty; such as the company experiencing cash flow difficulties, struggling to sell its stock and not paying creditors on the agreed terms.
If one or more of these is present, directors are advised to seek professional advice. We think the list is very useful in a New Zealand context to determine whether a company may be trading recklessly.
A company need not cease trading the moment it becomes insolvent, and typically the courts will allow a grace period for the company to attempt to remedy its financial position. Generally, however, the time allowance will only be a matter of months.
Limits to application of ASIC report to New Zealand
The ASIC paper is intended as a guide to the approach ASIC will take in the exercise of its statutory function to investigate breaches of directors’ duties. In New Zealand, these duties are usually enforced at the request of a liquidator or, in some cases, a receiver, creditor or shareholder. New Zealand courts are, however, likely to take into account similar principles regardless of whether the proceedings are initiated by a public body or not.
Introduction of a safe harbour?
In addition to the ASIC paper, the Australian Government has released a discussion document3 which signals the possible introduction of a statutory safe harbour for directors in relation to their duty to prevent insolvent trading.
The safe harbour would apply in limited circumstances to the directors of companies who are attempting to reorganise or trade out of insolvency and would be available where directors could demonstrate that they were:
relying on true and accurate financial records
receiving advice from an appropriate professional
using their business judgement and assessing that the reorganisation was in the interests of the creditors as a whole, and
diligently pursuing the restructuring.
If the safe harbour is introduced, it may be that liquidators and directors in New Zealand could refer to those criteria when considering whether continued trading was, or is, appropriate.
The ASIC report makes it abundantly clear that once a company enters into troubled waters, directors are under an onerous duty to ensure they behave responsibly.
We await with interest the final report and the extent to which the New Zealand courts will be guided by its contents.
Our thanks to Philip Ascroft, summer clerk, for writing this edition of Brief Counsel.