Exoneration of directors from insolvent trading liability

26 August 2015

In this issue:

  • Discussion of exoneration provisions under which directors may be excused from insolvent trading liability
  • The stages of inquiry undertaken by the courts in evaluating exoneration applications
  • The standard of conduct required of directors seeking exoneration from personal liability in insolvent trading cases


In cases where a court declares that a director, in contravention of section 588G(2), Corporations Act, has failed to prevent his or her company incurring debt when the company was insolvent, the court may have before it a submission from the director seeking exoneration from personal liability.

In these circumstances the director is applying to have the court exercise its discretion under section 1317S or 1318, Corporations Act to excuse the director from liability. Such relief from liability may extend to compensation orders, civil penalties, and disqualification orders which otherwise may be made against the director.

Clearly, prudent directors should familiarize themselves both with the provisions that give rise to insolvent trading liability, and the means available to avoid liability, as well as the nature and scope of those provisions that may result in relief from liability.

The nature and operation of sections 1317S and 1318, Corporations Act

Sections 1317S and 1318 make substantially similar provision for the relief of persons who have contravened a civil penalty provision under the Corporations Act. The purpose of the provisions is to “excuse company officers from liability in situations where it would be unjust and oppressive not to do so, recognizing that such officers are businessmen and women who act in an environment involving risk in commercial decision-making.”: Hall v Poolman (2007) NSWSC 1330 ( para.315).

The exoneration provisions reflect a broad legislative policy of not inflicting liability if a contravention is the product of honest error or inadvertence, so long as the court can do so without prejudice to third parties or the public interest in ensuring compliance with the requirements of the Corporations Act: see Wave Capital Ltd (2003) FCA 969 (para.29).

Each provision involves the following stages of enquiry (see ASIC v Healey (No 2) (2011) FCA 1003 (para.84):

  • Whether the applicant for relief has acted honestly
  • Whether having regard to all the circumstances the applicant ought fairly to be excused from liability, wholly or in part

It will be appropriate to review each stage as it relates to insolvent trading liability.

Has the director acted honestly?

The first requirement involves an enquiry into whether the director’s conduct was morally wrong in a commercial sense. Importantly, in the context of insolvent trading liability, demonstrating an absence of deceit or other acts of conscious impropriety will not of itself be sufficient to satisfy the requirement of honesty.

For example, representations to creditors about how soon payment will be made based on the director’s self-deception or ignorance of the company’s prospects, although not necessarily involving conscious deception, will amount to dishonest behavior in relation to director liability for insolvent trading.

Similarly, allowing a creditor to embark on a course of dealing with the company which the director knew or ought to have known would lead to the detriment of the creditor precludes any suggestion that the director acted honestly in the sense encompassed by sections 1317S and 1318: see ASIC v Edwards (2006) NSWSC 376 (para.35).

On the other hand where the director has demonstrated that he or she has acted without deceit, and without intent to gain improper advantage, while making a genuine attempt to carry out the duties of office, the courts have shown a willingness to accept the director has acted honestly: see Hall v Poolman (2007) NSWSC 1330 (para.325).

A finding that the director did not act honestly is sufficient to dispose of the director’s application for exoneration. Conversely, a finding that the director has acted honestly requires the court to then consider the additional question whether the director “ought fairly to be excused.”

Whether the director ought fairly to be excused

Here the courts are required to form a view as to whether, notwithstanding breaches of the Act, the director has “acted honourably, fairly, in good faith and in a common sense manner as judged by the standards of others of a similar professional background.” (see ASIC v Edwards (No3) (2006) NSWSC 376 (para.10).

When viewed from this perspective it is understandable why relief in insolvent trading cases has rarely been granted. Reconciling the director’s conduct constituting breach of the Act with the director acting reasonably will be difficult.

Notwithstanding, the courts have on occasions been willing to exercise their discretion in favour of directors. For example, in the frequently cited decision in Hall v Poolman (2007) NSWSC 1330, although the director allowed the company to incur debts while insolvent the court recognized that the director had a difficult decision to make pending the outcome of a settlement proposal with the taxation commissioner. If the settlement proposal was accepted, the company would, in the opinion of competent professionals, be restored to solvency.

In the case the court determined that the director ought fairly to obtain partial relief from liability for the period during which reasonable efforts were being made to return the company to solvency. However, when it should have been apparent that there was no reasonable prospect of the company resolving its taxation dispute, for debts incurred beyond this period the director was not exonerated from liability.

The partial exoneration from liability achieved in Hall v Poolman may be compared with the complete exoneration which occurred in McLellan v Carroll (2009) FCA 1415. Here the court was satisfied that the director’s approach to the insolvency problems being experienced by his company “was that to be expected of a reasonable, commercially experienced director with ongoing issues” (para.191) such that the director ought fairly to be excused.

Of particular relevance was the willingness of the director to obtain and act on advice, including business advisory services. And so, although the director was found to have allowed the company to incur debts while insolvent, he did so against a background of difficult decisions as to whether to continue trading, while acting upon advice from business and industry experts throughout the relevant period. Note: although the advice obtained was not sufficient to satisfy the defence against insolvent trading liability provided by section 588H(3)(a) (i), it was found by the court to be advice received “throughout the relevant period upon which it was reasonable for [the director] to rely” (para.193) so as to justify exoneration.

These cases of partial or complete exoneration may be contrasted with the recent decision in Smith v Boné, in the matter of ACN 002 864 002 Pty Ltd (in liq) (2015) FCA 319, 7/4/2015. Here the Federal Court rejected the director’s claim for relief under sections 1317S or 1318. The court found that the director had not sought credible advice about the financial position of the company throughout the relevant period of insolvent trading. Moreover, the court formed the view that, as a means of freeing up funds to pay certain creditors while leaving others partly paid or unpaid, the director negotiated payment plans with the taxation commissioner without any realistic means of the company paying the tax debt.

As a result the court considered the conduct of the director in its dealings with the commissioner of taxation, and creditors who were left unpaid or partly paid was not fair and so could not be excused.

Note: Although the case is instructive in its dealing with exoneration provisions the decision needs to be read with caution as the matter is currently on appeal to the Full Federal Court.

Summing up

The purpose of sections 1317S and 1318 is to allow the courts to exonerate company officers from liability under the Corporations Act in cases where in the opinion of the court it would be unjust or unduly harsh not to do so.

This broad policy justification needs to be balanced against the imperative that the provisions of the Corporations Act relating to insolvent trading are to be observed by directors, and exoneration provisions, if too readily applied by the courts, would undermine the operation of the Act.

Predictably, balancing the requirements of the Corporations Act with exoneration provisions has resulted in the pendulum swinging towards giving effect to insolvent trading provisions, with a high proportion of exoneration applications being abandoned or proving unsuccessful.

Nonetheless, as apparent from the above discussion, the courts have on occasions shown a willingness to exercise their discretion in favour of directors. In doing so, clear guidelines have been provided by the courts to directors as to the standards they must satisfy if a court is to be persuaded to excuse them from personal liability.

However, the message to directors is clear - better to seek professional advice with a view to avoiding liability than to seek forgiveness.