What is the definition of insolvency in business?
Insolvency means a business is not able to pay its bills as and when they are due. So, trade creditors being well overdue or tax debt accumulating can be indicators of insolvency. Another indicator of insolvency is a business where the liabilities exceed the assets. If a director does not keep and maintain proper books and records the company may also be deemed to be insolvent.
A company director has to have a reasonable expectation that the business can pay its debts and has a responsibility to ensure that the company does not trade while it is insolvent.
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What happens if a company becomes insolvent?
If a director allows a company to continue to incur debts after it becomes insolvent they can be held personally liable for the increased amount. If a company goes into liquidation, the liquidator is able to make a claim against the director for insolvent trading and pursue the recovery of the amount from them personally. Often liquidators may argue that the date of insolvency is earlier than the director may think.
Insolvent trading claims can be difficult actions for a liquidator to pursue. Directors often make the defence that they had a reasonable expectation the company could pay its debts. This may be that they expected an upturn in financial performance or believed they could either borrow or inject more money into the business. It can often be a question of how reasonable these expectations were.
Liquidators will pursue insolvent trading claim where they believe they have a strong case and the director has significant personal assets. The liquidator acts in the best interests of creditors and will assess the cost of legal action along with the likelihood of being paid if they are successful.
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Is trading insolvent illegal?
Yes – insolvent trading is illegal. A director may face both civil and criminal penalties for breaking insolvent trading laws.
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What is the penalty for insolvency?
In addition to facing a legal action from the liquidator, for the full amount of the debt incurred while the company was insolvent, a director can also face a civil penalty. The maximum civil penalty is very significant, being 5,000 penalty units or three times the benefit obtained and detriment avoided. As at February 2022 a penalty unit is $222 so the maximum civil penalty could be $1.1m or more.
A director may also face a criminal penalty. The maximum penalty for the most serious offences includes a term of imprisonment for up to 15 years.
While claims by a liquidator are relatively common, the director has the opportunity to defend the claim or reach a commercial settlement with the liquidator. The imposition of civil penalties is far less common. Criminal penalties are rare, and usually involve cases where these has been deliberate fraud or other serious misconduct by the director. You will not go to jail for insolvent trading unless there has been dishonesty or where you have committed criminal offences, rather than simply been in a position where the company was unable to pay its debts.
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What should I do if I am worried my business may be insolvent?
Anyone who has concerns about the solvency of their business should seek professional advice. This may be talking through the issue with an accountant or other professional advisor. If necessary, you should seek expert advice on the potential personal impact of business insolvency.
If a business is insolvent it should not continue to trade and incur additional debt. It may be possible to continue to pursue an interest in the business and the industry without being exposed to the potential risk of an insolvent trading claim.