How to Avoid Personal Liability When Your Company Is Insolvent

Section 95A of the Corporations Act 2001 (Cth) (‘Corporations Act’) defines insolvency as the inability of a company to pay its debts as and when they become due and payable. This is commonly described as a cash-flow test and forms the foundation of any assessment of a company’s financial position.

According to section 588G of the Corporations Act, directors are required to prevent a company from incurring debts while it is insolvent. When insolvency is suspected, directors must take immediate action to protect the company from further financial harm. This may include obtaining appropriate professional advice, as obtaining advice at an early stage is often the most effective way to protect both the company and the director personally. Directors seeking to rely on the statutory safe harbour regime for protection from personal liability (as discussed further below) should be aware that such protection is only available where directors take genuine and proactive steps.

What Is Insolvent Trading and When Does It Trigger Personal Liability?

Insolvent trading arises where a company incurs a debt at a time when it is insolvent, or where incurring that debt causes the company to become insolvent. Section 588G of the Corporations Act imposes a duty on directors to prevent this from occurring. Directors must remain informed about the company’s financial position and take reasonable action if warning signs appear.

A director may be exposed to personal liability where the company was insolvent at the time the debt was incurred, or became insolvent as a result, and the director knew or ought reasonably to have suspected that insolvency existed. Liability will arise where the director failed to take reasonable steps to prevent the company from incurring the debt.

The consequences can be significant, especially since liquidators frequently bring claims seeking compensation for losses suffered by creditors. Civil penalties may also be imposed and, in cases involving dishonesty, criminal liability is possible. These provisions are designed to ensure that directors do not allow a financially distressed company to continue trading at the expense of creditors.

How Can Directors Determine If a Company Is Insolvent?

As noted above, section 95A of the Corporations Act defines insolvency as the inability to pay debts as and when they become due and payable. A company may have substantial assets recorded on its balance sheet and still be insolvent if it lacks the liquidity to meet its obligations when required.

To ascertain whether a company is insolvent, courts assess the company’s financial position as a whole, taking into account its cash flow, access to funding, creditor arrangements, overdue taxation liabilities and the reliability of financial records. This holistic approach is used because insolvency cannot be reliably inferred from a single factor, but rather must be determined by considering a range of financial indicators.

In Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation (2001) 53 NSWLR 213, the Court confirmed that insolvency is a question of fact and must be assessed by reference to a company’s overall financial position. A temporary shortfall in cash may not indicate insolvency if there is a genuine and immediate prospect of funding. However, an ongoing pattern of unpaid debts or reliance on informal extensions may indicate a more genuine inability to meet obligations.

Similarly, in The Bell Group Ltd (in liq) v Westpac Banking Corporation [No 9] [2008] WASC 239, the Court emphasised that insolvency must be assessed by examining whether the company could meet its debts in the ordinary course of business, distinguishing between temporary financial distress and a sustained inability to pay debts as they fall due.

Directors should also consider recurring losses, accumulating tax liabilities, unpaid employee entitlements, creditor pressure and difficulty producing accurate financial information. Delegating responsibilities does not relieve directors of liability, as they are expected to remain properly informed about the company’s financial position.

What Steps Should Directors Take Immediately When Insolvency Is Suspected?

When a company begins to display signs of insolvency, prompt action is essential. The first step should be to obtain independent professional advice. Insolvency practitioners and restructuring lawyers can assist in assessing the company’s position and identifying realistic options. Early advice often preserves alternatives that may no longer be available if action is delayed.

Directors must also ensure that proper books and records are maintained. Under section 588E of the Corporations Act, a lack of record-keeping can give rise to presumptions of insolvency in subsequent proceedings. Inadequate records not only affect decision-making but can significantly weaken any defence to an insolvent trading claim.

Directors should then consider the available restructuring options, such as refinancing, small business restructuring processes, or voluntary administration where appropriate. Continuing to take on further debts without a clear and documented plan to improve the company’s financial position significantly increases the risk of personal liability.

Where insolvency is likely, directors must consider the interests of creditors when making decisions. Continuing to trade may be appropriate in some circumstances, but only where there is a genuine and properly considered plan to improve the company’s financial position.

Can the Safe Harbour Provisions Protect Directors from Liability?

Section 588GA of the Corporations Act provides a statutory “safe harbour” from insolvent trading liability. The protection applies where, after suspecting that the company may be insolvent, a director begins developing and takes a course of action that is reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator.

A “better outcome” is assessed objectively. In determining whether this requirement is met, the court will consider whether the director has properly informed themselves of the company’s financial position, taken appropriate steps to prevent misconduct, ensured that proper financial records are maintained, obtained advice from a qualified adviser, and developed or implemented a restructuring plan aimed at improving the company’s financial position.

Safe harbour is not automatic and is subject to important limitations. It will not apply where the company has failed to pay employee entitlements when due or has not complied with its taxation reporting obligations. The director also bears the evidential burden of demonstrating that the requirements of the provision are met.

Overall, safe harbour protects directors who act early, obtain appropriate advice, and actively pursue a genuine restructuring strategy. It does not protect directors who delay action or continue trading without a clear and properly developed plan.

When Should Directors Seek Professional Insolvency Advice?

Directors should seek advice at the earliest sign of sustained financial difficulty. Waiting until creditors commence recovery proceedings or issue statutory demands significantly reduces available options and increases risk.

Early engagement with experienced advisers can assist with negotiations with creditors, the development of restructuring proposals and, where necessary, a structured transition to formal insolvency processes. For companies operating across Australia, obtaining specialist insolvency advice at an early stage can be critical in navigating these issues effectively.

Obtaining advice early not only helps identify the available options, but also may demonstrate that directors have taken reasonable steps to pursue a better outcome than immediate liquidation or administration. This can be important if their decisions are later examined.

Conclusion

Directors of companies facing financial difficulty have serious legal responsibilities. The insolvent trading provisions of the Corporations Act require directors to actively monitor the company’s financial position and take timely action where needed. Assessing insolvency involves looking realistically at whether the company can meet its debts, based on accurate and up-to-date financial information.

Seeking advice early, keeping clear records, and carefully managing any restructuring process are important steps in reducing personal risk. While the safe harbour provisions can provide protection, they apply only where directors take genuine and proactive steps to address the company’s financial position.

If your company is experiencing financial pressure, obtaining tailored insolvency advice as early as possible is one of the most effective ways to protect both the business and your personal position.