Insolvent Trading And Lifting Of Corporate Veil: A Case Study

Concept of Insolvent Trading

Question:

Write a brief explanation about why the directors' duty to prevent insolvent tranding exists and the circumstances and consequences of the veil of incorporation' being lefted for insolvent tranding?

From what you know OHS Solution predicament, Discuss whether any of directors may be about to breach or already breached the duty to prevent insolving tranding. What will you about Ying?

When a director permits their company to incur debts at the time of its insolvency, it is known as insolvent trading. If such debts are not paid, the liquidator may claim for compensation against such director at the time of commencement of liquidation. The directors may be directed to pay compensation for the losses incurred by the creditors. Section 588 G of the Australian Corporation Act imposes a duty on the directors that they should make sure that their company incurs debt, only when it is solvent (SU-KING, H., 1999). Thus, the duty is to prevent insolvent trading. It was held in the case of Woodgate v. Davis 2002, that this duty is imposed on the directors for two reasons:

To create attentiveness among the directors, who are under the financial stress so that they behave more responsibly, and avoid any further increase in the burden of the company’s debt.

For the welfare of creditors and to protect them from the loss, which they may suffer due to insolvency of the company (KEAY, A. and MURRAY, M., 2005).

Section 588 G imposes two duties on the directors: first, not to permit to trade, in the state of insolvency and second, to prevent a company from trading so as to avoid it from becoming insolvent. The main purpose of this section is to hold the personal liability of the directors for the debt, which are incurred by the company at the time when it is insolvent or for those debts, which lead a company to insolvency (SYMES, C.F., 2003). For making a director liable for breach of duty under section 588 G, the following elements must exist:

If the person in question was director of the company, at the time the company incurred debt;

The company was either insolvent at the time it incurred debt or became insolvent because of incurring debt;

At the time of incurring debt, there existed reasonable grounds to suspect that the company was insolvent or would become insolvent because it incurred the debt and;

At the time when the debt was incurred, the director was aware that there were reasonable grounds to suspect that the company was insolvent or any reasonable man under similar circumstances in the company would be aware of the same (LITHGOW, P., 1995).

Lifting the corporate veil was first defined in Pioneer Concrete Services Ltd v Yelnah Pty Ltd (1986) 5 NSWLR 254, as that although the creation of  a new individual company gives it a status of a separate legal entity, but on some particular occasions, the courts may look behind the legal entity to the real controllers of the company. It means that the separate identity of the corporation is ignored and the shareholders of the company are held  responsible for the actions of the company as if they were shareholders’ actions (GRAHAM, T. and POOLE, J., 2010).

Section 588 G of Australian Corporation Act

1. Duty to prevent insolvent trading:

In the given case, all the directors of the OHS solutions, Des, Emma and Satish had the duty to prevent insolvent trading. All the conditions of section 588 G are fulfilled in this case. They all were directors of the company when they took a loan of $50,000 from the bank for their company. Second, since they were aware of the fact that some IT problems prevented the access to some of the advertising material and hence the customers were dissatisfied with the services of OHS solutions. Third, at the time debt was incurred and a large account became due from trouble shooters Ltd., they had reasonable grounds to suspect in the situation that unless their IT problem was solved properly, their company would become insolvent due to the debt incurred. Fourthly, directors Emma, Satish and Des made a breach of section 180 (1), a duty of care and diligence in the exercise of powers and responsibilities of the director.  In spite of being aware of the fact that they were unable to provide satisfactory advertising services to their customers due to IT issues in their system, they did not take reasonable care before entering into further contracts that whether their system was corrected and had become capable of providing appropriate services.

Thus, all the elements of section 588 G are satisfied and thus the duty to prevent insolvent trading existed in this case, which the directors failed to fulfill.

2. Circumstances and consequences of lifting the corporate veil:

In the given case the corporate veil may be lifted on the ground of demand of justice, which has been regarded as a valid ground by the courts in a number of cases in the past. Moreover, mostly the corporate veil is lifted in case of close corporations, means those corporations which have a very few shareholders (SHUB, O., 2006).

In Harrison v Repatriation Commission,

Here, the directors made the company OHS solutions behave in a particular way with their own actions and it was due to their own wrong doing that the company became insolvent. It was held by the court that the lifting of corporate veil becomes necessary to know the exact situation and the reality of the relationship between the applicants and the company so that no injustice is done to the creditors and the directors are prevented from shifting the burden of their own wrong actions on the corporation (OH, P.B., 2010).   

Thus, here the carelessness and negligence on the part of the directors to prevent the company from insolvent trading and hence a breach of their duties will allow the lifting of corporate veil and consequently all the directors of the OHS solutions will be held personally liable for all the debts incurred by the company.

Section 180 (1) of the Australian Corporation Act (ACA) provides that it is the duty of the director to exercise proper care and diligence while performing his duties and exercising his powers as a director of the company. This section also requires that the  test for degree of care and diligence of a director in the discharge of his duties and exercise of his powers would be the same which a reasonable man would be expected in the same circumstances, if he would be the director of the company.

Lifting of Corporate Veil

Section 588 (G):  provides that it is the breach of duty by the director if:

1. At the time, the company incurred debt, he/she was director of that company.
2. The company had been either already insolvent or became insolvent due to the incurring of debt.
3. There existed reasonable grounds to suspect that the company would become insolvent

• The director was aware of such grounds; or
• Any reasonable person, in similar circumstances would be aware.

4. He/ she became unsuccessful in preventing the company from insolvent trading.

In the given case, the position of each of the directors can be discussed as below:

Emma: was the finance director of the OHS solution and was responsible to look after all accounts of the company. During the meeting in February, 2007, after 6 months of the company’s operation, Emma failed to give details of the accounts of the company and found that everything was a mess in this regard. Moreover, she found that there was a large account due from Trouble Shooters Pty Ltd. Thus, she failed to exercise proper care and diligence in the discharge of her duties, which any reasonable man would be expected to do in the similar circumstances and on a similar position and hence made a breach of her duty under section 180 (1). Moreover, she failed to take any preventive measures to prevent the insolvent trading because it was her major responsibility to conduct the finance of the company and keep all the other directors informed about it. She allowed the other directors to incur debt when there were reasonable grounds to suspect that the company would become insolvent when there was already a loan from a bank and a large sum from Trouble Shooters was due. Her carelessness led the company on the path to become insolvent. She cannot take the plea of being a non-executive director of the company because the court has held in a number of cases that a non-executive director is also equally responsible and duty bound to take reasonable care in the discharge of duties, which other directors are expected to. Reference can be made to the following similar cases in this regard:

James Hardie decisions: ASIC v Hellicar & Ors; Shafron v ASI [2012] HCA17 and [2012] HCA 18 respectively

In this case, several non-executive directors were held to be liable for making a breach of their duty of care and diligence in the exercise of their powers, being directors of the company and the court directed that even if non-executive directors, but they are expected to be cautious in the major decisions (POLLARD, S.M., 1994).

Australian Securities and Investments Commission v Rich and Others (2003) 44 ACSR 341.

It was held in this case that although the director in question was a non-executive director, but, owing to his qualification along with experience, he had a responsibility towards the corporation and also had the duties of  a director and was thus accountable for breach of duty of care and diligence on his part.

Hence, on the basis of the above precedent cases and the corresponding situation of OHS solutions, it can be concluded that Emma made a breach of her duties under section 180 (1) of the Corporation Act.

Satish: was the executive director of the company and was responsible to look after the technical side of the company. In spite of being aware that there were some technical IT issues in their website and their company was not able to provide appropriate services to their clients, he did not pay attention as if the Trouble Shooters were successful in removing the defects. Without checking it properly, Satish informed the managing director of the company, Des that IT problems were fixed. Moreover, Satish was aware of the fact that the two businesses were dissatisfied with the company’s services due to these IT issues and were threatening to sue the company for breach of contract. In spite of having knowledge about this fact, Satish allowed Des to enter into a contract of $10,000 with a company, Promotions Plus Pty Ltd. for promotion of their website. Thus, Satish with the awareness that the company had already been in debt and with reasonable grounds to suspect that the company would become insolvent, permitted the company to trade. Hence, Satish made a breach of his duty to prevent insolvent trading under section 588 G. Reference can be made to similar case laws:

Case Study: OHS Solutions

Commonwealth Bank of Australia v. Friedrich and others (1991) 84, 129, 213-4:

In this case, the chairman of Australia’s National Security Council signed the  Council’s annual accounts and took a loan of $ 97.5 from the Commonwealth Bank stating that the Council was solvent. However, his statement was based on the information provided by the chief executive of the Council, Freidrich, who deceived him. But, the court held that being a director of the Council, it was the duty of the chairman to closely look into the accounts of the Council (TRETHOWAN, I., 1992).

Statewide Tobacco Services Ltd v. Morley (1990, appeal 1992) 84:

In this case, Mrs. Morley remained as director of the company for years after the death of her husband, who was the founder of the company. Although, she never took part in the company affairs. She remained as the governing director and her son managed the company all these years. When the company became insolvent and owed heavy debt to other creditors, the court held that failure on the part of Mrs. Morley to inquire into the details of the accounts of the company was a breach of the duty to prevent insolvent trading (SU-KING, H., 1999).

Des: was the managing director of OHS solutions and was thus responsible for managing the day to day activities of the company. He did not pay reasonable attention required for the efficient working of the company. He left it on Satish and Emma for running the company. When informed by Satish that the IT issues were solved, he did not take necessary steps to inquire into the same up to his satisfaction. Moreover, without inquiring into the actual financial status of the company and the debts incurred, he entered into a trade of $10,000 with a promotional company for the purpose of promoting the website of their company. He did not reasonable measures to prevent the company from becoming insolvent and thus made a breach of his duty to prevent insolvent trading. The following cases prove this point:

David Hill & Anor v. David Hill Electrical Discounts Pty Ltd (2001):

The court held that if a person is actually involved in the management of the company’s business and major crucial decision making is in his hands, and then if he enters into trade with reasonable grounds to suspect the insolvency of the company, he is liable for breach of duty to prevent insolvency of the company (TRETHOWAN, I., 1992).

Ying: was the guarantor of OHS solutions. Along with this, Support Pty Ltd being a shareholder of OHS solutions and Ying being the director of the Support Pty Ltd, Ying also became a shareholder and director of the company. A guarantor, in general, is the owner of the limited company and who appoints a director for managing the day to day affairs of the company. The overall company’s control is with the guarantor, including the appointment and removal of the company’s directors, deciding the goals and objectives of the company. The money, which is put forward by a guarantor is the amount, which can be called into question in case the company fails to pay its debts and along with this, the guarantor can also be made personally liable for the same.

In the given case, since the Support Pvt Ltd was also one of the shareholders of the OHS solutions, thus Ying being a director of Support Pvt Ltd also became a shareholder as well as director of OHS solutions. Thus, when the duty to prevent insolvent trading comes into question, Ying, being a director of the company may also be included as a part of it and may be held liable for breach of duty to prevent insolvent trading of the OHS solutions. Especially, if Ying proposes to purchase the OHS solutions, he, being the director of Support Pvt Ltd and also being the guarantor of OHS solutions, may be held personally liable for the debt of OHS solutions. Apart from that, for failure to take steps to prevent insolvency of OHS solutions, he would be made liable to prevent insolvent trading. Thus, it is advised that Ying should not proceed towards the purchase of the OHS solutions else she herself will become vulnerable, in the first instance for breach of duty to prevent insolvent trading. Moreover, being a guarantor, she may be held personally responsible for all the debts of the OHS solutions. 

References:

GRAHAM, T. and POOLE, J., 2010. 'Switching assets from one shadowy hand to another': piercing the veil of company and trust.Trusts & Trustees, 16(9), pp. 705-726.

KEAY, A. and MURRAY, M., 2005. Making company directors liable: a comparative analysis of wrongful trading in the United Kingdom and insolvent trading in Australia. International Insolvency Review, 14(1), pp. 27-55.

LITHGOW, P., 1995. Insolvent Trading. Australian Business Law Review, 23(2), pp. 155.

MASON, C., 1993. Australia clamps down on company directors. International Tax Review, 4(9), pp. 19.

MORRISON, D., 2003. The economic necessity for the Australian insolvent trading prohibition. International Insolvency Review,12(3), pp. 171-189.

OH, P.B., 2010. Veil-Piercing. Texas Law Review, 89(1), pp. 81-145.

POLLARD, S.M., 1994. Fear and loathing in the boardroom: Directors confront new insolvent trading provisions. Australian Business Law Review, 22(6), pp. 392.

SHUB, O., 2006. Separate Corporate Personality: Piercing the Corporate Veil. FDCC Quarterly, 56(2), pp. 253-266.

SU-KING, H., 1999. Directors' duties to prevent insolvent trading. Australian Business Law Review, 27(3), pp. 224-242.

SYMES, C.F., 2003. A new statutory director's duty for Australia -- a 'duty' to be concerned about employee entitlements in the insolvent corporation. International Insolvency Review, 12(3), pp. 133-145.

TRETHOWAN, I., 1992. Directors' Personal Liability to Creditors for Company Debts. Australian Business Law Review, 20(1), pp. 41.