Chapter 16. Debt recovery through the legal system

Some of the methods that people have used to avoid their debts, which I outline in this book are fraudulent (sic) and could have given rise to criminal charges, had they either been reported, caught or found. Other methods are very legal and infact (sic) are the methods with which the Courts themselves use to ensure that all parties in litigation procedures are treated fairly. If you choose any action in this book then I suggest that you check to see if it is currently within the bounds of the laws of the State where you live. … If the methods I explain turn out to be less than legal, and you are caught, then please write and tell me from your cell. I will include your name in the credits of the second edition of the book, suitably amended with your suggestions.

Keith B White, “How to Avoid Your Debts”

An overview of the process
Each State has a slightly different process and there are a variety of different names for each step of the process, but it’s not too hard to make sense of. However, let me stress that this is a very brief overview. Before acting on any matter of law, appropriate advice ought to be taken. The fact that there are entire books written for each State on the debt collection process through the court system should indicate to readers that there is a great deal of detail which can’t be covered in this short chapter.

Summons

In each State, the process starts when the creditor sues the debtor. It’s the start of any legal process against an individual, and in some cases, against a company. The first document is variously known as a “summons”, “statement of liquidated claim”, “complaint”, or “claim”, depending on the State. For simplicity I’ll refer to this first document as a summons. In effect it is a claim to the court that the debtor owes you money. It identifies the debtor and gives the court some (usually) brief information about what the debt is for – for example, goods sold and delivered, or services rendered, or a dishonoured cheque.

This is where most debts get paid. The summons is served on the debtor and at that point he realises that the creditor really is serious about wanting payment. He either finds the money or makes arrangements to pay by instalments. In some States summonses can be served by post and in some cases they will be served by court bailiffs. Generally, creditors get the best result when summonses are personally served by private process servers who get some form of bonus for extracting payment or negotiating an arrangement to pay. The majority of process servers, however, do not collect money.

Asked to put a figure on the percentage of debts sued which are paid at this point, debt collectors and lawyers picked between 10% and 30%. It varies, of course, with the value and type of debt. There is no research on this subject that I can locate but it seems clear that this is certainly one of the likeliest points in the legal process for the debtor to cave in and pay.

In general, actions can be commenced in either federal courts or the relevant state court. The lawyer makes the decision. The choice of jurisdiction may affect:

  1. The fee scales – generally lower costs are awarded in the State courts; and,
  2. The speed with which the matter is dealt with – generally plaintiffs in federal courts have to wait longer for their cases to be heard.

Application for summary judgment – In some cases an application for summary judgment will be used instead of the simple form of summons.

Under the summary judgment procedure the plaintiff produces evidence of the claim, usually in the form of an affidavit (a sworn statement) setting out the facts and the plaintiff’s belief that there is no defence. For example, the fact that a defendant has attempted to pay but that the cheque bounced is strong evidence in this sort of situation. A defendant who tries to deny liability is in the position of having to provide enough of a defence to persuade the court that the matter should actually go to a full trial. This process makes it more difficult for a defendant to delay matters by raising a spurious defence. If there is no arguable defence, judgment is entered for the plaintiff. The summary judgment procedure is more expensive but is generally considered worthwhile where the debt is for any significant amount of money.

Judgment

If the debt is defended, the case must be decided by a judge and there is extra expense and extra delay. Often debts are defended as a delaying tactic. It varies but it wouldn’t be unusual to wait six months for a hearing where a judge decides the case. In some instances it can take years to get a judgment.

However, as a rule of thumb we can expect about 90% of those served with a standard form of summons and who don’t pay to go to judgment by default. A certain number of days after service of a summons, if the debt is not paid and the summons is not defended, the creditor applies for judgment to be entered. Because there is no defence there is no need for a hearing. This process should be distinguished from entry of judgment under the summary judgment procedure where there is a short hearing to determine whether or not there is an arguable defence.

The entry of judgment means that the debt is now a matter of public record. The court has said that the debt is definitely owed. Only in exceptional cases (say, for example, if he hasn’t been served with the summons, or there is some other obvious injustice) can the debtor successfully recommence the argument that he doesn’t owe the money.

Creditors need to understand, however, that judgment doesn’t necessarily force the debtor to pay. What it does do is allow you, the “judgment creditor”, to progress to the enforcement stages – seizing wages (garnishee), seizing goods (writ of execution, also known as a distress warrant or warrant to sell or recover property in some States), bankruptcy of an individual or winding up of a company.

Execution

Bad news for those creditors whose spirits lifted at the sight of the word “execution”; the death sentence is not available for debtors. A “writ of execution” directs a sheriff or bailiff of the court to seize and sell a judgment debtor’s property to pay the judgment creditor. The procedure is also known as the writ of fieri facias, or more commonly, fi. fa.

These can be very effective in some circumstances but there are a considerable number of obstacles. The four main problems are that:

  1. Debtors can refuse access to the sheriff or bailiff. This problem is avoided if the debtor is a shop, or has property in a public place.
  2. Second-hand goods fetch much less at auction than their retail price when they were brand new.
  3. Debtors will often claim that any goods of value are leased, or the subject of some form of security. Of course, often this is the truth. The sheriff can only sell goods that belong to the debtor or in which the debtor has a part interest. But if the debtor owns 10% of a car and a finance company owns the other 90% there is little point in going through the exercise of selling the car at auction. The reality is that the auction price probably won’t even pay out the finance company. The finance company in this situation must agree to the sale before it can go ahead.
  4. The sheriff usually doesn’t take the goods away. He takes possession in a technical sense, usually by wrapping the goods with tape which clearly identifies them as being the subject of an execution. If the debtor removes the tape and sells the goods to an innocent third party for value the third party is protected and takes good title.
    Ownership of land is easier to establish than ownership of goods. Essentially the same process is used for seizing land or goods but in most jurisdictions an attempt must be made to recover against goods before land, unless permission to go for the land first has been granted by the court.

South Australians report that proceeding against land is very effective. The debtor receives the writ and has a “for sale” sign put on the front lawn on the same day. Very few are actually sold. The threat is enough to extract payment.

In Victoria, on the other hand, the “writ of execution against land” is less highly regarded. The debtor can at any time apply to the court for a stay of execution or order that the debt be paid by instalments. And most married debtors own houses jointly with a spouse which adds complexity and difficulties. Better, according to some practitioners, to bankrupt the debtor and let the trustee in bankruptcy sell the property.

Examination

All States have a process which drags the debtor before the court for examination as to her means and ability to pay the debt. The “examination summons” (NSW), “summons for oral examination” (Vic), and “oral examination” (Qld), are purely fishing expeditions, seeking information – the courts in those States will not make an order for payment by instalments. The “judgment summons” (WA) and “investigation summons” (SA) have more teeth. The court will make an order against individual debtors but not companies when the examination is of a company director. In Western Australia the examination of a director is called “examination in aid”. For some debtors the trauma or hassle of coming before the court is something to be avoided. The way to avoid it is to pay the debt. Some creditors work on the theory that the wife in a husband and wife business is more likely to want pay up to avoid an examination.

Garnishee

If A owes money to B, and B owes money to C, C can obtain a garnishee order which directs A – the “garnishee” – to pay the money directly to C. With some limitations, creditors can garnishee wages and the contents of bank accounts. The problems with garnisheeing wages are that:

  1. Typically creditors are not allowed to take the whole wage; there are rules as to how much the debtor must be left in order to survive;
  2. In some cases there will be restrictions on the duration of an order, requiring the creditor to apply for a second garnishee order perhaps as soon as four weeks after the first. Garnishee of wages is not permitted at all in South Australia except with the debtor’s consent.

Debts must be due and owing so the garnishee is best applied to large, one-off payments. One mercantile agent I know follows the horses religiously makes a habit of garnishing prize money from racing clubs when he sees a debtor’s horse win a race. The keys in this situation, as in all attempts to garnishee, are:

  1. Having the information that someone owes the debtor money; and
  2. Speed in serving the documents before the payment is made.

Bankruptcy

At any point after judgement, without going through the steps of examination or execution, the creditor may proceed with bankruptcy. This process is discussed in more depth below but typically this involves the service of a “bankruptcy notice”, then a “creditor’s petition”, then a court hearing at which the debtor is declared bankrupt.

Charging order

A judgement creditor can apply to a superior court to create a security over stocks and shares or the interest in a partnership of a judgement debtor. The process is fairly long and drawn out. The charging order “nisi” is granted conditionally in the first instance. This prevents the debtor from dealing with the asset and any third party which holds the assets from allowing the asset to be transferred. The debtor then has the right to come before the court and argue that the order should not be made permanent or as it is termed, “absolute”. The next step for the creditor is to apply to the court for an order for sale.

When the asset is sold, prior interests such as mortgages take priority; that is, they get paid out ahead of the holder of the charging order. The charging order is most commonly used for shares.

Imprisonment

In some States imprisonment for debt is still possible. Typically, the court will want to see that the debtor had the means to pay and failed to keep to payment arrangements. In some cases imprisonment will be for failing to attend an examination hearing.

Imprisonment comes (if at all) only at the end of a long process which includes examination and instalment arrangements. Debtors are unlikely to be imprisoned for long. For example, in South Australia bail is automatic so debtors are unlikely to be incarcerated for more than an hour or two while bail is organised. However, the sight of the bailiff coming to take them away and that hour or two behind bars can be a powerful incentive for some debtors to find the money.

Instalment orders and stays of execution

Most courts have some procedure to allow the debtor to pay by instalments on the debtor’s request. The making of an order forces the creditor to stop other enforcement actions so long as the instalments are met. In some jurisdictions the court will order the debtor to pay by instalments, usually after the debtor has been examined under oath as to her assets and means. In many cases, the creditor will not be unhappy to get the money by this form of drip-feed. The procedure is open to abuse by debtors, however, who apply for the instalment order only when on the verge of bankruptcy or when about to have their house sold from under them.

Red Lea Chickens Pty Ltd v Tansey is a case which may encourage judges and registrars at District/County and Local Court level to require more sensible levels of instalments. In this case the judgement debt was for $94,772 which was incurring interest at the rate of $829 per month. The judgement debtor’s claim that he could only afford to repay $400 per month was accepted by the judge in the District Court and he was ordered to repay the debt in instalments of that amount. This meant that the creditor couldn’t pursue any other action, such as bankruptcy, and that the debt would never be paid off because the debtor would only ever be repaying interest. The New South Wales Court of Appeal overturned the decision.

A stay of execution separate from an instalment order may be granted by the court on the application of the debtor. It will be for limited duration and is aimed at giving the debtor time, say, to come up with the money to prevent the sale of property.

Bankruptcy proceedings

Both Acts provided for debtors guilty of improper conduct to be stood in the pillory; one ear was to be nailed to the pillory and then cut off when the debtor was released from the pillory.

Dennis Rose describing the admirable English Bankruptcy Acts of 1604 and 1623

The process of bankrupting an individual 
Indicative timing (all going well) Action
1 March Creditor obtains judgment (for more than $2000)
1 April Creditor applies for the issuing of a bankruptcy notice
3 April Bankruptcy notice issued
29 April Service of the bankruptcy notice
29 May Failure to comply with the notice (= an “act of bankruptcy”)
1 June Presentation of a creditor’s petition – a return date before the court is given (say, 1 August)
15 June Service of petition and other documents on the debtor
1 August (five months after obtaining judgment) Return date for hearing of the petition – sequestration order is made, ie. thedebtor is now bankrupt
1 September (say) Bankrupt files a statement of affairs
31 July three years later Discharge from bankruptcy

When an individual is unable to pay her debts she can be bankrupted by her creditors (a creditor’s petition), or choose to declare herself bankrupt (a debtor’s petition). Either way, most of her property will be taken from her by the bankruptcy trustee and used to pay the creditors. She can keep personal effects, household furniture, a vehicle worth less than $5000 and a few other items. Her secured creditors will probably repossess their goods. If she is earning enough money, she will be required to pay some of this to the estate. (1022 out of 17,324 people who went bankrupt in the 1995-96 year – the most recent figures available – were assessed as being liable to contribute.) If she inherits money or wins a lottery while bankrupt, the money will be taken off her to pay creditors.She will have some restrictions placed upon her to prevent her incurring more debt, or leaving the country. Anomalously, she can’t run a company but can still run a business as a sole trader or partner. If trading under a business name she is obliged to disclose her bankruptcy to anyone she has business dealings with.

On the plus side for the debtor are the fact that her unsecured creditors can no longer pursue her for her debts and that after a period she will be allowed to make a fresh start with the slate wiped clean. She is automatically discharged after three years unless the bankruptcy trustee concerned objects (usually on the grounds that the bankrupt has been unco-operative or dishonest in some way). At 30 June 1996 there were 286 bankrupts whose bankruptcy had been extended to five years and 824 for whom the period had been extended to eight years.

In some circumstances the bankrupt can also apply for earlier discharge. There were 3010 early discharges granted in the year to 30 June 1996. 186 bankrupts paid all their debts in full and had their bankruptcy annulled.

The affairs of a bankrupt are generally administered by a registered trustee, usually an accountant. If none agrees to do so, ITSA – the Insolvency and Trustee Service Australia – fills in.

Why threaten bankruptcy?

In the year to 30 June 1996, 14,980 people chose to go bankrupt voluntarily on a “debtor’s petition”, presumably because they couldn’t see any other way out of their financial problems. This was 86% of the total bankruptcies for the year.

If so many choose bankruptcy at their own request why then do creditors pay, typically, a minimum of $2,000 to bankrupt debtors? The answer is: because many debtors don’t want to go bankrupt.

There is considerable stigma attached to the status. For many business-people it signals the end of their dream of self-employment. And of course, it reduces their chances of getting credit in the future. Regrettably, the number of prosecutions is pathetic – 17 for the whole country were listed in the 1995-96 annual report – but a bankrupt does commit a criminal offence if, among many other things, she makes false or misleading statements, tries to hide assets or hide the books, obtains credit of (at the time of writing) $3,358 or more without disclosing bankruptcy or runs a company while bankrupt.

So debtors battle to find the money to pay the petitioning creditor. In a reasonably large proportion of cases, the creditor gets paid, often at the last minute.

In the 1995-96 year there were 10,586 bankruptcy notices but only a third as many creditors’ petitions. Only 60% of creditors’ petitions resulted in bankruptcies. The pattern is consistent, year after year. There are a number of possible reasons why the process might not proceed to the next stage. It could be that:

  • The debtor went bankrupt on her own petition first;
  • The debtor persuaded her creditors to accept a composition. This could only have applied to a small percentage;
  • The debtor couldn’t be served;
  • The creditor decided that the debtor wasn’t going to pay and that there was no point in incurring further expense.
  • The debtor applied for and was granted an instalment order.

In many cases, however, the reason for not proceeding is that the debtor paid. Assuming that a good proportion of the 63% of bankruptcy notices which didn’t result in creditors’ petitions and the 40% of creditors’ petitions which didn’t result in bankruptcy were paid I would conclude that bankruptcy proceedings are one of the best – that is, most effective – ways to force business debtors to pay.

It’s worth noting too that those who went bankrupt on creditors’ petitions include those who were deceased. Personally I would be surprised to find many deceased debtors rushing up at the last minute to pay “on the court steps”, as many live debtors do. If deceased estates could be removed (the numbers are not available) the probability of a petitioning creditor getting paid would look even better.

Debt agreements

The principal legislation covering personal insolvency is the Bankruptcy Act 1966. The Bankruptcy Legislation Amendment Act 1996 (Cth) made changes to the prncipal Act in relation to voidable transactions, income contributions, the form of bankruptcy notices, the expansion of the role of the Insolvency & Trustee Service Australia, the creation of a National Personal Insolvency Index and the introduction of debt agreements for consumer bankrupts.

Perhaps the most significant of these is the last. The trend throughout the western world has been for increasing numbers of non-business debtors to go bankrupt and for legislators to create new insolvency options to try and reduce the numbers and/or shield the consumer debtor from the full harshness of bankruptcy law. In the US (the home of consumer credit) for example, there is a boom in this area with 1.1 million consumers choosing bankruptcy in the 1996 year and the numbers to the middle of 1997 trending towards 1.3 million. In Australia in the 1995-96 year there were a record 12,589 consumer bankruptcies, up 24% from the previous year. Of the total number of bankruptcies 73% were non-business. Debt agreements are Australia’s attempt to deal with this problem.

They are a new form of insolvency administration for people who don’t want to become bankrupt and have levels of debt not more than $52,000, assets which would not be exempt from bankruptcy of less than $52,000, and annual income of less than $26,000. (These numbers are all in round figures.)

The procedure is initiated by the debtor in a proposal to the Official Trustee which sets out the debtor’s assets, what’s going to be done with those assets, and who’s going to do it. Typically the proposal will suggest payment of less than the full amount of the debts, a moratorium on payment, or periodic payments out of income. A debtor who has been bankrupt or had a previous debt agreement within the previous ten years cannot enter into a new debt agreement.

The Official Trustee puts the proposal to the creditors. It is accepted if a majority in number and 75% by value agree to it. A proposal for a debt agreement is an act of bankruptcy so if it is rejected, the creditors can use it as the basis for a creditor’s petition to bankrupt the debtor.

When an agreement is accepted, details are recorded in the National Personal Insolvency Index. From this point, creditors cannot take legal action to bankrupt or enforce a debt against the debtor. The agreement ends when the obligations under it are discharged or the agreement falls over.

It has not proven popular to date, apparently because the threshold is too low.

Acts of bankruptcy

A creditor’s petition must specify an “act of bankruptcy” which the debtor has committed. Usually this will be the failure of the debtor to comply with a “bankruptcy notice”, an earlier document which the creditor has served on her, although there are a variety of others under section 40 of the Bankruptcy Act 1966. For examples, a debtor has committed an act of bankruptcy if:

“A writ of execution is issued against a debtor and the sheriff seizes property and sells it, or holds it for 21 days, or is unable to seize property so that the writ is returned unsatisfied;”

Notice given by the debtor of suspension of payment of debts;

A debtor fails to present a debtor’s petition within seven days after consenting at a meeting of creditors to do so.

For these acts of bankruptcy proof is relatively straightforward. For others it is more difficult. Many are somewhat obscure, so I won’t reproduce the complete list which is a long one. In practice the vast majority of creditor’s petitions result from failure to comply with a bankruptcy notice but creditors should be aware of the others. Pointing out to a debtor that he has just committed an act of bankruptcy may be the lever that will extract payment and if you are able to use, say, an unsatisfied writ of execution, you may well save money and time and do away with some of the difficulties of document service.

How to wind up a company

Indicative timing (all going well) Action
1 March Creditor obtains judgment (optional and generally considered unnecessary)
14 April Service of “statutory demand” on debtor company under section 459F of the Corporations Law
6 May Failure to pay within 21 days after service – presumption of insolvency
15 May Filing of petition – a return date before the court is given (say, 1 July)
20 May Service of petition on debtor company
Advertise
1 July Return date of the petition – winding up order is made

If a company is unable to pay its debts, it may be wound up by the court. A creditor who is owed more than $2,000 serves a “statutory demand” (under section 459F of the Corporations Law) on the company. If the debt is not a judgment debt (and therefore proven) the demand must be backed up by an affidavit which confirms the details. The statutory demand procedure has become so successful that few creditors now bother to get judgment first.The debtor company can apply to have the demand set aside, usually on the grounds that it disputes the debt, or has a counterclaim, or that there is a major defect in the documents. In Asset Holdings Pty Ltd v Rosta Electrical Industries Pty Ltd (in Liq) the judge explained the approach of the court in an application under the Corporations Law s 459G to set aside a statutory demand. As in the summary judgment procedure, the court does not examine the merits of the dispute other than to see if there is in fact a genuine dispute.

The debtor company has three weeks to satisfy that demand. If it fails to do so, the creditor, within three months, files an application to wind up the company. In the absence of compelling evidence to the contrary, the court presumes that the company is insolvent, otherwise it would pay the debt. It therefore winds the company up. That is, it appoints a liquidator who sells any assets she can find and pays to the creditors any money she gets.

There are two other situations which can allow a creditor to wind up a company. The first is when a receiver has been appointed (and variations on that theme). The second is when “execution or other process issued on a judgment, decree, or order of an Australian court in favour of a creditor of the company was returned wholly or partly unsatisfied.” In other words, the failure to satisfy a writ of execution allows the winding up process to start, just as it provides an act of bankruptcy in the case of individual debtors.

Of course, what the creditor really wants is for the debtor company to pay up because of the threat of winding up.

The pros and cons of winding up actions

The pro argument is simple – a creditor may get paid. The consequences of winding up their company may be serious for directors and shareholders. A director who has typically put great amounts of time, money and effort into a business can be expected to have an emotional commitment to it. Aside from liability for personal guarantees to the bank, and perhaps to other creditors, and for unpaid share capital, there may be a risk that the liquidator will accuse them of trading while insolvent (as I’ll explain later in this chapter). Many more directors are investigated and prosecuted for this than in the past.

This means there is usually a strong incentive for directors of companies to pay off creditors who threaten liquidation – the “squeaky wheel” principle. A creditor who is well ahead of the pack – who takes action before other creditors realise there is a real problem – stands the best chance of benefiting.

I should mention in passing the fact that while statutory demands and the threat of winding up actions are very effective methods of getting paid and are used by tens of thousands of creditors every year for this purpose, the courts repeatedly state the view (which flies in the face of commercial reality) that this is not what they are there for. They would rather you got judgment and used the writ of execution and other slower, less effective post-judgment enforcement methods.

The downside for creditors is that, first, the debtor company may simply not have the money or see any way of paying. Therefore the company goes into liquidation. The creditor who winds up the company probably doesn’t get paid 100 cents in the dollar and has added to her loss through the expense of the winding up (although the creditor is supposed to be reimbursed for the costs of winding the company up and this has a high priority for payment). You might typically expect to pay about $3,000 to wind up a company.

Second, as with bankruptcy proceedings against an individual, even if the creditor’s action and expense leads to payment, it may also alert other creditors to the debtor’s problems and open the floodgates. If, eventually, the debtor company succumbs, the liquidator may well come asking for the money back as a voidable preference (as discussed in the previous chapter).

Creditors can also wind up an incorporated society which is unable to pay its debts, through a similar procedure.

Compromises with creditors

Under Part 5.1 of the Corporations Law, a company may come to a formal compromise with its creditors either before or after liquidation. In other words, the company’s directors persuade the creditors to accept less than full payment, or a delay in payment, usually in order to allow the business to continue and, if all goes well, trade out of its problems. Approval is required either from the affected creditors or from the court. A resolution is adopted if supported by a majority of creditors in number, representing 75% in value.

Arrangements under Part 5.1 have never been particularly common. The introduction of the voluntary administration means that they are now even less prevalent

A similar procedure applies to individual debtors under the Part X of the Bankruptcy Act. A resolution passed by a majority (by value) of creditors at a creditors’ meeting may require a debtor to:

  1. Execute a deed of assignment (where all property of the debtor is assigned to creditors). The deed is supervised by a registered trustee; or,
  2. Accept a composition (an arrangement where the creditors agree to payment by instalments or less than full payment.) A composition is supervised by a registered trustee or a solicitor; or.
  3. Go bankrupt.

As well as deeds of assignment and compositions, there is a third possibility, the deed of arrangement. This is a sort of catch-all deed under Part X of the Bankruptcy Act which covers any other orchestration of the debtor’s affairs and, again, is supervised by a trustee or solicitor. An example might be an arrangement which allows a debtor to manage and sell his business.

A debtor may also propose a composition or scheme of arrangement after becoming bankrupt. These often involve relatives lending the bankrupt money or the bankrupt making future salary available to creditors. If accepted by the creditors (a majority in number and 75% by value) the bankruptcy is automatically annulled. Australia’s most famous composition was almost certainly that arranged by Alan Bond, who in 1995 persuaded his creditors to accept .0007 cents for each dollar they were owed.

The total of all types of arrangements for individuals in the year to 30 June 1996 was 552 – 101 deeds of assignment, 236 compositions, and 215 deeds of arrangement. In comparison, the total number of bankruptcies was 17,324.

Priority of debts in insolvency

Often a bankrupt or of a company in liquidation has some assets which can be sold to pay creditors. Who gets paid first? Working out the order that debtors get paid is a complex business but fortunately only insolvency practitioners and their legal advisers have to work through it in detail. Although there are a large number of special cases, the significant items of the queue and their order of priority are:

  1. Petitioner’s costs and trustee’s remuneration and expenses;
  2. Wages and salaries of employees;
  3. Ordinary claims, (of which debenture holders are first in line, and unsecured creditors last.)

These apply to both bankruptcies and company liquidations (section 556 Corporations Law, Sections 109-114 Bankruptcy Act). Any class of creditors will be paid out on a pro rata basis. That is, if there is enough in the kitty to pay 10% of the total unsecured debt, each unsecured creditor will get ten cents for every dollar owed.

Directors’ responsibilities

A creditor who loses money when a company fails often blames the directors. Directors have always had some duties of care but it has been understood that there can be no business without a degree of risk and that a director could be punished by being held personally responsible only if she has been fraudulent or reckless, or grossly negligent. The courts have borne in mind the fact that it is much easier to be wise in hindsight and there have been problems of proof. Because of this, there has long been a feeling among creditors that the guilty have been escaping unpunished.

However, under section 588G of the Corporations Law, which took effect on 23 June 1993, directors have a fairly demanding duty to prevent trading while insolvent. If a company director – let’s pick a name at random and call him Alan Bond – knows that his company is already insolvent when it incurs a new debt, he can be found to be personally liable for the debt. A company is solvent only if it can pay all its debts as and when they become due and payable (section 95A(1)). Likewise, a parent company may be liable for the debts of a subsidiary company if those debts were incurred while the subsidiary was insolvent.

The elements necessary for liability under s588G of the Corporations Law are:

  1. the person must be a director of a company at the time the company incurs the debt;
  2. the company must incur a debt;
  3. the company must:
    1. be insolvent at the time the debt is incurred; or
    2. become insolvent by incurring that debt; or
    3. become insolvent by incurring that debt and other debts at the same time;
  4. there must be reasonable grounds for suspecting that:
    1. the company is insolvent; or
    2. the company would become insolvent by incurring:
      that debt; or
      that debt and other debts at the same time;
  5. the person is aware at the time the debt is incurred that there are such grounds for suspecting any of the matters set out in (4); or
  6. a reasonable director of a company in the same circumstances would be aware of the grounds for suspecting any of the matters set out in (4).”
    He may also be prosecuted for a criminal offence, rather than just a civil action to recover the money. Being misinformed by “a competent and reliable person” is a reasonable defence. A director also has responsibilities under the common law and under section 232 of the Corporations Law.

The potential personal liability of directors means that many will jump ship as soon as the company hits rough waters. Creditors should note that it is much more important to be aware of changes of directors than in the past.

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