Why directors have the duty to prevent insolvent trading
The directors of Australian corporations have the duty to prevent insolvent trading by the company on the ground of common law and statute in Australia. The duty of directors is placed in s 588Gof the Corporations Act 2001, which is to make sure the company can work out when debt is incurred.
The primary reason for designing these provisions that let directors be responsible for preventing insolvent trading by the company is to protect the interest of creditors. S 588Gcomes in to effect if
(1) The person is the director of a company when the company incurs a debt and
(2) The company is insolvent at the time of incurring the debt and
(3) There are reasonable grounds for suspecting that the company was insolvent, or would become insolvent at the time the debt was incurred and
(4) The director is aware of this grounds, or a reasonable person in like position and same circumstances would be aware and
(5) The person does not prevent the company from incurring the debt successfully
Therefore, it is reasonable to believe that the company cannot incur debt if it is insolvent. This is because under this situation, the company does not have the ability to pay back to the creditors, which causes the interests of the creditors are suffering threat. In order to prevent the welfare of creditors from suffering loss due to the dishonesty or irresponsibility of directors, these provisions are designed, which can make sure that the interest of creditors is protected from loss.
The other reason for designing these provisions that let directors be responsible for preventing insolvent trading by the company and provide sanctions if directors do not perform their duty correctly is to encourage directors of the company to perform their duties correctly when the company is or is going to be insolvent. This duty falls under director’s duty of care and diligence. If the directors are not aware of the financial situation of the company, they have the duty for not fulfill their duty of care and diligence. And if they are aware of the financial situation of the company, and fails to prevent the insolvent trading, they breach the duty of not fulfill their prevention the insolvent trading. In practice, directors as the main part of the company, they expect the company can trade with others so as to increase the eventual return to the stakeholders when the company is insolvent. According to Bans Pty Ltd v Ling (1995) 13 ACLC 524, trading such as lease the premise of the company or sell the business of the company are expected to improve the return. However, these trades will do harm to the welfare of creditors. Therefore the law assigns the directors of company to act as the role to prevent these trades. Directors are encouraged by these provisions to perform their duties correctly, rather than to hurt the interest of creditors.