(1) Write a brief explanation about why the directors’ duty to prevent insolvent trading exists and the circumstances and consequences of the ‘veil of incorporation’ being lifted for insolvent trading?
(2) From what you know of OHS Solutions’ predicament, DISCUSS whether any of the directors may be about to breach or have already breached the duty to prevent insolvent trading. (In order to do this you will need to compare what is happening in OHS Solutions case with other precedent cases and refer to the relevant sections in the Corporations Act.) What will you advise Ying?
(1) Section 588G of the Corporation Act, 2001 states the responsibility on the directors to ensure that the company is solvent especially in those cases when the debt is incurred by the company (Thomson Reuters, 2015). The directors have to prevent insolvent trading by the company. It is said that this duty imposed on the directors is made in order to protect the unsecured creditors of the company (Ramsay I, 2000). The directors have been bestowed with this responsibility towards the company.
This shall be said to have been breached in the following situations:
When the company is insolvent or becomes insolvent because of the debt;
There were reasonable grounds to believe that the company is insolvent or will become insolvent
The directors are aware of the fact that the company is insolvent or likely to be insolvent (Comasters, 2003).
The director will be said to have breached the duty under Section 588G when he knows that the company is insolvent or will become insolvent and incurs debt.
The directors have been given the right under section 588G to prevent insolvent trading and in case the same is breached the directors have the right to make necessary claims. In case the director knows that the company is insolvent and is incurring debt then Section 588M allows recovering the compensation for damages suffered from the directors. The creditors’ suffer loss in such cases as the whole debt or part debt is unsecured. The liquidator shall have the right to claim damages against the director (Worrels, 2013).
The directors of the company are required to carry the business of the company with care and diligence. The directors cannot escape by stating that they had no knowledge about the fact that the company is insolvent when the company was incurring debt. If they are not aware about the financial capabilities of the company then they have not obliged their duty of carrying due diligence and care. In the present case study the directors are also the shareholders of the company and they are fully liable for the actions they have undertaken (Research Matic, 2013). The directors are aware about the fact that the company has a huge amount of debt due and if it incurs a new debt then it will become insolvent. This shall not be recommended by the directors of the company.
Once the company is registered it is a separate legal person than its members. Its liabilities are separate from the liabilities of its members. The court clearly states that the members shall not be held liable for any liabilities of the company no matter what position or role they hold in the company. This was clearly stated in the case of Saloman v Saloman & Co. Ltd (1897, HL). The company has been formed under the Companies Act and has a separate legal entity. Mr. Saloman acts only as an agent of the company. The ownership and management of the company do not go hand in hand. It was decided that it is necessary that the secured creditors of the company are paid before the unsecured creditors of the company. This is a prime case of lifting the corporate veil. Lifting of veil of incorporation for insolvent trading was made to increase the level of responsibility on the directors for the decision they make affecting adversely to the creditors. When the directors of the company are also shareholders of the company then the creditors may attach liability to the directors of the company by lifting the corporate veil. In the case study all the directors Des, Emma, Satish and Ying-director of Support Pty. Ltd are shareholders of the company and hence as the company is being poorly managed which is making the company move towards insolvency they shall be liable towards the payment to creditors of the company. In such a case if any decision is taken which makes the creditors feel that their unsecured debt would be at stake because of the decision it shall lift the corporate veil. The same has also been illustrated in the case of Adam v Cape, where the Court of Appeal held that the corporate veil shall only be lifted where the company has concealed the true facts. The grounds for lifting of corporate veil should be when the justice has not been granted or sham or fraud exists (Ramsay I, 2000). The court shall lift the corporate veil of incorporation when the company has been made to be used for dishonest or wrongful purpose. Also illustrated in the case of Gilford Motor Co. Ltd v. Home [1933] Ch 935 (CA), where the defendant was the managing director of the company and was regulated by a covenant that he shall not approach the present clients after his termination of services. After leaving the company he started a new company with his wife and approached the same clients of his earlier employer. This is wrong use of his contacts. The main aim for lifting the corporate veil is to prevent the protection of limited liabilities being wrongly used and to reduce fraud and sham. The concept of lifting the corporate veil applies only to those members who have actually violated the rules and created such a situation (Law Teacher, 2003). It is for the protection of those parties who have a trust relationship with the company.
(2) All the directors of the company know the fact that the company, OHS Solutions, has become insolvent as it finds out a large account from Trouble Shooters that was overdue. Now though Ying knows that the management of the company is not doing well and that OHS solutions could be purchased, it is not legal for Ying to get into such a transaction. As, Ying is the director of the company she has the duty to not get involved in any kind of trading knowing that the company is insolvent. This is against Section 588G of the Corporation Act, 2001. Moreover, Support Pty. Ltd. is also a guarantor for the debt taken by OHS Solutions and so cannot buy OHS solutions. In case any of the directors, namely, Des, Emma, Satish and Ying get involved in any trading activity when OHS is insolvent they shall breach their duty as a director. Till now they have not breached any of their duty as they have not got involved in any trading activity since the time they came to know that OHS has become insolvent. All the business transactions are done before declaration of company being insolvent was made. The directors shall commit criminal offence in case they do any wrong activity to incur debt. The main purpose of imposing this duty on the director is to increase the responsibility of the director and to protect the well-being of the shareholders of the company (PWC, 2011).
Directors are considered to be in the like position in the company where he knows about the affairs of the company and so the company considers various factors like the size of the company, the type of the business, delegation of functions and responsibilities, distribution of work, expertise area etc.
In a company the executive directors take participation in day to day management of the company and are supposed to know about the financial position of the company whereas in case of non-executive directors, they are not involved in the day to day working and generally rely on the information given to them on various occasions and forms like board meeting, various notices or agendas etc. Like in the case of Metal Manufactures Ltd v Lewis (1988) 6 ACLC 725, there were only two directors of the company, Primary Metals and Resources Pty Ltd; namely, Mr. and Mrs. Lewis (the company). In September 1993 the company went into a contract with the plaintiff. In the later stage the company did not oblige by the duly signed contract which led to award of damages against the company. The plaintiff later discovered that the company was given orders to wind up the company in September, 1984. Knowing this fact the plaintiff sued both the directors on the basis of trading when the company was insolvent under Section 556 of Companies (NSW) Code. The case was concluded by stating that there were only two directors in the company in which Mr. Lewis was the managing director of the company and because of his position in the company he shall be deemed to have entered into a contract on behalf of the company with the plaintiff. When the contract was entered the company was not in good financial conditions to pay off its debts. Mrs. Lewis was not involved in the day to day working of the company and she was in the company designated as a director only for the signing purpose. She had no knowledge about the debt due on the company and whenever she took interest in the same she was told by Mr. Lewis to not get involved in the same. Mrs. Lewis was in no way associated or aware about the debt conditions of the company. Mr. Lewis did not contest liability under section 556 of the Companies (NSW) Code and accepted with the judgment passed whereas Mrs. Lewis raised for defense under section 556(2)(a) and she got success in the trial. A plea was made against the decision passed in favor of Mrs. Lewis which was dismissed by the Court of appeal stating that the appeal is rejected and the decision taken under trial is correct. It is concluded that the silent directors of the company shall not be liable for incurring debt taken by the managing directors where they had no role to play in taking the decision of raising or incurring debt. In this case the silent director shall not be held liable (Law of Association).
In the case study of OHS Solutions, Ying and Emma are the non-executive directors of the company but in the board meeting held in March they all are made aware about the financial position of the company and hence they cannot take the defence of not being aware about the debts reflecting in the accounts. Therefore, as per Section 588 G the directors of the company cannot get into any trading when the company is insolvent. I would advise Ying of not getting into any trading activity even though he is a non-executive director of the company but he is accountable equally as an executive director. If he undergoes into any trading activity when there were reasonable grounds to believe that the company is not solvent he shall be equally liable for punishment. Ying in such a case shall be punished under Section 588G. The same has been illustrated in the case of Statewide Tobacco Services Ltd v Morley (1990) 2 ACSR 405, it was held that a non-executive director who cannot stop the company from incurring debt because it requires voting from a majority of shareholders shall not take this as a shield of not been able to stop the company to incur debt when the company was insolvent as he did not have support from majority of directors. This is because that even though he did not have support from majority of directors he is still required to take all necessary steps to prevent the company from trading when it was insolvent. The proof that the non-executive director had taken reasonable steps to stop the company from trading while insolvent if he was not able to convince other directors to not incur debts when the company is not solvent and the director has asked for winding up of the company or given his/her resignation (Lewis P, 2010).
There are also various defences available to the directors in case they are not able to stop the company from incurring any debt (PWC, 2011). The cases would be:
1. When the director is under this impression that the company is solvent when the debt has incurred as there are reasonable grounds to believe so and that the company would not go insolvent after incurring the debt (PWC, 2011). In such a case the court shall observe that whether the statements given by the director are justified or not. What needs to be seen is that whether the company will be able to pay off its debt when it becomes due or not. In the case of Metropolitan Fire Systems Pty Ltd V Miller the court held that to suspect something entails lesser level of knowledge than to expect it. Expectation should be more than just hoping for it. The directors should be confident when they claim a time when the company will be able to pay of its debts in future course of time (Ramsay I, 2000).
2. The director believes that there is a reliable person who is monitoring the solvency of the company and informing the director about the same. The directors should have a reasonable ground to believe that the person is fulfilling its responsibility (PWC, 2011). In such cases the directors expects that the company is solvent at the time when the debt is being incurred based on the information given by such reliable person and hence believe that the company would remain solvent even after the debt will be taken(Ramsay I, 2000).
3. The time when the debt is incurred the director does not take any participation in the management of the company because of health reasons or any other good reason for non-participation (PWC, 2011).
4. The director has taken all the necessary steps to prevent the company to incur debts when it was insolvent (PWC, 2011). One example of it is where the director has taken any step for appointment of administrator of the company (Ramsay I, 2000).
The main aim of framing of Section 588G in the Companies Act is to protect the interest of creditors of the company. Though it may look like after going through the section that competent people might shirk away to take the responsibilities and position as a director of the company because of the responsibilities it holds and punishment it takes along with non-fulfilment of responsibilities. However it can be argued on the same that the all the penalties imposed on the directors for breach of their duty under Section 588 G has been neutralised and supported by provisions of Section 588H. Section 588H is made to protect the interest of the directors and give them a sigh of relief (PWC, 2011). It is very essential for the directors to know and understand the duty they have been given to prevent insolvent trading and should give its advice as and when the company is in any financial difficulties thereby advising the company with any alternative solution to prevent the company from getting into insolvency and to ensure that their position as a director is well protected (Merity C and Harris S, 2010).
BIBLIOGRAPHY:
Thomson Reuters, (2015), Directors duty to prevent insolvent trading, Available from website: https://www.findlaw.com.au/. [Accessed on 22nd January 2015].
Ramsay I, (2000), Company directors’ liability for insolvent trading, CCH Australia Limited, Melbourne.
Comasters Law Firm and Notary Public, (2003), Directors’ duty to prevent insolvent trading, Available from website: https://www.comasters.com.au/. [Accessed on 22nd January 2015].
Worrels, (2013), Insolvent trading, Available from website: https://www.worrells.net.au/. [Accessed on 22nd January 2015].
Law Teacher, (2003), Lifting the veil separation of the personality, Available from website: https://www.lawteacher.net/. [Accessed on 22nd January 2015].
Research Matic, (2013), Veil of Incorporation, Available from website: https://www.researchomatic.com/. [Accessed on 22nd January 2015].
Pricewaterhouse Coopers, (2011), Company law duties, Available from website: https://etraining.communitydoor.org.au/. [Accessed on 23rd January 2015].
Law of association, Insolvent trading, Notes from the Law of Associations course Available from website: sydney.edu.au/. [Accessed on 23rd January 2015].
Merity C and Harris S, (2010), Australia: ASIC releases new guide for directors on duty to prevent insolvent trading, Available from website: https://www.mondaq.com/ [Accessed on 23rd January 2015].
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