Company Law

TOPIC 4

A COMPANY AS A CORPORATE ENTITY



EFFECT OF REGISTRATION OF THE COMPANY

Why incorporate or form a company?

The reasons for and against the incorporation of a business into a company
are varied. Section 112 of the Corporations Act lists the types of
companies that can be registered under that Act. Those companies are as
follows:

proprietary companies - limited by shares or unlimited with share
capital;

public companies - limited by shares; limited by guarantee; unlimited
with share capital; or no liability companies. With respect to no
liability companies, note section 112(2), (3) and (4) and the need for
the relevant constitution requiring that the sole object of the
company be for "mining purposes" (defined in section 9).

With respect to proprietary companies, note section 113 of the Corporations
Act.

One of the most important prohibitions contained in the Corporations Act in
this regard is set out in section 115. That section precludes a person
from participating in the formation of a partnership or association that
has an object gain for itself or for any of its members; and has more than
20 members unless the partnership or association is incorporated under an
Australian law.

Note the prohibition in section 116 of the Corporations Act.


Steps in registering a company

You should note Part 2A.2 of the Corporations Act beginning at section 117.
Once an application is lodged under section 117 ASIC may give the company
an ACN and register the company and issue a certificate setting out the
matters contained in section 118(1)(c). ASIC must keep a record of the
registration.

In relation to names note Part 2B.6 of the Corporations Act beginning at
section 147. However, note the need for a company to exhibit its name:
section 144. In particular, note the need to have "Limited", "No
liability" or "Proprietary" as part of the name: (section 156) unless
sections 150 or 151 apply. In relation to change its name to see section
157 and 157A.

A company comes into existence on registration: section 119.

With respective jurisdiction of registration note section 119A.

A company must have at least one member: section 114. A person becomes a
member, director or company secretary on registration if the person is
specified in the application with their consent: section 120. Note also
sections 121 and 122 dealing with registered office and expenses in
promoting and setting up the company. Finally, a company may have a common
seal (section 123) and this aspect is important when dealing with the
application of sections 127 and 129 which is covered in Topic 8 in this
course.

Advantages of registration

Registration of a company brings with it a number of advantages. Some of
these are:


a) Separate legal personality

Upon incorporation the company becomes a new and independent legal entity.
It is completely separate from the subscribers who formed it and from those
who manage it. A creditor can generally only sue the company, not its
members, to recover damages. However exceptions exist to this latter point
and these are outlined later in this Topic.


b) Limited liability

If the company is one limited by shares (defined in section 1070A), then
section 516 of the Corporations Act provides that a member's liability is
limited to the amount unpaid, if any, on these shares. This can be
contrasted with a partnership where there is, except for limited liability
partnerships, unlimited liability and therefore all the assets of a partner
are vulnerable in the event of default by another partner. The extent of a
member's liability depends on the type of company as provided in section
112 of the Corporations Act.

It should be noted that limited liability applies only to members. A
company does not enjoy limited liability in its dealings with outsiders.


c) Flexibility

When drafting up the company's constitutional documents[1], it is possible
to give directors and shareholders various combinations of rights. For
example, it is possible to have differing voting rights and varied
entitlements to dividends and the division of powers between members and
shareholders can be established. It should be noted that a private
company, known as a proprietary company, has some restraints imposed on its
flexible structure. Some of these restraints are set out in sections
113(1) and (3) of the Corporations Act.


d) Perpetual succession

A company will continue as a legal entity regardless of the death or
changing circumstances of its members. It does not exist for a specific
period of time.


e) Transferability and transmissibility of shares

Shareholders in companies often have flexibility in being able to transfer
or assign their shares to other parties. In such cases a transfer will
occur when the ownership of the share passes from one shareholder to
another resulting in the transferee becoming a member of the company after
registration of the transfer. However, companies can impose restrictions
on the ability to transfer shares and this is common with respect to
proprietary companies. In this regard section 1072G provides for a
replaceable rule that directors may refuse to register a transfer of shares
in the company for any reason.

Similarly transmission of shares is possible where a shareholder dies,
becomes incapable through incapacity or becomes bankrupt. In such cases
the shares vest in the deceased shareholder's personal representative or
the Official Trustee in bankruptcy.


f) Imputation of taxation

Companies are able to impute the tax they have paid back to shareholders.
This ability means that the same revenue is not taxed twice and that an
individual can receive dividends which may not attract any further tax.


g) Power to acquire, hold and dispose of property

A company being a separate legal entity can own property. This property is
not owned by the members as they only own shares in the company. In
Macaura v Northern Assurance Co Ltd [1925] AC 619, Macaura owned a timber
yard. He had an effective insurance policy to cover the destruction of any
timber by fire. He subsequently formed a limited company in which he was a
substantial shareholder and assigned the timber to the company, the
purchase money for the timber remaining owing to him. He did not assign
the insurance policy to the company, nor did the company take out its own
policy. A fire destroyed the timber.

The insurance company's refusal to pay the claim made by Macaura was upheld
by the court. The limited company, considered by law to be a legal entity
separate to its shareholders, had an insurable interest in the timber but
had no policy. Macaura had a policy, but he had no insurable interest in
the timber: all he had was a debt owing to him by the company[2].

Also changes in membership of the company have no effect on the ownership
of the company's assets.


h) Capability of suing and being sued

As a company is a separate legal entity it may sue to enforce rights and it
may be sued by others. Importantly, members in some instances may sue on
behalf of the company. This latter aspect will be dealt with in Topic 7
under the headings, "Members Remedies" and "Derivative Actions".


i) Privilege against self-incrimination

Historically courts have preceded on the basis that a corporation could
claim privilege against self-incrimination. This was clearly an advantage.
However since the recent decision in Environment Protection Authority v
Caltex Refining Co Pty Ltd (1994) 68 ALJR 127 this position is no longer
clear. In this case Caltex was the holder of a licence under the State
Pollution Control Commission Act 1970 (NSW) to discharge waste into the
ocean. The Environmental Protection Authority prosecuted Caltex for
discharging oil and grease into the ocean in breach of its licence. The
Authority subsequently served Caltex with a notice under the Clean Waters
Act 1970 (NSW), sec 29(2)(a) requiring it to produce certain documents
relating to its discharge of waste. Caltex objected to the validity of the
notice and the Authority then issued a notice to produce under the Land and
Environment Court Rules 1980 (NSW).

Caltex sought to have the notices set aside on the basis that a production
could incriminate them. The trial judge held that the privilege against
self incrimination did not apply to corporations but the New South Wales
Court of appeal allowed the appeal. The High Court held however, by
majority, that the privilege was not available to corporations.



1. Disadvantages of registration

As opposed to these advantages in incorporating a company, there are a
certain number of disadvantages. For example:-

a) Limitations on shareholders bringing proceedings on behalf of the
company

There are procedural difficulties for shareholders to bring a court action
on their own behalf and on behalf of their company. Historically, the so-
called rule in Foss v Harbottle [1843] 2 Hare 461 was illustrative of such
a problem. In that case two shareholders brought an action on behalf of
themselves and all other shareholders against the directors, solicitor and
architect of their company. They alleged that the defendants had
fraudulently misapplied company property and that the board was not
properly constituted. The defendant's argued that the plaintiff's plea,
even if proved, did not entitle them to succeed.

The Court held that the injury of which the plaintiff's complained of was
not an injury to themselves but to the company. Therefore the company
should sue in its own name. According to Wigram VC:

"It was not, nor could it successfully be, argued that it was a
matter of course for any individual members of a corporation thus to
assume to themselves the right of suing in the name of the
corporation. In law the corporation and the aggregate members of the
corporation are not the same thing for purposes like this; and the
only question can be whether the facts alleged in this case justify a
departure from the rule which, prima facie, would require that the
corporation should sue in its own name and in its corporate character,
or in the name of someone whom the law has appointed to be its
representative."

Now this area is governed by section 236 – 242 of the Corporations Act
which is covered in Topic 7 under the headings, "Members Remedies" and
"Derivative Actions".


b) Limited role that shareholders have in management

A company often has a separation of powers between management and
shareholders. According to Samuels JA., in Winthrop Investments Ltd v
Winns Ltd [1975] 2 NSWLR 666 at 683:

"...[T]he shareholders may have, ultimate control, because they can
alter the articles or remove the directors: but they cannot interfere
in the conduct of the company business where management, as here, is
vested in the board ... they have no general power to transact the
company's business, or to give effective directions about its
management."

The main decision in this area is Automatic Self-Cleansing Filter Syndicate
Co. Ltd v Cunninghame [1906] 2 Ch 34. In this case an article gave power
of management to directors "...subject to such regulations as may from time
to time be made by extraordinary resolutions." A further article gave the
board power to sell property owned by the company on terms it thought fit.
Shareholders at a meeting purported by ordinary resolution to direct the
board to sell property and the board refused and relied on the articles.
The Court held that unless an extraordinary resolution was passed, as
provided for in the articles, the shareholders could not ignore the
articles and give directions[3].


c) The ever-increasing penalty provisions applying to the defaulting
officer and director

d) Fees and paperwork associated with compliance

Under the Corporations Act there are a number of returns to be completed
and some of these require filing fees, for example, filing of the Annual
Return. There is also paperwork associated with meetings, accounts, and
registers and there may be a need for auditors or at least accountants.
These bureaucratic requirements may be seen as disadvantages to proprietors
of businesses.


THE COMPANY AS A SEPARATE LEGAL ENTITY

A company is an artificial legal entity which enjoys rights and is subject
to duties and obligations. It comprises a number of members, both natural
and non natural persons. The company is also a separate legal entity and
can have limited liability. Separate legal personality was firmly
established in Salomon v A. Salomon & Co Ltd [1897] AC 22.
Salomon had traded on his own as a leather merchant and shoe manufacturer
for over thirty years. While his business was solvent he formed a company
called "Aron Salomon and Company Limited" and sold his business to this
company. The Companies Act 1862 (UK) required seven subscribers and
Salomon, his wife and five children each subscribed one share to satisfy
the statute.

Salomon valued his business at 39,000 pounds which appeared to be an
inflated figure. However instead of taking cash for the sale of the
business, Salomon took 20,000 fully paid one pound shares in addition to
debentures to the value of 10,000 pounds. These debentures were secured by
a floating charge. The balance of the purchase price remained as an
unsecured debt.

Soon after the company came into financial difficulties and needed an
injection of funds. In response, Salomon borrowed 5000 pounds from
Broderip which he advanced to the company. To obtain this loan, Salomon
had his debentures cancelled and reissued to Broderip, but on terms that he
should obtain a residual benefit after the debt was discharged.

Payments to Broderip fell into arrears and Broderip enforced his security.
The company's liquidation followed. After Broderip was paid, there
remained a balance of indebtedness secured by the debentures. Salomon
claimed his reversionary entitlement. However if this claim was satisfied
there would be no funds left to pay out the other unsecured creditors. The
liquidator attempted to resist the claim by arguing that the debentures
were invalid on the ground of fraud.

At first instance, Vaughan Williams J[4], held that the company was merely
acting as Salomon's nominee and agent and therefore Salomon as principal
had to indemnify the company's creditors personally. On appeal, the Court
of Appeal in rejecting Salomon's appeal, held that Salomon was a trustee
for the company which was his mere shadow.

Salomon appealed to the House of Lords which rejected the lower courts'
rulings. According to Lord MacNaghten[5]:

"The company is at law a different person altogether from the
subscribers to the Memorandum and, although it may be that after
incorporation the business is precisely the same as it was before, and
the same persons are managers, and the same hands receive the profits,
the company is not in law the agent of the subscribers or trustee for
them. Nor are subscribers as members liable, in any shape or form,
except to the extent and in the manner provided by the Act. That is,
I think, the declared intention of the enactment".

Lord Watson emphasised[6] that the creditors of the company could have
searched the Companies Register to ascertain the names of the shareholders
and the number of shares which they held. However the failure to do this
should not impute a charge of fraud against Salomon.

Lord Herschell[7] looked at the intention of the statute in that it sought
to protect shareholders by limiting their liability.

Lord Halsbury LC had a similar view. According to his Lordship there was
no right to add to the requirements of the statute, nor to take from the
requirements which had been enacted. "The sole guide must be the statute
itself." Once a person was a shareholder they were shareholders for all
purposes and the statute was silent as to the extent or degree of interest
which had to be held by the individual corporators.

Importantly Lord Halsbury added an important qualifier to the immutability
of the separate legal entity doctrine. His Lordship said;

"I am simply here dealing with the provisions of the statute, and it
seems to me to be essential to the artificial creation that the law
should recognise only that artificial existence - quite apart from the
motives or conduct of individual corporators. In saying this, I do
not at all mean to suggest that if it could be established that this
provision of the statute to which I am adverting had not been complied
with, you could not go behind the certificate of incorporation to show
that a fraud had been committed upon the officer entrusted with the
duty of giving the certificate and that by some proceeding in the
nature of scire facias you could not prove the fact that the company
had no legal existence. But short of such proof it seems to me
impossible to dispute that once the company is legally incorporated it
must be treated like any other independent person with its rights and
liabilities appropriate to itself and that the motives of those who
took part in the promotion of the company are absolutely irrelevant in
discussing what those rights and liabilities are..."

From this judgment by the House of Lords the concept of "a company" was
seen as a legal entity in its own right. The very heart of separation and
independence from those involved in the company's management and structure
was established as a result of Salomon's case. If creditors dealt with the
company it was to the latter to which recourse had to be made, not to those
who were behind the entity. Over time this traditional perception would be
severely eroded. Recent illustrations of the principle in Salomon's case
appear in Lee v Lee's Air Farming [1961] AC 12 and Industrial Equity Ltd v
Blackburn (1977) 52 ALJR 89.

In Lee v Lee's Air Farming (1961) AC 12, Lee formed a company, Lee's Air
Farming Ltd, to carry on the business of aerial top-dressing. Lee held all
the shares except for one which was held by his solicitor. Lee was
governing director of the company and employed as its chief pilot. Lee was
killed while working for the company when an aeroplane crashed. His widow
sued under the company's workers' compensation insurance. The New Zealand
Court of Appeal rejected the claim on the basis that since Lee was the
governing director of the company, he could not also be its employee. His
widow appealed to the Privy Council.

The Court held that the company was a separate legal entity. According to
Lord Morris:

"A contractual relationship could only exist on the basis that there
was consensus between two contracting parties. It was never suggested
(nor in their Lordships' view could it reasonably have been suggested)
that the company was a sham or a mere simulacrum. It is well
established that the mere fact someone is a director of a company is
no impediment to his entering into a contract to serve the company.
If, then, it be accepted that the respondent company was a legal
entity their Lordships see no reason to challenge the validity of any
contractual obligations which were created between the company and the
deceased."

Lord Morris also said:

"Always assuming that the company was not a sham then the capacity of
the company to make a contract with the deceased could not be impugned
merely because the deceased was the agent of the company in its
negotiation. The deceased might have made a firm contract to serve
the company for a fixed period of years. If within such period he had
retired from the office of governing director and other directors had
been appointed his contract would not have been affected. The
circumstance that in his capacity as a shareholder he could control
the course of events would not in itself affect the validity of his
contractual relationship with the company. When, therefore, it is
said that `one of his first acts was to appoint himself the only pilot
of the company', it must be recognised that the appointment was made
by the company, and that it was none the less a valid appointment
because it was the deceased himself who acted as the agent of the
company in arranging it. In their Lordships' view it is a logical
consequence of the decision in Salomon's case that one person may
function in dual capacities."

In Industrial Equity v Blackburn (1977) 52 ALJR 89, the High Court refused
to treat a subsidiary company as merely part of its holding company for the
purposes of determining the profits of the holding company because of the
separate legal entity concept. In this case the question arose "whether in
ascertaining the amount of profits available for distribution by a holding
company by way of dividend, it is correct to look at the profit of the
holding company itself or to the group profit as disclosed by the
consolidated accounts." The court held that it was correct to do this.
According to Mason J:

"However, it can scarcely be contended that the provisions of the Act
operate to deny the separate legal personality of each company in a
group. Thus, in the absence of contract creating some additional
right, the creditors of company A, a subsidiary company within a
group, can look only to that company for payment of their debts. They
cannot look to company B, the holding company, for payment."

It should be noted that the provisions contained in sec 588V-588X of the
Corporations Law allows a liquidator to recover compensation from a holding
company where its subsidiary has been involved in insolvent trading. This
is discussed later in this Topic.


MITIGATING THE RIGOUR OF THE SEPARATE LEGAL ENTITY DOCTRINE

Once it was acknowledged that a company enjoyed a separate and legal
existence apart from its members, another consideration needed to be dealt
with, namely the rights of creditors. The fact that many companies were
incorporated with limited liability further entrenched the notion that
creditor's rights were limited. If creditors dealt with this separate
legal entity in which members had limited liability, then any recourse
which they may have had would be to the company itself. Thus the separate
legal entity doctrine was a two-edged sword. On the one side the rights of
members were limited and on the other side, a creditor practical ability to
seek redress was limited. Courts and the legislature then had to balance
these respective rights to prevent abuse. A starting point to analysing
the quest for a balance can be found by examining the chequered history of
limited liability in the corporation confine.

Limited liability found its inception with regards to companies in 1854 in
the Limited Liability Act[8]. The justification for its inception can be
found in arguments conveniently summarised by Farrar[9] as follows:

limited liability allowed small capital to be turned to profitable
employment;

it was a question of free trade against monopoly;


unlimited liability was impracticable and impeded work such as
railways, canals and docks;


unlimited liability prevented prudent men from becoming members of
companies which were consequently being formed by the rash and
reckless.

Interestingly, there were a number of arguments against the introduction of
limited liability[10]. Some of these arguments were:

limited liability was not a privilege to be given to partners but it
was a right to be taken from creditors;

it encouraged people to trade beyond their means;

it led to speculation and fraud;

there was adequate capital available without it.

Up until the passing of the Limited Liability Act 1854, a form of limited
liability existed in a practical sense in particular circumstances. For
instance, it was common for clauses to be included in deeds of settlement
and prospectuses[11] which limited the liability of those behind the
scheme. According to Gower[12]:

..."[U]nlimited liability, though a danger to the risk taker, was
often a snare and a delusion rather than a protection to the public
and no handicap at all to the dishonest promoter. The difficulties of
suing a fluctuating body and the even greater difficulties of levying
execution made the personal liability of the members largely illusory.
Moreover, the investor was supposed to become a member by signing the
deed of settlement and until he did so his identity would not be known
by the creditors. But in fact `stags' would deal in allotment letters
or scrip certificates to bearer without signing the deed and often
before any formal deed was in existence, and dishonest promoters, who
alone might be under any legal liability, might disappear with the
subscription moneys."

Despite these convenient ways of introducing limited liability and the
arguments against it, Government intervention was not far away and the
introduction of statutory limited liability was a by-product of such
intervention. The form of this limited liability introduced by the Limited
Liability Act 1854 was, however, subject to certain qualifications and it
could be argued that right from the beginning, limited liability as it
applied to companies was not going to be absolute.

The qualifications to enjoying limited liability were built into this
initial legislation. For example:

the company needed to have at least 25 members holding 10 pound shares
of which 20% had been paid up;

three-quarters of the company's capital needed to have been
subscribed;

the word "limited" was to have been included as part of the company's
name;

directors of such limited liability companies were personally liable
when they paid a dividend knowing the company to be insolvent or made
loans to the members;

the company had to wind up if three-quarters of the capital was lost.

The Limited Liability Act 1854 was soon repealed and later its provisions
were incorporated in the Joint Stock Companies Act 1856. This latter Act
allowed incorporation with limited liability with minimal restrictions and
it removed most of the qualifications contained under the 1854 Act
mentioned above, although directors were still to be liable for payment of
dividends when the company was insolvent. In fact, all that was necessary
to incorporate was for a minimum of seven persons to sign and register a
memorandum of association. According to Gower[13]:

..."[T]he legislature had adopted Lord Bramwell's recommendations and
accepted his view that those who dealt with companies knowing them to
be limited had only themselves to blame if they burnt their fingers.
The mystic word `Limited' was intended to act as a red flag warning
the public of the perils which they faced if they had dealings with
the dangerous new invention." [bold added]

The question which can be asked is whether the colour of this `red flag'
has faded? Historically, creditors have been precluded from recovering
from shareholders or directors an amount in excess of the unpaid amounts on
their shares, yet both the courts and the legislature have widened the gaps
in the corporate veil. As mentioned at the beginning of this Chapter a
number of situations now exist whereby directors and others who take part
in management of a corporation will be personally liable for debts incurred
by the company. This liability may be exclusive personal liability or
concurrent liability with the company. Whatever the liability, the
distinct legal personality pronounced in Salomon's case[14] by the House of
Lords has been shown, on occasions, not to be an immutable principle. Both
the legislators and the courts lift the corporate veil and seek out the
realities of the situation. They may deny the usual legal consequences of
incorporation and of the red flag. Further legislation directly imposes
personal liability upon management. Limited liability is not sacrosanct
and the principle in Salomon's case no longer rules.

Since the decision in Salomon's case there has been a steady stream of
common law decisions and legislative enactments which have eroded the
immutability of the separate legal entity doctrine and have thus exposed
officers to personal liability to a company's creditors. These decisions
and enactments are conveniently seen as ways to `lift or pierce the
corporate veil'[15].

According to Easterbrook and Fischel, "piercing seems to happen freakishly
... like lightning, it is rare, severe and unprincipled."[16] But this so
called freakish happening has occurred on a number of grounds. Farrar
notes that[17]:

"... [I]t is difficult to rationalise the cases except under the
broad, rather question-begging heading of policy and by describing the
main categories under which they fall. These are:

agency;

fraud;

group enterprises;

trusts;

enemy;

tax;


the Companies Act itself."

We will now analyse some of these grounds under the convenient headings of
"common law" and "statute".

1) Common Law

a) Fraudulent use of the corporate form

Lord Halsbury in Salomon's case acknowledged that the corporate veil will
not protect a fraudulent person hiding behind the corporate structure.
Illustrative of this is the decision in Gilford Motors Co Ltd v Horne
[1933] 1 Ch D 935.

In this case the defendant was employed under a service contract as
managing director of the plaintiff company. As part of this contract he was
forbidden, when ceasing his employment with the company, from taking away
the plaintiff's customers. The defendant left the plaintiff company, formed
a competitive business and a company in which he was one of three
shareholders. The new company solicited the plaintiff's customers and the
plaintiff sought an injunction restraining this conduct. The defendant
argued that he was not soliciting customers of the plaintiff and that if
there was any solicitation, it was from a separate legal entity, namely the
new company which had no contract with the plaintiff. This argument was
rejected by the Court.

According to Lord Hanworth MR[18], the new company was a "mere cloak or
sham" for the defendant, its purpose was to enable the defendant to engage
in a business in breach of the covenant contained in his contract with the
plaintiff.

In Re FG (Films) Ltd [1953] 1 WLR 483, an American company owned most of
the shares in an English company and exercised control over it. The
American company financed and produced a film in India and then caused the
English company to apply for a subsidy under the Cinematograph Films Act
1938 (UK). A subsidy would have been paid if the film was made by a
British film maker. It was held that no subsidy should be paid as the
British company had acted as a mere nominee and agent of the American
company. According to Vaisey J[19]:

"[T]he British company's intervention in the matter was purely
colourable. They were brought into existence for the sole purpose of
being put forward as having undertaken the very elaborate arrangements
necessary for the making of this film and of enabling it to qualify as
a British film."

Similarly in Jones v Lipman [1962] 1 WLR 832, Lipman agreed to sell land to
Jones. Before completion of the contract, Lipman transferred the land to a
company of which he and a clerk employed by his solicitors were the only
shareholders and directors. Jones brought an action for specific
performance of the contract against both Lipman and the company.

The Court held that the company was a sham and ordered specific performance
of the contract. According to Russell J:

"The defendant company is the creature of the first defendant, a
device and a sham, a mask which he holds before his face in an attempt
to avoid recognition by the eye of equity."

In Creasey v Breachwood Motors Ltd (1992) 10 ACLC 3052, Creasey worked for
Breachwood Welwyn Ltd as its general manager pursuant to a written
contract. This company carried on the business of a garage trading in cars
from premises owned by Breachwood Motors Ltd. F and S were the
shareholders and directors of both these companies. In 1988, Creasey was
dismissed by Breachwood Welwyn Ltd and he claimed damages for wrongful
dismissal against this company.

In November 1988, Breachwood Welwyn Ltd ceased trading and in December 1988
Breachwood Motors Ltd took over its business and continued its operations
under the same trading name. This takeover was carried out without regard
to the separate entity of Breachwood Welwyn Ltd and the interests of its
creditors, especially Creasey, if his claim for wrongful dismissal were to
succeed.

As a result of the actions of F, S and Breachwood Motors Ltd, Creasey found
himself with a judgement against Breachwood Welwyn Ltd, an insolvent
company, the assets of which had been removed to Breachwood Motors Ltd.
Breachwood Motors Ltd refused to meet any part of the judgement. One of
the questions which had to be decided was whether the corporate veil could
be pierced?

The Court held that the corporate veil could be pierced. Nothing could
justify F and S's conduct in deliberately shifting Breachwood Welwyn Ltd's
assets and business into Breachwood Motors Ltd in total disregard of their
duties as directors and shareholders. This meant that Breachwood Motors
Ltd were liable for the liability of Breachwood Welwyn.


(b) Agency

In some circumstances a company may act as an agent for others, for
example, shipping agents or investment brokers. Moreover, it is possible
for a company to act as the agent for its own shareholders. This may be
done by express contract or impliedly.

In Smith, Stone & Knight Ltd v Birmingham Corp [1939] 4 All ER 116,
Birmingham Corporation, a local council, compulsorily acquired premises
owned by the Birmingham Waste Co. Ltd. This company was a wholly-owned
subsidiary of Smith, Stone & Knight Ltd. Indeed, of the 502 issued shares
in the waste company, 497 were held by Smith, Stone & Knight and the other
5 were held on its behalf. The Waste Company had no staff, no separate
books of account and on the evidence it was treated like one of Smith,
Stone & Knight's departments. Accordingly a claim for compensation for
loss of business was made by Smith, Stone & Knight Ltd. Birmingham
Corporation argued that Smith, Stone & Knight Ltd. could not succeed
because the loss had been sustained by the waste company - a separate legal
entity.

The Court held that compensation was payable as the Waste Company was
carrying on no business of its own but was in fact carrying on the Smith,
Stone & Knight business as agent for them.

Atkinson J held that the following six factors must be proven in order to
show the requisite agency relationship and thus be able to lift the
corporate veil:

Profits of the subsidiary must be treated as profits of the holding
company;

Those conducting the subsidiary's business must be appointed by the
holding company;

The holding company must be the head and brain of the trading venture;

The holding company must be in control of the venture and must decide
what capital should be spent and what should be done;

The profits made by the subsidiary's business must be made by the
holding company's skill and direction; and

The holding company must be in constant and effective control.

This decision was adopted in Pioneer Concrete Services Ltd v Yelnah Pty Ltd
& ors (1987) 5 ACLC 467. In this case a dispute occurred between major
competitors in a concreting industry. Hi-Quality Concrete (Holdings) Pty
Ltd was the holding company for a large group of companies, known as the Hi-
Quality group. This group was under the control of Messrs Hargreaves, Ward
and Armstrong. Hi-Quality Concrete (NSW) was part of this group and was a
fully-owned subsidiary of the holding company.

In 1982 Hargreaves, Ward and Armstrong together with Hi-Quality Concrete
(NSW) Pty Ltd and Hi-Quality Concrete (Holdings) Pty Ltd entered into a
deed with the plaintiff. In the deed "Hi-Quality" was defined as Hi-
Quality Concrete (NSW) Pty Ltd. In 1985 the holding company entered into
transactions which were alleged to be in breach of this deed. The other
members of the group denied any breach of the agreement on the basis that
they were not parties to the 1985 transactions and that the holding company
was not a party to the 1982 deed.

The Supreme Court of New South Wales held that the specific provision
defining "Hi-Quality" meant that the holding company was specifically
excluded from the promises in the 1982 deed and therefore could not be in
breach of the deed. Young J acknowledged the separateness of the legal
entities involved and held that on the facts there could be no imputation
of the promise by the subsidiary to the holding company. In other words
the corporate veil could not be lifted. Importantly the court could not
infer an agency agreement, nor could they find a partnership between the
companies in the group or a sham or a facade[20]. Further there was "no
question of a corporation being formed for the sole purpose or for the
dominant purpose of evading ... a contractual or fiduciary obligation."[21]

According to Young J[22], the corporate veil would not be lifted when it
appears that "there was a good commercial purpose for having separate
companies in the group performing different functions even though the
ultimate controllers would very naturally lapse into speaking of the whole
group as `us'."

This issue was also examined in Briggs v James Hardie & Co Pty Ltd (1987) 7
ACLC 841. In this case Briggs suffered from a medical condition allegedly
caused by negligence of his employer. His employer was a subsidiary of the
defendant. In an action against both his employer and its holding company,
one argument which had to be addressed was whether the corporate veil could
be lifted so as to find the holding company liable.

The New South Wales Court of Appeal admitted to the possibility of the veil
being lifted and remitted the case back for determination.


(c) Groups of companies

Companies may form part of a group of companies where for example, they
operate with a holding company and subsidiaries. On occasion, courts will
regard the entities as one. In DHN Food Distributors Ltd v Tower Hamlets
London Borough Council [1976] 1 WLR 852, three companies in a group of food
distributors were treated by the court as one[23]. In this case one
company, D.H.N. Food Distributors [DHN], owned and controlled a business of
importing and distributing groceries. It operated out of a warehouse which
was owned by a subsidiary, called Bronze Investments Ltd. Vehicles which
were used in the business were owned by another subsidiary, D.H.N. Food
Transport Ltd. DHN held all the shares in both the subsidiaries and the
companies had common directors.

In 1969 the local council, known as Tower Hamlets London Borough Council,
made a compulsory purchase order so as to acquire the land on which was
built the warehouse. DHN was unable to relocate and the business
subsequently closed down. On the issue of compensation, there were two
factors to consider. First, the value of the land and secondly
compensation for disturbance in having the business closed down. On the
first issue, the council offered and paid an agreed sum to Bronze
Investments Ltd. However with regards to the "disturbance value", the
council argued that none was payable as Bronze Investments were not
disturbed. The council admitted that both DHN and DHN Food Distributors
Ltd were disturbed, however they argued that those two companies were not
entitled to any compensation at all because they had no interest in the
land. The council argued that DHN was only a licensee of Bronze Investments
Ltd. Under the Compulsory Purchase Act 1965 (UK) if a person has no
greater interest than a tenant from year to year in the land, then he is
only entitled to compensation for that lesser interest. As a licensee can
be evicted on short notice, the compensation payable to DHN would be
negligible.

The English Court of Appeal treated the companies as one economic entity
and following from this, DHN could be treated as owner of the property and
was thus entitled to compensation for disturbance to its business[24].
According to Lord Denning[25]:

"We all know that in many respects a group of companies are treated
together for the purpose of general accounts, balance sheet, and
profit and loss account. They are treated as one concern. Professor
Gower in Modern Company Law (3rd ed., 1969), p 216 says: ... `there is
evidence of a general tendency to ignore the separate legal entities
of various companies within a group, and to look instead at the
economic entity of the whole group.' This is especially the case when
a parent company owns all the shares of the subsidiaries - so much so
that it can control every movement of the subsidiaries. These
subsidiaries are bound hand and foot to the parent company and must do
just what the parent says ... They should not be treated separately so
as to be defeated on a technical point. They should not be deprived
of the compensation which should justly be payable for disturbance.
The three companies should, for present purposes, be treated as one,
and the parent company DHN should be treated as that one[26]."

Lord Goff also believed that this was a case in which one was entitled to
look at the realities of the situation and to pierce the corporate veil.
In his Lordship's opinion[27]:

"I would not at this juncture accept that in every case where one has
a group of companies one is entitled to pierce the veil, but in this
case the two subsidiaries were both wholly-owned; further they had no
separate business operations whatsoever; third, in my judgment, the
nature of the question involved is highly relevant, namely, whether
the owners of this business have been disturbed in their possession
and enjoyment of it."

An Australian illustration of this "group enterprise" circumstance occurred
in Hobart Bridge Co Ltd (in liq) v Commissioner of Taxation (1951-52) 25
ALJ 225. In this case the appellant was granted a franchise to build a
bridge across the Derwent river in Tasmania. The company's source of
revenue was to include profit from the subdivision and sale of land
adjacent to the bridge. The promoter had secured options over the land and
a subsidiary company was formed to purchase it. The appellant held
approximately nine-tenths of the shares in the subsidiary. No sales of
land were made by the subsidiary, however some preparatory work was done.
An Act was passed whereby the government acquired all the undertaking of
the appellant and later they acquired all of the shares in the subsidiary
company. By the share transactions the appellant made a substantial
profit.

The respondent treated this profit as assessable income earned pursuant to
a profit-making scheme of which the subsidiary was the "collecting medium".

The High Court rejected this and held that the subsidiary was not to be
deemed the medium or machinery for a scheme. There was to be no lifting
of the corporate veil simply because the formation of the subsidiary
reduces tax liability. The subsidiary had a real existence and a valid
reason for its incorporation.

Kitto J referred[28] to the judgment of Lord Sumner in Gas Light
Improvement Co v Inland Revenue Commissioners[29] where his Lordship
stated:

"It is said that all this was `Machinery' but that is true of all
participations in limited liability companies. They and their
operations are simply the machinery, in an economic sense, by which
natural persons, who desire to limit their liability, participate in
undertakings which they cannot manage to carry on themselves, either
alone or in partnership, but, legally speaking, this machinery is not
impersonal though it is inanimate. Between the investor, who
participates as a shareholder, and the undertaking carried on, the law
interposes another person, real though artificial, the company itself,
and the business carried on is the business of that company, and the
capital employed is its capital and not in either case the business or
the capital of the shareholders. Assuming, of course, that the
company is duly formed and is not a sham (of which there is no
suggestion here), the idea that it is mere machinery for effecting the
purposes of the shareholders is a layman's fallacy. It is a figure of
speech, which cannot alter the legal aspects of the facts."

In Qintex Australia Finance Ltd v Schroders Australia Ltd (1991) 9 ACLC
109, Rogers CJ suggested that the whole issue of the separateness of the
corporate legal entity be re-examined in the light of the so-called tension
between the realities of commercial life and the applicable law. Although
the court in the case at hand had to determine which company in the Qintex
group of companies should be able to claim the benefit of the contract
entered into, a number of more general remarks were made concerning the
separate legal entity doctrine. According to Rogers CJ it may be
desirable[30]:

"... [F]or Parliament to consider whether this distinction between
the law and commercial practice should be maintained. This is
especially the case today when the many corporate collapses of
conglomerates occasion many disputes."

In Briggs v James Hardie Co Pty Ltd (1989) 7 ACLC 841 Rogers AJA noted
that complete domination or control over a subsidiary may not by itself
lead to the corporate veil being lifted. Further the judge suggested[31]
that different considerations should apply when this veil is to be lifted
in tortious situation as compared with actions based in contract and
taxation.



2. Statute - Corporations Act

Under the Corporations Act there are numerous illustrations of personal
liability attaching to management despite the company structure being in
existence and perhaps being the entity which contractually dealt with a
third party.


a) Section 183

Promoters who enter pre-registration contacts[32] may incur personal
liability to those with whom they dealt on behalf of a non-existent entity,
irrespective of any contractual intention. This is due to the operation of
section 131of the Corporations Act. Bay v Illawong Stationery Pty Ltd
(1986) 4 ACLC 429. See also sections 711, 728 and 729.


b) Section 153

This section requires a company to set out its name on all its public
documents and negotiable instruments. It is a strict liability offence for
breach. In an English case, Jenice Pty Ltd v Dan (1994) 12 ACLC 3209 a
company's cheques bore the name "Primkeen Limited" when its name was
"Primekeen Ltd". A cheque which was later dishonoured was issued and
signed by a director and the payee attempted to make the director liable.
The Court held that the director was not liable. The company's name was
mentioned notwithstanding the typographical error. This was different from
omitting the whole name.


c) Sections 588G-588Z and 592-593 (Insolvent Trading)

Introduction to sections 588G-588Z

When a company has a liquidity crisis its directors and officers need to
take special care in their dealings with those outside the company.
Directors need to consider their company's ability to pay all its debts as
and when they become due. This is particularly so when the company is in
financial difficulty and some form of financial management structure is in
place. If a reasonably competent director would conclude that the company
lacks that capacity or would lack that capacity after incurring the debt,
they should not cause the company to incur further debts.

The relevant provisions of the Corporations Act regulating insolvent
trading are contained in sections 588G-Z. Those provisions contain a
complete code for the regulation of such trading. Sections 588G-588Z of
the Corporations Act are provisions which commenced operation on and from
the 23 June 1993. These sections were designed to replace the insolvent
trading provisions contained in sections 592-593 of the Corporations
Law[33]. However these latter provisions will continue to apply to debts
incurred prior to 23 June 1993 in circumstances amounting to insolvent
trading.

The duty

Section 588G(1) imposes a duty upon directors to prevent a company from
engaging in insolvent trading. The heading to Division 3 of the
Corporations Act refers to this duty and this heading is regarded as part
of the Corporations Act because of the operation of sec 109D.

Section 588G(1) applies if:

a) the director was a director of the company at the time when the
company incurs a debt; and

b) the company is insolvent at the time of the incurring the debt or
becomes insolvent by incurring that debt or by incurring at that time
debts including that debt; and

c) at the time there are reasonable grounds for suspecting the company
was insolvent or would become insolvent as a result of the
transaction; and

d) that time is at or after the commencement of this Part, that is 23
June 1993.

Section 588G(3) provides that by failing to prevent the company from
incurring the debt, the person will contravene the section if they were
aware at the time that there are such grounds for so suspecting or a
reasonable person in a like position in a company in the company
circumstances would be so aware.


Further, section 588G(3) provides that a person commits an offence if:


a) the company incurs a debt at a particular time; and


b) at that time, the person is a director of the company; and


c) the company is insolvent at that time, or becomes insolvent by
incurring that debt, or by incurring at that time debts
including that debt; and


d) the person suspected at the time when the company incurred the
debt that the company was insolvent or would become insolvent as
a result of incurring that debt or other debts; and


e) the person's failure to prevent the company incurring the debt
was dishonest.


a) If either section 588G(2) or (3) is satisfied, then section 588M
can be used to enable a creditor to recover compensation for
loss resulting from insolvent trading as long as section 588R or
section 588S are satisfied.


It should be noted that both those who contravene the section and those
"involved in the contravention" (section 79) can be caught.

Relevantly, section 588M provides that if:


a) a person (director) has contravened section 588G(2) or (3) in
relation to the incurring of a debt by a company; and


b) the person (creditor) to whom the debt is owed has suffered loss
or damage in relation to the debt because of the company's
insolvency; and


c) the debt was wholly or partly unsecured when the loss or damage
was suffered; and


d) the company is being wound up,


then a creditor may, if they have satisfied either section 588R or section
588S, recover from the director, as a debt due to the creditor, an amount
equal to the amount of the loss or damage.


Section 588R enables a creditor to commence proceedings with the written
consent of the company's liquidator.


Section 588S enables a creditor to sue for compensation without the
liquidator's consent but only after giving notice to the liquidator.


Section 588M(4) provides that proceedings under section 588M may only begun
within six years after the beginning of the winding up. Further, section
588M has the effect in addition to, and not in derogation of, any rule of
law about the duty or liability of a person because of the person's office
or employment in relation to the company and does not prevent proceedings
from being instituted in respect of a breach of such a duty or in respect
of such a liability (section 588P).





According to para 1229 of the Explanatory Memorandum which accompanied
these provisions:

"[A] court would be expected to look at two separate issues when
considering whether the duty had been breached. The first matter
would be what circumstances that particular company was in, including
the size of the company, the type of the company, the nature of its
enterprise, the provisions of its articles, the composition of its
board and the distribution of work between the board and other
officers. The second matter that a court would be expected to look at
would be, in the light of the circumstances referred to, what would a
reasonable person in the position of director normally be expected to
do to ensure that he or she would be aware of any insolvency problem.
In particular a court might expect the following:

that directors of a large company would ensure that among their
number there should be one or more who are talented in the field
of corporate financial management;


that directors of a large company should read, be able to
understand and seek any necessary clarification of the key
financial information put before the board, such as a balance
sheet and a profit and loss statement;


that the board ensure that appropriately skilled people are
engaged to carry out the company's accounting functions;


that the board would require relevant accounting information to
be supplied ahead of regular board meetings at which key
financial decisions are to be made, and that, where a
significant borrowing is to be undertaken, the management should
supply the board with a statement of the company's current
financial position as well as the particulars of the way in
which the principle, interest and other charges are to be
serviced over the anticipated term of the loan;


that the board make arrangements for monitoring the use of any
authorisation granted in relation to the use of the company
seal, the entering into contracts with financiers or the signing
of cheques and bills of exchange; and


where the nature of the business may expose the company to a
high risk of sudden liquidity restriction, or the company is
known by the director to be in a delicate financial position,
that extra care and more rigorous safeguards may be adopted."

Importantly, there is nothing in section 588G which necessitates the
winding up of the company as a precondition to activating the section,
however it can be argued that the heading to Part 5.7 (including Part 5.7B
in which sections 588G-588Z is located) of the Corporations Act makes it
clear that section 588G is part of particular legislation concerned with
the recovery of property or compensation after a winding up has begun.
Furthermore some of the sections related to section 588G, such as sections
588M and 588R, reinforce the view that they operate only where the company
is being wound up. In contrast, other related sections such as sections
588J and 588K, are not expressed to be contingent upon winding up occurring
and it is arguable that these particular sections are not confined to
winding up situations.

Taking each of the elements in section 588G(1) in turn, the following can
be stated:

1) Directors

With respect to `directors', section 9 of the Corporations Act provides
that a "director" would include any person occupying or acting in the
position of director by whatever name called and whether or not validly
appointed or authorised and any person in accordance with whose directions
or instructions the directors are accustomed to act - so called "defacto"
directors. See Taylormaid Marine Industries Pty Ltd v Beaurepaire & Ors
(1987) 5 ACLC 253. Further persons dealing with a company can assume that
a person is a director in certain situations [sec 129].

The definition may also include alternate directors if called upon to act.
See Playcorp Pty Ltd v Shaw & ors (1993) 11 ACLC 641.


2) Incurring of a "debt"

Another requirement to found a cause of action under section 588G(1) is
proof that "the company incurred a debt." This involves an examination of
two requirements. First, what qualifies as a `debt' for the purposes of
the section and secondly, what is involved in the `incurring' of a debt.


a) The meaning of `debt'

The meaning of the word "debt" is not defined in the legislation. However
it has been interpreted to bear its ordinary technical meaning as something
recoverable by an action for debt and thus must be ascertained or capable
of being ascertained: Ogden's Ltd v Weinberg (1906) 95 LT 567; Hussein v
Good (1990) 1 ACSR 710. Therefore, a "debt" refers to an obligation for
the payment of money or money's worth and there is authority to suggest
that the obligation must be for an ascertained liquidated sum: 3M Australia
Pty Ltd v Watt (1984) 9 ACLR 503; Jelin v Johnson (1987) 5 ACLC 463.

In CAC v Shapowloff (1974) CLC 27,964, the defendant, by telephone,
allegedly ordered 5,000 shares from a broker on behalf of his company. The
terms were that the company would pay for them only when the broker
received the scrip. In other words, the liability remained contingent
until the scrip was received. The broker obtained these shares in 29
transactions and 29 contract notes were forwarded to the company. The
shares were not paid for and the company was wound up. The defendant was
charged with knowingly being a party to contracting a debt provable in the
winding up of that company having, at the time the debt was contracted, no
reasonable or probable ground of expectation of the company being able to
pay.

A declaration was sought from the Supreme Court. Before any evidence was
taken, as to the meaning of the word `debt' in the section, Jacobs P in the
Court of Appeal (1974) CLC 27,974 declared at 27,977:

"[T]hat for the purposes of sec 303(3) of the Companies Act where a
series of contracts is made from time to time which result in a
liability on behalf of the company to pay in respect of each of them,
then each such liability constitutes a debt; and the time when each
such debt is contracted is the time when each respective liability
arises, and not the time or times when the balance is declared or
computed."

The Magistrate, believed that contingent debts should be included within
the meaning of the word "debt". Here liability arose when the contract
notes were delivered to the company. This view was affirmed by Cantor J in
the Supreme Court and by Mahoney JA in the Court of Appeal.

Notwithstanding these comments on contingent debts, it appears that some
divergence of opinion has developed because of the lack of clarity in the
section as to whether these debts are "debts" within the meaning of sec 592
Corporations Law. The section does not expressly state whether "debt"
includes a contingent debt and this omission could lead to unsatisfactory
results. Illustrative of these concerns is the Victorian Supreme Court
decision in Hussein v Good (1990) 8 ACLC 390. In this case the defendant,
a director of a clothing retail company ordered a range of clothing from
the plaintiff, a manufacturer. The date of delivery was originally to be
March 1988 but this, by agreement, was changed to 3 May 1988. Payment was
to be made upon delivery.

Part of the total goods were delivered on 3 May 1988 but no payment was
made. A few days later money was collected by the plaintiff, however one
of the cheques used for payment was dishonoured. Before notice of
dishonour was given, the remainder of the goods were delivered. No further
payment was made.

On 16 May 1988 the defendant's accountant advised the defendant to put the
company into voluntary liquidation. The company was placed under the
control of a liquidator. The company was placed under the control of a
liquidator. The plaintiff claimed against the defendant pursuant to
section 556 of the Companies Code (now section 588G Corporations Act).

The Court held that the date to determine whether there were reasonable
grounds to expect that the company could not pay all its debts as and when
they became due was in May 1988 and that at that date the defendant did not
expect the debt would be paid. A debt it was held,[34] meant "what is owed,
state of owing something". Here nothing was owed until the delivery of the
manufactured garments.

According to Southwell J, Shapowloff was distinguishable from the present
case:

"I see some difficulty in drawing an analogy between the particular
circumstances surrounding transaction between a purchaser of shares
and his agent, the broker, where the creation of a contingent
liability can usually be expected to become a present indebtedness
very quickly, perhaps upon the same day, and a case where, as in the
present case, a trader in goods places an order with a manufacturer in
circumstances where any contingent liability, if there was one, would
not become a present indebtedness until some months thereafter."

The defendant unsuccessfully argued that the date on which the debt was
incurred was November 1987, when the goods were ordered.

In Standard Chartered Bank v Antico (1995) 131 ALR 1 at 57 Hodgson J stated
that:


"a company incurs a debt when, by its choice, it does or omit
something which, as a matter of substance and commercial reality,
renders it liable for a debt which it otherwise would not have been
liable."


Further, in ASIC v Plymin (No 1) (2003) 46 ACSR 126 Mandie J noted at 247:


"the weight of authority shows that a debt can be incurred when the
contract giving rise to the debt is entered into, even if
contingencies affect the debt or the debt is a future debt. In the
case of a future debt, it may be incurred at the time of entering the
contract if it is then an ascertained or an ascertainable amount. By
the same token, a debt may in appropriate circumstances be incurred
within the meaning of the section at a time later than the entry of
the contract under which the debt arises or may arise. Although it is
necessary to consider the terms of the relevant contract, the question
when the debt is incurred within the meaning of this section does not
depend on strict legal analysis but turns on when, in substance and
commercial reality, the company is exposed to the relevant liability."


In Australian Securities and Investments Commission v Edwards (2005) 220
ALR 148; 54 ACSR 583; [2005] NSWSC 831 Barrett J stated that incurring, a
debt involves any "act, omission or other circumstance which causes the
company to owe the debt".

In Hawkins & ors v Bank of China (1992) 10 ACLC 588, it was held that
"debts" can include a contingent liability[35]. According to Gleeson CJ:

"`Debt' is capable of including a contingent liability. The word was
used in that sense in sec 291 of the Companies Act 1961, which
referred to `debts payable on a contingency'. That expression did not
involve a contradiction in terms. Dictionaries define `debt' as a
liability or obligation to pay or render something. Such a liability
may be conditional as well as present and absolute.

Likewise a contractual obligation to supply goods even after they
have been paid for, will not constitute a debt for the purposes of the
section. This is because as at the time of the contract all that
could be claimed if the goods were not supplied would be an action for
damages. "A potential liability for damages does not constitute the
incurring of a debt for the purposes of sec 592."[36]

In Deputy Commissioner for Corporate Affairs v Abbott & Anor (1980) CLC
34,428 it was held that[37]:

"The word `debts' means something recoverable by an action for debt
and nothing can be recovered in an action for debts except that which
is ascertained or can be ascertained.; see Ogden's Ltd v Weinberg
(1906) 95 L.T. per Lord Davey at p.567".

This view was accepted and followed by Master Seaman in Jelin Pty Ltd v
Johnstone & Anor (1987) 5 ACLC 463 and it appears that the word is used in
its ordinary sense[38] and therefore claims for unliquidated damages[39]
and outstanding interest would be excluded[40]. In addition taxes which
are due and payable and which may even be deemed to be debts owing to the
crown are not `debts' for the purposes of section 588G[41]. However,
claims for outstanding workers compensation premiums are debts within the
meaning of the section.[42] Finally, the fact that a company's liability
to pay a debt has been extinguished (subject to proofs of debt) upon a
winding up, does not mean that directors and management will avoid
liability[43] as creditors have a vested right to sue the officer.

b) The meaning of "incurring" a debt

Section 588G(1A) contains a "debt" table which is designed to assist
ascertain the point in time when a debt was incurred. It is non-
exhaustive.

Predecessor legislation covered situations where the defendant was
knowingly a party to the contracting of a debt by the company. For
example, the purchase of shares via a telephone order[44]; purchase of
goods and services[45]; entering into contracts to help build project
homes[46]; arranging for advances to be made to the company. The question
is, is section 588G of the Corporations Act restricted to debts which have
been contracted[47]?

In Jelin Pty Ltd v Johnson & Anor (1987) 5 ACLC 463, the plaintiff sought
to recover damages from the defendant because it had been deprived of a
judgment debt. This judgment debt was given by the Federal Court in
relation to misleading statements made by servants of the company. The
plaintiff submitted that the relevant debt was incurred either when the
plaintiff introduced funds into the business on the faith of the misleading
statements of the servants or agents or when the Federal Court gave its
judgment. Master Seaman QC said that neither on the day on which the
misrepresentations were made, nor on the day when judgment was given by the
court awarding damages, nor on any day between these two days, did the
company `incur a debt'[48].

"The incurring of a liability in damages is not the same as
`incurring a debt' under the section".

A similar conclusion was reached in relation to a liability to pay
taxation[49].

In Hawkins & ors v Bank of China (1992) 10 ACLC 588 it was held that the
giving of guarantee constituted the incurring of a debt. The liability
incurred under the guarantee was to pay an already-accrued sum which was a
liquidated amount. Even though it was unusual to say that the company may
not have incurred a debt at the time when it had given the guarantee,
nevertheless according to Gleeson CJ and Sheller JA it was proper to say
that the company incurred a debt to the bank at some stage. Their Honours
noted:

"[T]hat the words `incurs' and `debt' are not words of precise and
inflexible denotation. Where they appear in sec 556 they are to be
applied in a practical and commonsense fashion, consistent with the
context and with the statutory purposes."

According to Gleeson CJ[50]:

"the word `incurs' takes its meaning from its context and is apt to
describe, in an appropriate case, the undertaking of an engagement to
pay a sum of money at a future time, even if the engagement is
conditional and the amount involved is uncertain. Once it is accepted
that `debt' may include a contingent debt then there is no obstacle to
the conclusion that, in the present context, a debt may have been
taken to have been incurred when a company entered a contract by which
it subjected itself to a conditional but unavoidable obligation to pay
a sum of money at a future time."

Kirby P adopted a similar view and held[51] that:

"The act of `incurring' happens when the corporation so acts as to
expose itself contractually to an obligation to make a future payment
of a sum of money as a debt. The mere fact that such a sum of money
will only be paid upon a future contingency does not make the
assumption of the obligation any less `incurring' a `debt'."

Associated with ascertaining whether a company has incurred a debt is the
concomitant task of being able to specify the particular time when the debt
was incurred.

In Russell Halpern Nominees Pty Ltd v Martin & Anor[52], the plaintiff
company agreed to lease premises to two other companies. Rent was not
received and it was found that immediately before and at the time of
entering into the agreement for lease, both tenants were unable to pay
their debts as and when they fell due. A writ based upon sec 556 was
struck out on the basis that it did not disclose a reasonable cause of
action. The Supreme Court by majority, dismissed the appeal.

According to Burt CJ.[53]:

"[W]hatever the expression `incurs a debt' might mean, it is clearly
descriptive of an act which when done by the company in the stated
circumstances exposes a director of the company and a person who took
part in the management of the company when the debt was incurred,
[sic] when the act was done, to a criminal liability. The incurring of
the debt by the company in the stated circumstances is the act which
constitutes the offence created by the subsection and that act is done
at a particular and identifiable point of time, [sic] `when the debt
was incurred.' ... To hold otherwise would be to say that if a company
when in all respects financially sound were to enter into a lease for
a term of years and at some time thereafter and for reasons which
could not be anticipated it were to fall on bad times and be unable to
pay its debts, the directors would thereafter and on every rent day
within the remainder of the term be guilty of an offence for the
reason that on the rent day the company `incurs a debt'. I am unable
to accept that".


3) "Insolvent" at the time of the incurring the debt or becomes
insolvent

The definition of "insolvency" is central to the operation of the insolvent
trading provisions. Liability is not triggered under the insolvent trading
provisions unless the company was insolvent at the time the particular debt
was incurred, or became insolvent by incurring that debt or other debts:
section 588G(1)(b).


Prior to 23 June 1993, no statutory definition of insolvency existed.
However the Corporations Act now contains section 95A which provides
definitions of both solvency and insolvency. Those definitions have been
argued[54] as representing:


"a particularly important reform … in relation to Part 5.7B
because it refines and partly codifies the complex law
surrounding the situation which arises when a company is
insolvent."


Under section 95A(1) a person is deemed solvent, "if and only if, the
person is able to pay all the person's debts as and when they become due
and payable."


Under section 95A(2) a person who is not solvent is insolvent.


It has been held that the definition contained in section 95A suggests that
a cash flow test is intended rather than a simple balance of assets over
liabilities: Leslie v Howship Holdings Pty Ltd (1997) 15 ACLC 459. This
was reinforced by Prior J in Powell v Fryer (2000) 18 ACLC 480 at 482 where
his Honour stated that the primary cash flow test of insolvency was as
follows:


"The commercial solvency of the company is not proved by merely
looking at its accounts and making a mechanical comparison of its
assets and liabilities. Insolvency is a question of fact falling to
be decided as a matter of commercial reality in the light of all the
circumstances with things being viewed as it would by someone
operating in a practical business environment. The statutory focus is
on solvency, not liquidity. Thus it is appropriate to consider the
terms of credit or financial support available to the company with
which to defray any debts owed to creditors. The question is not to
be answered merely by looking at the financial statements."


Similar views were expressed by Palmer J in Hall v Poolman (2008) 65 ACSR
123 and in Lewis v Doran (2004) 50 ACSR 175.


The definition of insolvency contained in section 95A differs from the pre-
existing law which had developed around its predecessors in insolvency
legislation as those predecessor provisions defined insolvency as an
ability to pay the debtor's debts "from his own monies": see, for example,
section 122 of the Bankruptcy Act 1966 (Cth) and section 451 of the
Companies (NSW) Code 1981. However, those sections have had some influence
over what is required to be satisfied to prove solvency. Cases such as
Sandell v Porter (1966) 115 CLR 666 held that a debtor's ability to pay
"from his own monies", as required by section 95 of the Bankruptcy Act 1966
(Cth), included an ability to raise money by its sale, pledge or mortgage
of his assets. However, money obtained by unsecured borrowings was not
treated by the Courts as the debtor's "own money": see Armour; Ex parte
Official Receiver v Commonwealth Trading Bank (1956) 18 ABC 69 at 74; Kyra
Nominees Pty Ltd (in liq) v National Australia Bank Ltd (1986) 4 ACLC 400
at 405; Norfolk Plumbing Supplies Pty Ltd v Commonwealth Bank of Australia
(1992) 6 ACSR 61 at 615.


It appears to be the case that the Courts, prior to the enactment of
section 95A of the Corporations Act were heavily in support of the view
that the requirement that a debtor be able to pay "from his own money" in
order to demonstrate solvency excluded from consideration the debtor's
ability to obtain unsecured loans.


The Exposure Draft Bill of the Corporate Law Reform Bill (Cth) published in
February 1992, in the clause that ultimately became section 95A, defined
insolvency as a debtor's inability to pay his or her debts as they became
due and payable "from his or her own money". In the light of that, Palmer
J noted in Lewis v Doran (2004) 50 ACSR 175 at 193-194, "it is legitimate
to assume that the inclusion of those words was intended to convey that the
case law which had developed around those words in prior insolvency
legislation was to continue to be applicable". However, when the Bill
became law, the words "from his or her own money" were dropped and no
explanation of why those words were omitted from section 95A as enacted is
to be found in the Harmer Report or in the Explanatory Memorandum.

In Southern Cross Interiors Pty Ltd (in liq) v Deputy Commissioner of
Taxation , (2001) 39 ACSR 305; (2001) 53 NSWLR 213 at [54] Palmer J
summarised the law in this area by setting out the following
principles[55]:


"i) whether or not a company is insolvent for the purposes of CA
ss.95A, 459B, 588FC or 588G(1)(b) is a question of fact to be
ascertained from a consideration of the company's financial
position taken as a whole: Sandell v Porter, Pegulan Floor
Coverings Pty Ltd v Carter (1997) 24 ACSR 651 and Powell v
Fryer;


ii) in considering the company's financial position as a whole, the
Court must have regard to commercial realities. Commercial
realities will be relevant in considering what resources are
available to the company to meet its liabilities as they fall
due, whether resources other than cash are realisable by sale or
borrowing upon security, and when such realisations are
achievable: Sandell v. Porter, Taylor v. ANZ, Newark and Sheahan
v. Hertz.


iii) in assessing whether a company's position as a whole reveals
surmountable temporary illiquidity or insurmountable endemic
illiquidity resulting in insolvency, it is proper to have regard
to the commercial reality that, in normal circumstances,
creditors will not always insist on payment strictly in
accordance with their terms of trade but that does not result in
the company thereby having a cash or credit resource which can
be taken into account in determining solvency: Bank of
Australasia v. Hall [1907] HCA 78; (1907) 4 CLR 1514, at 1528;
Norfolk Plumbing at 615; Taylor v ANZ at 784; Guthrie v. Radio
Frequency Systems Pty Ltd (2000) 34 ACSR 572, at 575;


iv) the commercial reality that creditors will normally allow some
latitude in time for payment of their debts does not, in itself,
warrant a conclusion that the debts are not payable at the times
contractually stipulated and have become debts payable only upon
demand: Antico at 331; Hall v Aust-Amec (supra); Melbase (supra)
at 199; Carrier (supra) at 253; Cuthbertson & Richards Sawmills
Pty Ltd v Thomas (supra) at 320; Lee Kong (supra) at 112;


v) in assessing solvency, the Court acts upon the basis that a
contract debt is payable at the time stipulated for payment in
the contract unless there is evidence, proving to the Court's
satisfaction, that:


there has been an express or implied agreement between the
company and the creditor for an extension of the time
stipulated for payment; or


there is a course of conduct between the company and the
creditor sufficient to give rise to an estoppel preventing
the creditor from relying upon the stipulated time for
payment; or


there has been a well established and recognised course of
conduct in the industry in which the company operates, or
as between the company and its creditors as a body, whereby
debts are payable at a time other than that stipulated in
the creditors' terms of trade or are payable only on
demand:


vi) it is for the party asserting that a company's contract debts
are not payable at the times contractually stipulated to make
good that assertion by satisfactory evidence: Powell v Fryer
(supra) at 600; Melbase (supra); Cuthbertson & Richards Sawmills
Pty Ltd v Thomas (supra)."


In Lewis v Doran (2004) 50 ACSR 175 Palmer J reiterated the above views by
stating at 198:


"I think that I must approach the application of s.95A [of the
Corporations Act] with two considerations in mind. First, the words of
s.95A must be construed as they stand, without addition or
subtraction. Second, the law both before and after the enactment of
s.95A is unequivocally and emphatically clear that insolvency is,
first and last, a question of fact "to be ascertained from a
consideration of the company's financial position taken as a whole. In
considering the company's financial position as a whole, the Court
must have regard to commercial realities. Commercial realities will be
relevant in considering what resources are available to the company to
meet its liabilities as they fall due, whether resources other than
cash are realisable by sale or borrowing upon security, and when such
realisations are achievable."


His Honour added at 199:


"In my opinion, the omission of the words "from its own monies" from
the definition of insolvency in s.95A now leaves the Court free to
determine the question of retrospective insolvency free of a
qualification which might well be appropriate to determine only
prospective insolvency. The omission leaves the Court free to
determine insolvency, whether retrospective or prospective, as a
question of commercial reality having regard to the particular facts
of the case."


Later in his judgment Palmer J stated (at 200)[56]:


"I conclude that section 95A of the Corporations Act has changed the
pre-existing law as to the definition of insolvency as stated in cases
such as Sandell v Porter, and that it is no longer necessary in order
to assess solvency to ascertain whether the company is able to pay all
of its debts "from its own monies", in the sense discussed in those
cases. In my opinion, section 95A requires the Court to decide
whether the company is able, as at the alleged date of insolvency, to
pay all of its debts as they become payable by reference to the
commercial realities. If the Court is satisfied that as a matter of
commercial reality the company has a resource available to pay all its
debts as they become payable that it will not matter that the resource
is an unsecured borrowing or a voluntary extension of credit by
another party."


Therefore it is the case that all cash resources available to a company
including credit resources are to be taken into account when assessing
solvency: See Metropolitan Fire Systems Pty Ltd v Miller (1997) 23 ACSR
699. This would include promises of financial support: see Dunn v
Shapowloff [1978] 2 NSWLR 235 and should include unsecured borrowings or
voluntary extensions of credit. It could also be argued that it would
include the anticipated proceeds of a fully underwritten equity raising.


It is to be noted however that the "commercial realities approach" appears
to carry greater weight in New South Wales than it does in other states:
see Emanuel Management Pty Ltd v Foster's Brewing Group Ltd (2003) 178 FLR
1, [2003] QSC 205; Powell v Fryer (2001) 159 FLR 433; 37 ACSR 589; [2001]
SASC 59.


The test of insolvency in section 95A is directed towards paying all its
debts as and when they become due and payable. The inquiry under section
95A, and consequently the inquiry under section 588G(1)(b), concerns the
company's ability to discharge all its debts rather than merely particular
debts, on their respective dates of payment, at the time when a particular
debt is incurred. It is therefore the case that liability can be
established under section 588G(1)(b) without reference to the particular
debt incurred if, at the time the particular debt was incurred, the company
was unable to pay other debts.


In Fliway transport Pty Ltd v Soper (1988) 21 NSWLR 19; 14 ACLR 690; 7 ACLC
129, it was held that for a debt to fall due it must at least be
recoverable by legal action and, it would appear, that mere inaction by a
creditor in enforcing its rights against a debtor is not usually influence
whether or not the debt has become due: Pioneer Concrete Ltd v Ellston
(1985) 10 ACLR 289 at 301. However, if the creditor has allowed, or
created a reasonable expectation for a period of grace for repayment, this
may impact upon the determination of whether the debt has become due: Re
Newark Pty Ltd (in liq) [1993] 1 Qd R 409 and therefore impact upon the
debtor company's insolvency. Thus it may be permissible to take into
account a course of dealing between the parties: see also Manpac Industries
Pty Ltd v Ceccattini (2002) 20 ACLC 1304; See also Southern Cross interiors
Pty Ltd (in liq) v Deputy Commissioner of Taxation , (2001) 39 ACSR 305;
(2001) 53 NSWLR 213.


Further, the inclusion of the words "as they become due" also indicates
that insolvency must be determined with reference to a consideration of the
company's position over a period of time and not a particular instance: Re
Universal Management Ltd (in liq) (1981) NZCLC 95-026. A temporary lack of
liquidity does not always mean that the company is insolvent: see Hymix
Concrete v Garrity (1977) 13 ALR 321. The Courts have recognized that the
ability of the company to procure funding from other sources to meet its
liabilities can be taken into account to determine that the company is in
fact solvent. However the authorities suggest that directors will need to
prove that there was a legitimate basis for the belief that funds would
become available.

In ASIC v Plymin (No 1) (2003) 46 ACSR at 386 a number of common indicators
of insolvency were identified including the following:


a) Continuing losses;


b) Liquidity ratios below 1;


c) Overdue Commonwealth and State taxes;


d) Poor relationship with primary bank, including inability to
borrow further funds;


e) No access to alternative finance;


f) Inability to raise further equity capital;


g) Suppliers placing the company on cash- on-demand terms, or
otherwise demanding special payments before resuming supply;


h) Creditors unpaid outside trading terms;


i) Issuing of post-dated cheques;


j) Dishonoured cheques;


k) Special arrangements with selected creditors;


l) Solicitor's letters, summonses, judgments or warrants issued
against the company;


m) Payments to creditors of rounded sums which are not
reconcilable to specific invoices;


n) Inability to produce timely and accurate financial information
to display the company's trading performance and financial
position, and make reliable forecasts.



a) Rebuttable presumptions of insolvency


A major difficulty in finding directors liable under the insolvent trading
provisions has been proof of insolvency on the day that the particular debt
was incurred. It is sometimes the case that the financial records of the
company are inadequate or they enable proof of insolvency on dates other
than the one required. According to the Australian Law Reform Commission in
its General Insolvency Inquiry[57], in many situations,

"the liquidator is a stranger to the past business operations of the
company, and is often confronted with considerable difficulty in
affirmatively establishing that a company was insolvent at a time
prior to the winding up, even though there may be every indication
that this was the case."


In order to overcome the problem and to assist in determining whether or
not a company was insolvent at the time a debt is incurred or becomes
insolvent by incurring that debt or by incurring at that time debts
including that debt, section 588E(3) and 588E(4) of the Corporations Act
contain two rebuttable presumptions of insolvency in civil recovery
proceedings and, if applicable, reverse the onus of proof. Thus section 95A
will only be relied on where the statutory presumptions of insolvency are
unable to be relied upon or are able to be rebutted.


Section 588E relevantly provides:


Presumptions to be made in recovery proceedings
(1) In this section:
"recovery proceeding" , in relation to a company means:
…
a) proceedings for a contravention of subsection 588G(2) in
relation to the incurring of a debt by the company
including proceedings under section 588M in relation to the
incurring of the debt but not including proceedings for an
offence); or
(2) …
(3) If:
(a) the company is being wound up; and
(b) it is proved, or because of subsection (4) or (8) it must
be presumed, that the company was insolvent at a particular
time during the 12 months ending on the relation-back day
(bold added);
it must be presumed that the company was insolvent throughout
the period beginning at that time and ending on that day.
(4) Subject to subsections (5) to (7), if it is proved that the
company:
(a) has failed to keep financial records in relation to a
period as required by subsection 286(1); or
(b) has failed to retain financial records in relation to a
period for the 7 years required by subsection 286(2);
The company is to be presumed to have been insolvent throughout
the period.
(5) …
(6) …
(7) …
(8) …
(9) A presumption for which this section provides operates except
so far as the contrary is proved that the purposes of the
preceding concerned.
Section 9 of the Corporations Act defines "relation-back day", (referred to
above in section 588(3)(b)) in relation to a winding up of a company or
Part 5.7 body, as meaning:
a) if, because of Division 1A of Part 5.6, the winding up is taken to
have begun on the day when an order that the company or body be wound
up was made - the day on which the application for the order was
filed; or
b) otherwise - the day on which the winding up is taken because of
Division 1A of Part 5.6 to have begun.
Division 1A of Part 5.6 of the Corporations Act sets out when a winding up
is taken to begin. Section 513A within that Division deals with a winding
up ordered by the Court under sections 233, 459A, 459B or 461. Section
513B within that Division however deals with a voluntary winding up and
relevantly provides that where a company resolves by special resolution
that it be wound up voluntarily, the winding up is taken to have begun or
commenced:


"if, immediately before the resolution was passed, the company was
under administration – on the section 513C day in relation to the
administration." (underlining added) (section 513B(b))


The "section 513C day" in relation to an administration of a company is the
day on which the administration begins (see section 513C(b)). Therefore,
under the presumption in section 588E(3), where it is proved that a company
which is being wound up was insolvent at a particular time during the 12
months prior to the relation-back day, it is presumed that the company was
insolvent from that time until the relation-back day.


b) Reasonable grounds to suspect insolvency

Section 588G(1)(c) provides that a director of an insolvent company is
exposed to liability for insolvent trading if, at the time the debts are
incurred:


"… there are reasonable grounds for suspecting that the company is
insolvent or would so become insolvent ."


The test described by section 588G(1)(c) is an objective one (Powell v
Fryer (2001) 37 ACSR 589, at [76]-[77]) per Olsson J (with whom Duggan and
Williams JJ agreed):


"… the state of knowledge of a particular director and any assessment
which he may have made as to the ability of the company to pay its
debts is irrelevant. The court must make its own judgment on the basis
of facts as they existed at the relevant time and without the benefit
of hindsight.

By reason of section 588G(2)(b) it is sufficient that a reasonable
person in a like position in a company in the company's circumstances
would be so aware. Regard is to be had to the facts and circumstances
that the director ought to have known, as well as to the facts and
circumstances that were actually known to him: Credit Corp Australia
Pty Ltd v Atkins (1999) 30 ACSR 727 at 769."

See also Hall v Poolman (2008) 65 ACSR 123 and Metropolitan Fire Systems
Pty Ltd v Miller (1997) 23 ACSR 699; [1997] FCA 399.


According to Kitto J in Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266;
40 ALJR 13 at 303:


"A suspicion that something exists is more than a mere idle wondering
whether it exists or not; it is a positive feeling of actual
apprehension or mistrust, amounting to `a slight opinion, but without
sufficient evidence' ... Consequently, a reason to suspect that a fact
exists is more than a reason to consider or look into the possibility
of its existence."


Kitto J's comments were endorsed by Palmer J in Hall v Poolman (2008) 65
ACSR 123 at [234], where his Honour held that a suspicion of insolvency
falls somewhere between a belief that insolvency exists, on the one hand,
and a mere wondering whether it exists, on the other. Suspicion is a
positive feeling of apprehension, an admittedly tentative belief, without
sufficient evidence to form a concluded and supportable opinion.


Aligned with demonstrating whether there are reasonable grounds for
suspecting that the company is insolvent or would so become insolvent,
section 588G(2) provides for two distinct ways in which a director can be
found to have had the requisite suspicion:

Actual awareness, that is if the person is aware at that time that
there are such grounds for so suspecting; (section 588G(2)(a)) or

Where a reasonable person in that position would have been so aware
(section 588G (2)(b)).

The test set out in section 588G(2)(a) is a subjective test. The test set
out in section 588G(2)(b) is an objective test[58].

Thus, if it cannot be established that the director had actual awareness of
reasonable grounds for suspecting insolvency, a director can still be
liable if a reasonable person in their position would have been aware.
Whether a reasonable person in the director's position would have been
aware is assessed by the objective standard of a director of ordinary
competence. According to Einfeld J in Metropolitan Fire Systems Pty Ltd v
Miller (1997) 23 ACSR 699 at 703:

"[the test is] one of objectively reasonable grounds which must be
judged by the standard appropriate to a director of ordinary
competence… Questions of knowledge of and participation in the
incurring of the relevant debt are now relegated to the status of
factual matters which may arise should the directors seek to establish
one of the statutory defences afforded by the legislation. The
establishment of liability is therefore not contingent on elements
personal to the respondents."


In Australian Securities and Investments Commission v Plymin (No 1) (2003)
175 FLR 124; 21 ACLC 700; 46 ACSR 126 Mandie J held at [426]:


"What s 588G(2)(a) requires is proof of a subjective awareness by the
director of grounds, whether or not the director had a "subjective
suspicion" of insolvency, which grounds may be objectively be
characterised as "reasonable grounds" for suspecting such insolvency."


In the same case, his Honour held at [325] that:

"It would seem to follow ... the essence of a failure by a director to
prevent a company from incurring a debt is a failure by that director
to take all reasonable steps within his power to prevent the company
from incurring such debt. The effect of the provisions, shortly
stated, is that if the requirements of s 558G(1) are proved in
circumstances where either subsection (a) or subsection (b) of s
588G(2) is also proved, a director will be taken to have failed to
prevent the company from incurring the debt, unless it is proved that
the director- took all reasonable steps to prevent the company from
incurring the debt."


In Elliott v Australian Securities and Investments Commission (2004) 10 VR
369; 22 ACLC 458; 48 ACSR 621; [the Victorian Court of Appeal considered at
length the requirements of section 588G(2)] and held at [116]:


"It is in our view clear that the effect of s 588G(2) is that a
director contravenes the section "by not preventing" or "by failing to
prevent" a company from incurring a debt, and that a director will be
taken to have so failed if debts are incurred by a company at a time
when there are reasonable grounds for suspecting that the company is
insolvent."


At [117] the Court in Elliot said that section 588G(2) does not require
proof that an individual director failed in his or her duty to take a step
which would have been effective to prevent the company incurring the debt.

The inclusion of the term "in a like position in a company in the company's
circumstances" allows the court to have regard to a wide range of factors
including, the size of the company; the type of business conducted by the
company; the composition of the board; whether the director was an
executive or non-executive director; the delegation of functions and
responsibilities between directors; the distribution of work between board
members and management and professional qualifications and special
expertise held by the director: see Commonwealth Bank of Australia v
Friedrich (1991) 5 ACSR 115.


The time that awareness of the director is assessed is immediately before
the particular debt was incurred: Metropolitan Fire Systems Pty Ltd v
Miller (1997) 23 ACSR 699: 3M Australia Pty Ltd v Kemish (1986) 10 ACLR
371; 4 ACLC 185.

As noted above, the issue of whether or not there existed reasonable
grounds to expect that the company can pay all its debts is determined
objectively. Continuing in business at the risk of creditors or taking no
steps to save the company from insolvency[59], when the person knows that
there is no objectively reasonable expectation of the company being able to
meet its obligations, could bring about personal liability. This will be
despite the fact that the director or person involved in management is
working long hours so as to rehabilitate the company and that the reasons
for the collapse of the company's business were substantially beyond their
control[60].

In Commonwealth Bank of Australia v Friedrich (1991) 9 ACLC 946, Eise was
the honorary and part-time chairman of the National Safety Council of
Australia Victorian Division (NSC), a non-profit company limited by
guarantee. Friedrich was the chief executive officer of the NSC. The
State Bank of Victoria lent money to the NSC at a time when its liabilities
exceeded assets. However the NSC's accounts showed an excess of assets
over liabilities. This was due to the fraudulent activities of Friedrich.
The annual accounts for two successive financial years were the subject of
qualified auditor's reports, which Eise had not seen and the directors'
reports had been signed by Eise on the day of the annual general meeting
and were purportedly approved by the board. In fact the board had not
considered the matter. Subsequently the State Bank lent large sums of
money to the NSC and through its legal successor, the Commonwealth Bank,
lodged a claim against each member of the NSC board under sec 556(1)
Companies Code 1981. All of the directors except Eise settled.

One of the three issues[61] in contention was whether immediately before
the time when each of the debts were incurred there were reasonable grounds
to expect that the company would not be able to pay all its debts as and
when they became due?

According to the Victorian Supreme Court, the existence of "reasonable
grounds" for the purposes of sec 556(2) [sec 592(2) Corporations Law] is to
be determined by a wholly objective test. Tadgell J stated[62], that "the
sub-section does not require proof that anyone would not have reasonable
grounds to expect and it does not refer to the defendant's state of
knowledge." The Judge added that[63]:

"[T]he plaintiff must prove facts which, immediately before the time
when the company incurred the relevant debt, gave a person seeking
properly to perform the duties of a non-executive director of that
company reasonable grounds to say: `I expect that the company will not
be able to pay all its debts as and when they become due'."

The situations where a defendant would have no reasonable or probable
ground of expectation of the company being able to pay the debt can be
summarised as follows:

1. Where an officer has not adverted to the matter and there exists an
objective belief that there is no reasonable or probable ground of
expectation.

2. Where the officer has a subjective expectation but there is no
objective ground for this expectation.

3. Where the officer has a subjective expectation that the company
cannot pay but there exists an objective expectation of being able to
pay.

4. Where the officer does not care whether the debt will be paid and
objectively there was no ground of expectation.


Statutory defences available to directors

Under predecessor legislation to section 588H, there were only two defences
which were available to directors or managers to enable them to escape
liability for insolvent trading. Those defences were: first, the debt was
incurred without their authority or consent; or second, at the time when
the debt was incurred, they did not have reasonable cause to expect that
the company would not be able to pay its debts. The required standard of
proof of the defences provided by the predecessor section was on the
balance of probabilities.

In Metal Manufactures Ltd v Lewis (1988) 6 ACLC 725, Mr and Mrs Lewis were
the only directors of Primary Metals and Resources Pty Ltd (the company).
In September 1993 the company had agreed to buy goods from the plaintiff
and later it breached this contract resulting in an award of damages being
made against it. However in September 1984, Primary Metals and Resources
Pty Ltd was ordered to be wound up. The plaintiff thereupon sued Mr and
Mrs Lewis under the then insolvent trading provisions contained in section
556 of the Companies (NSW) Code.

Mr and Mrs Lewis were the only directors of the company. Mr Lewis was its
managing director and it was he who entered into the contract on behalf of
the company with the plaintiff in his capacity as managing director. The
court noted that it was not clear how or when Mr Lewis became managing
director. At the time the contract was made the company could not pay its
debts, but at no stage was Mrs Lewis involved in the day to day running of
the business and was in fact only regarded as a "director for signing
purposes only". Mrs Lewis had no knowledge of the particular debt to the
plaintiff and whenever she made inquiries with Mr Lewis about possible
difficulties of the company she was told not to concern herself. In
particular Mrs Lewis did not know or even address the issue of whether the
company could pay its debts.

Mr Lewis did not contest liability under section 556 of the Companies (NSW)
Code and consented to the judgment, however Mrs Lewis raised the defence in
sec 556(2)(a) and was successful before the trial judge. The plaintiff
appealed. The Court of Appeal in a two to one majority dismissed the
plaintiff's appeal. Kirby P was in dissent.

The question arose as to the liability of silent directors for contracts
entered into by a managing director of their company. The trial judge,
Hodgson J[64], held that the defence in sec 556(2)(a) would be satisfied if
a defendant proved first, that they did not participate in the incurring of
the debt and secondly that none of the actual participants in incurring the
debt had the defendant's express or implied authority or consent to incur
the debt. On the issue of "inaction" by a defendant, the Judge said, if a
defendant's inaction implies authority or consent, then the defence is not
available, however this was not the case here.

In the New South Wales Court of Appeal, McHugh JA described the giving of
consent by a director as equivalent to the signifying of `approval or
assent' to the incurring of debt whether that is done expressly or by
implication. Furthermore his Honour described the concept of "authority"
as involving both the knowledge or reason to suspect that a debt would be
incurred and the power to prevent it from being incurred. Integral to this
view was that "authority", had to relate to the specific debt incurred and
not merely be an authority to incur debts generally. Knowledge or reason
to suspect that a particular debt would be incurred had to be disproved on
this view. Here it was said that Mrs Lewis could not have assented and
furthermore she had no power to prevent the debt from being incurred.

Mahoney JA held that the word "without" in sec 556(2)(a) did not mean that
Mrs Lewis had to forbid the making of the contract. What the word meant,
his Honour said[65], was simply "the absence of the relevant authority or
consent." Importantly the judge rejected the view that liability could
attach to a person simply because they let someone else act as managing
director and therefore anything which the managing director did was done
with that other person's authority or consent. In these circumstances Mrs
Lewis did not consent or give her authority to the incurring of the debt.

In contrast to Metal Manufactures Ltd, is the Victorian Supreme Court
decision in Statewide Tobacco Services Ltd v Morley (1990) 8 ACLC 827
(Supreme Court) and (1992) 10 ACLC 1233. In this latter case the critical
question again was whether a silent director who left the conduct of the
business entirely to another director could make out the defence under the
then section 556(2)(a) of the Companies Code. The defendant also raised
the defence under sec 556(2)(b) of the Companies Code.

The facts of Morley's case were as follows. KM Trading Pty Ltd was a small
family company which ran tobacco kiosks in Melbourne. For the first twenty
years of the company's existence it was controlled by Keith Morley, the
company's governing director who was appointed pursuant to the articles.
However in 1978 Ian Morley, who was Keith Morley's son, took over
management of the business temporarily at the request of Mrs Morley, Ian
Morley's mother. Keith Morley died in 1979 and soon afterwards there was
an informal meeting between Mrs Morley, Ian Morley and his sister Jan
Sloan. These three were now the only shareholders and directors of the
company with Mrs Morley holding the majority of shares. At the request of
Mrs Morley and her daughter, Ian Morley was asked to take control of the
management of the company. Ian Morley agreed to this. Neither Mrs Morley
or her daughter involved themselves in the day to day running of the
business and Ian Morley did not keep them informed or provide them with
annual reports. Ian Morley continued to run the business until the company
was placed in liquidation in 1988.

Mrs Morley signed some returns, including the annual return and she made a
directors' statement. At some stage whilst her son was in control Mrs
Morley also signed a guarantee to the bank so as to secure overdraft
facilities for the company. No directors' meetings were held and no formal
dividends were paid although for a period of time Mrs Morley did receive
$300 per week described as her living expenses. Mrs Morley knew that the
company sold tobacco and like products to customers and that suppliers of
these products sometimes extended time for the company to pay. She saw no
invoices, statements or books of account and she did not ask to be provided
with relevant financial information. As a result she was unaware of the
company's inability to pay its debts.

A supplier of tobacco products supplied goods to the company at a time when
the company was insolvent and this supplier was owed in excess of $165,000.
This amount was still outstanding when the company went into liquidation.
The supplier instituted proceedings against Mrs Morley for the recovery of
this amount under section 556 of the Companies Code. Mrs Morley sought to
avoid liability by reliance upon each of the statutory defences in section
556(2). Success in either would enable her to escape responsibility for
the debt. The trial judge found that neither defence was made out.
Ormiston J stated[66]:

"The conclusions I have reached may be summarised as follows. Where:

1) a director, such as the defendant, takes no effective part in
the management of a company which continues to trade while
insolvent and, in particular, that director does not seek to
obtain regular trading accounts of the company; and

2) that director has participated in the conferring of general
authority upon an executive director, employee or agent incurs
debts to a creditor on behalf of the company in the course of
the insolvency;

then the director will have committed an offence and may be liable to
that creditor for those debts of the company pursuant to s.556(1) of
the Code and is not entitled to rely on any of the defences under
s.556(2)."

"In the context of this section, which requires proof of want of
`authority', the authority in question is that which is conferred by
the act of one or more directors, whether participating in the grant
of the company's authority as a member of the board of directors or in
his role as managing or executive director. If a director did not so
participate in the conferring of authority, whether express or
implied, only then can it be said that the particular debt was
incurred `without his express or implied authority'. To conclude
otherwise would ignore the realities of the day-to-day management of
companies."

The judge noted that Ian Morley had not been appointed managing director
pursuant to the articles, that Mrs Morley had power to determine her son's
employment and knew that in the ordinary course of his duties her son was
incurring debts of the very nature which were now under consideration. Ian
Morley, it was held, had no more power than any other member "of the board
who had the functions of management delegated to him by his fellow
directors. He held no formal office under the articles and was dependent
upon the continuation of the authority informally given by the other two
directors. They were therefore jointly responsible and thus acted for this
purpose as joint `principals'. If either of these directors, including Mrs
Morley, changed their minds and acted accordingly to withdraw his
authority, his authority would thereupon cease." In these circumstances
she gave authority to her son to incur the debts[67].

The Appeal division of the Supreme Court of Victoria agreed with this
finding[68]. Mrs Morley gave her implied consent and therefore could not
avail herself of the defence in sec 556(2)(a).

A similar decision occurred in Group Four Industries Pty Ltd v Brosnan
(1992) 10 ACLC 1437. In this case Mr and Mrs Brosnan, were the only
shareholders and directors of a company called Madras Pty Ltd (Madras)
which acted as the trustee for the Brosnan Family Trust. The trust was a
trading trust and its business was the sale and distribution of
airconditioners. The plaintiff supplied airconditioning equipment between
November 1985 and March 1986 to Madras and at the end of that period a
balance of approximately $72,000 was owing to the plaintiff. Madras was
wound up in April 1987. The plaintiff claimed that the defendants were
jointly and severally liable for the amount by virtue of section 556 of the
Companies (SA) Code.

At the time of these purchases from the plaintiff, Madras was insolvent.
The trial judge[69] found that Mr Brosnan was liable for payment of the
debt but dismissed the case against Mrs Brosnan. The plaintiff appealed
against this and the Full Court of the South Australian Supreme Court
allowed the appeal.

Mr Brosnan ran the company although there was no formal appointment of him
as managing director. He appeared to just take de facto control. Mrs
Brosnan was sometimes involved in taking delivery of goods, she signed some
cheques and did occasional banking. Every year she signed the company's
annual return. Although Mrs Brosnan knew that the company was having
financial difficulties at the time it incurred the debt to the plaintiff,
she claimed that she did not know that it was insolvent at that time.

The Full Court approved of Morley's case and held that she could avail
herself of the defence in section 556(2)(a) as she had consented to her
husband incurring the debt. According to Olsson J, Mrs Brosnan had to show
that she bore no relevant responsibility for the authority given to incur
the debt and this could only be shown if the director did not participate
as a member of the board or as managing or executive director, in the
conferring of authority upon the person who incurred the debt. Debelle J
noted that she took no step to attempt to prevent the incurring of the debt
and by acquiescing, she gave implied authority or consent.

As a result of the decisions in Lewis, Morley and Brosnan it is apparent
that the position in New South Wales is in conflict with the Victorian and
South Australian position.

The second defence which was previously available to directors appeared in
section 592(2)(b). Pursuant to that section it must be proven that the
defendant did not have a reasonable expectation that the company would not
be able to pay its debts. The want of reasonable expectation needed to
have been shown.

In Metal Manufactures Ltd v Lewis (1986) 4 ACLC 739[70], the interpretation
of section 556(2)(b) was argued in detail before the trial judge although
not on appeal. In this case, Hodgson J held that the defence under sec
556(2)(a) had been established but not that under sec 556(2)(b). With
regard to sec 556(2)(b), Hodgson J considered that, in determining whether
a defendant has made out a reasonable cause within the meaning of the
subsection, it was relevant to consider facts and circumstances known to
the defendant and also facts and circumstances which, by reason of the
defendant's duties, ought to have been known to the defendant. His Honour
pointed out that in determining a defendant's state of knowledge[71]:

"... [O]ne can have regard to matters such as illness and absence of
a person in order to decide whether or not he has reasonable cause to
expect something, but I do not think one can have regard to a person's
complete ignorance of his duties as a director of a company and his
complete neglect of such duties."

Ormiston J in Statewide Tobacco Services Ltd v Morley (1990) 9 ACLC 827
took a similar approach. The question of a director's reasonable cause of
expectation was, according to the Court, related to the extent of the
inquiries that the director has made and should have made about the
company's solvency. Ormiston J made it clear that director's should not be
able to hide behind ignorance of the company's affairs which are of their
own making, or, which has been contributed to by their failure to make
further necessary inquiries. The judge went on to state that although
directors are not required to have omniscience, each director is expected
to take a diligent and intelligent interest in the information either
available to them or which they might with fairness demand from the
executives or other employees and agents of the company. The Full Court
agreed with this interpretation.

In Group Four Industries Pty Ltd v Brosnan (1992) 10 ACLC 1437, Mrs Brosnan
could not rely on the sec 592(2)(b) defence and emphasis was placed upon
what a director ought to know and the facts which were known to Mrs Brosnan
would have led any reasonable, intelligent person of average competence to
suspect that all was not well with the company and to seek information.
According to Olsson J "she was not entitled merely to sit back in self-
imposed ignorance and then to seek relief based on that ignorance."

The above decisions still have relevance for the defences now contained in
section 588H of the Corporations Act. This Act provides four defences to
allegations of insolvent trading which, if established, would excuse a
director from the consequences of insolvent trading. The defences are
contained in section 588H(2), section 588H(3), section 588H(4) and section
588H(5) and are as follows:


First, it is a defence if it is proved that, at the time when the debt was
incurred, the person had reasonable grounds to expect, and did expect, that
the company was solvent at that time and would remain solvent even if it
incurred that debt and any other debts that it incurred at that time
(section 588H(2)).


Second, section 588H(3) provides that it is a defence if it is proved that,
at the time when the debt was incurred, the person:


A. had reasonable grounds to believe, and did believe:


i) that a competent and reliable person (the other person) was
responsible for providing to the first mentioned person
adequate information about whether the company was solvent;
and


ii) that the other person was fulfilling that responsibility; and


B. expected, on the basis of information provided to the first
mentioned person by the other person, that the company was
solvent at that time and would remain solvent even if it
incurred that debt and any other debts that it incurred at that
time.


Third, if the person was a director of the company at the time when the
debt was incurred, it is a defence it is proved that, because of illness or
for some other good reason, he or she did not take part at that time in the
management of the company (s 588G(4)).


Fourth, it is a defence if it is proved that the person took all reasonable
steps to prevent the company from incurring the debt (s 588G(5)).


Further, section 1317S enables the court to relieve a person wholly or
partly from a liability to which the person would otherwise be subject
where they have acted honestly and having regard to all the circumstances
of the case, the person ought fairly to be excused from the contravention.


Section 1318 is a similar provision to section 1317S and it enables the
court to relieve a person wholly or partly from liability where, in civil
proceedings for negligence, default, breach of trust or breach of duty, it
appears to the court that the person has acted honestly and having regard
to all the circumstances of the case the person ought fairly be excused for
that negligence, default or breach.

Looking at two of these defences the following can be said:

Section 588H(2)


It is a defence if it is proved that, at the time when the debt was
incurred, the person had reasonable grounds to expect, and did expect, that
the company was solvent at that time and would remain solvent even giving
incurred that debt and any other debts that it incurred at that time.


There are therefore two essential elements to establishing that defence:


a) The requirement that there be reasonable grounds to expect the
company will remain solvent; and,


b) That the director did, in fact, have that expectation.


In determining whether a director had reasonable grounds to expect the
company was solvent, an objective standard is applied to the facts known to
the defendant.


The word "expectation" is taken to mean a higher degree of certainty than a
mere hope possibility or suspicion: 3M Australia Pty Ltd v Kemish (1986) 10
ACLR 371; 4 ACLC 185. According to Austin J in Tourprint International Pty
Ltd (in liq) v Bott (1999) 32 ACSR 201, at [67] an "expectation" of
solvency, as required by the section, means:




"… a higher degree of certainty than 'mere hope or possibility' or
'suspecting'. The defence requires an actual expectation that
the company was and would continue to be solvent, and that the
grounds for so expecting are reasonable. A director cannot rely
on a complete ignorance of or neglect of duty and cannot hide
behind ignorance of the company's affairs which is of their own
making or, if not entirely of their own making, has been
contributed to by their own failure to make further necessary
inquiries."


Einfeld J made a similar point in Metropolitan Fire Systems Ply Ltd v
Miller (1997) 23 ACSR 699 at 703. In that case his Honour held (at 703)
found that the phrase requires that the directors have reasonable grounds
for being confident that the company is solvent.


Therefore the defence requires the director to establish not only an
expectation that the company was and would continue to be solvent, but that
the grounds that that expectation were reasonable. In practical terms this
means that the expectation of solvency must outweigh any factors which
would give rise to a suspicion of insolvency.


In order for the defence to succeed, there must be an expectation, held on
reasonable grounds, that recourse to assets will enable debts to be paid,
not at some indefinite time in the future, but so as to keep the companies
solvent according to the definition in section 95A, namely, as the debts
fall due for payment. According to Palmer J in Poolman v Hall, it is not
appropriate to base an expectation of solvency:

"… upon the prospect that [the company] might trade profitably
in the future thereby restoring its financial position. … The
question is whether the company at the relevant time is able to
pay its debts as they become due not whether it might be able to
do so in the future if given time to trade profitably …":
Sheahan v Hertz Australia Pty Ltd (1995) 16 ACSR 765, at 769;
Powell v Fryer (supra) at [75]."

Palmer J also stated the following in Poolman:


"The law recognises that there is sometimes no clear dividing
line between solvency and insolvency from the perspective of the
directors of a trading company which is in difficulties. There
is a difference between temporary illiquidity and "an endemic
shortage of working capital whereby liquidity can only restored
by a successful outcome of business ventures in which the
existing working capital has been deployed": Hymix Concrete Pty
Ltd v Garritty (1977) 2 ACLR 559, at 566; Re Newark Pty Ltd (in
liq); Taylor v Carroll (1991) 6 ACSR 255. The first is an
embarrassment, the second is a disaster. It is easy enough to
tell the difference in hindsight, when the company has either
weathered the storm or foundered with all hands; sometimes it is
not so easy when the company is still contending with the waves.
Lack of liquidity is not conclusive of insolvency, neither is
availability of assets conclusive of solvency: Expo
International Pty Ltd (in liq) v Chant [1979] 2 NSWLR 820, at
837.

Where a company has assets which, if realised, will pay
outstanding debts and will enable debts incurred during the
period of realisation to be paid as they fall due, the critical
question for solvency is: how soon will the proceeds of
realisation be available: see the authorities cited at para 187
above. Bearing in mind the commercial reality that creditors
will usually prefer to wait a reasonable time to have their
debts paid in full rather than insist on putting the company
into insolvency if it fails to pay strictly on time, I think it
can be said, as a very broad general rule, that a director would
be justified in "expecting solvency" if an asset could be
realised to pay accrued and future creditors in full within
about ninety days.

The position becomes murkier the less certain are the outcomes.
The market value of the asset may not be ascertainable until the
market is tested, so that it is not certain that the realisation
will pay in full both existing debts and those to be accrued
during the realisation period. The time at which the proceeds of
realisation become available may depend upon the state of the
market and the complexity of the transaction.

There comes a point where the reasonable director must inform
himself or herself as fully as possible of all relevant facts
and then ask himself or herself and the other directors: "How
sure are we that this asset can be turned into cash to pay all
our debts, present and to be incurred, within three months? Is
that outcome certain, probable, more likely than not, possible,
possible with a bit of luck, possible with a lot of luck,
remote, or is there is no real way of knowing?

If the honest and reasonable answer is "certain" or "probable",
the director can have a reasonable expectation of solvency.

If the honest and reasonable answer is anywhere from "possible"
to "no way of knowing", the director can have no reasonable
expectation of solvency.

If the honest and reasonable answer is "more likely than not",
the director runs the risk that a Court will hold to the
contrary in an insolvent trading claim.

If the honest and reasonable answer is "no way of knowing yet,
we need more information", the director must then ask: "How long
before we have the information so that we can give a final
answer?"

If the honest and reasonable answer to that question is: "By a
definite date which will not extend the realisation period (if
there is to be one) beyond three months", the director may
reasonably say: "Let's wait until then before deciding".

If the honest and reasonable answer is "there is no way of
knowing yet when we will have the information to make a
decision", the director must say: "Then there is no way that we
can now have a reasonable expectation of solvency and there is
no way we can reasonably justify continuing to trade without
knowing when we will know whether the company is insolvent. Call
the administrators". By this series of questions and answers I
do not mean to lay down some pro forma test of directors'
liability for insolvent trading. Each case depends on its
particular facts. These questions and answers merely serve to
illustrate that when a company is struggling to pay its debts,
the directors must face up to the issue of insolvent trading
directly and with brutal honesty: they must not shirk from
asking themselves the hard questions and from acting resolutely
in accordance with the honest answers to those questions."

Section 588H(3)

The defence in section 588H(3) allows a director to escape liability under
the insolvent trading provisions if he or she expected that the company was
solvent at the time the debt was incurred as a result of relying on
information provided by a competent and reliable person who was responsible
for providing information pertaining to the solvency of the company.
According to the Australian Law Reform Commission[72], the defence is
intended to encourage directors to ensure that proper and adequate
financial management systems are in place and thus promote legal
compliance.


This defence has two limbs, each of which must be satisfied. Section
588H(3)(a) requires a director to establish his or her belief in the
existence of a proper and adequate system for managing and monitoring the
financial status and solvency of the company. It also requires a belief
that the delegate responsible for those matters was continuing to fulfil
that responsibility. These beliefs must be based on reasonable grounds.
The focus of this limb is not on ascertaining whether the delegate is in
fact competent and reliable, but that the director actually believed on
reasonable grounds that this was the case.


Section 588H(3((b) requires the director to establish their expectation of
continuing solvency on the basis of information provided by the delegate.


If it is accepted that any of the defences in section 588H have been made
out, than the applicant's claim in so far as it is based on insolvent
trading will fail.




Section 1317S and 1318


Thus if the Court rejects the application of both of the pleaded defences
contained in section 588H, then directors may need to rely on section 1317S
and 1318 to avoid liability.


Section 1317S provides a basis for relief from liability under a civil
penalty provision where the person has acted honestly and the person ought
fairly to be excused in the circumstances of the case.


Section 1318 allows the court to relieve certain persons from liability in
civil proceedings for negligence, default, breach of duty or breach of
trust, if the person establishes that he or she acted honestly, and that he
or she ought fairly to be excused for the negligence, default, breach of
duty or trust having regard to all the circumstances of the case. And
application pursuant to section 1318 was rejected in Kenna and Brown Pty
Ltd (in liq) v Kenna (1999) 32 ACSR 430.


An order under either section is discretionary.


CONSEQUENCES FOR INSOLVENT TRADING WHERE THE STATUTORY DEFENCES DO NOT
APPLY

Criminal penalty

A breach of the duty to prevent insolvent trading will constitute a
criminal offence only if the director has permitted insolvent trading
knowingly and with a dishonest intention (section 1317FA).

Civil penalty order

As section 588G is expressed to be a civil penalty provision under section
1317DA, an application for a civil penalty order may be made to the Federal
Court or Supreme Court (sec 1317EA) by any one of the following entities
(sec 1317EB):

(a) ASIC;
(b) a Commission's delegate; or
(c) some other person authorised in writing by the Minister.

If the Court finds on the balance of probabilities (section 1317ED (1))
that a person has contravened section 588G, the Court must declare that the
person has contravened the provision (section 1317EA (2)) and, in addition,
it has a discretion to make an order prohibiting the person from managing a
corporation for a specified time and or requiring the person to pay the
Commonwealth a pecuniary penalty not exceeding $200,000 (sec 1317EA (3)(a)
and (b)). Where an order is made that a person is not to manage a
corporation this order must be complied with (section 1317EF) and any
penalty is payable to ASIC and is enforceable by ASIC or the Commonwealth
as if it were a judgment of the Court (section 1317EG).

An application for a civil penalty order cannot be made more than six years
after the contravention (sec 1317EC).

Compensation

When ordered by the Court when a civil penalty has been applied for:

Whether or not a Court makes a civil penalty order, the court can order a
person against whom a civil penalty order is sought to pay compensation to
the company (section 588J (1)). The Court can do that when satisfied on
the balance of probabilities (section 1317ED) that:

(1) the person committed a contravention of section 588G in relation to
the incurring of a debt by a company; and

(2) the debt is wholly or partly unsecured: and

(3) the person to whom the debt is owed has suffered loss or damage in
relation to the debt because of the company's insolvency.

Compensation is set at equal to the amount of loss or damage suffered by
the person and is payable to the company rather than the person who
suffered the loss or damage which gave rise to the liability.

An application for a civil penalty order would normally be made by ASIC
(section 1317EB (l)), however the liquidator has an entitlement to be heard
only if the court is satisfied that the person committed a contravention of
section 588G and only on the question whether the Court should order
compensation to the company (section 588J (3)).

It must be emphasised that compensation is payable to the company not to
the person who has suffered the loss or damage.


When ordered by a court of criminal jurisdiction:

If a Court finds a person guilty[73] of an offence by contravening section
588G of the Corporations Act in the circumstances set out in section 1317FA
(1) that is, knowingly, intentionally or recklessly and either:

dishonestly and intending to gain an advantage; or

intending to deceive or defraud someone,

the Court may order the person to pay compensation to the company if it is
satisfied that the debt is wholly or partly unsecured and the person to
whom the debt is owed has suffered loss or damage in relation to the debt
because of the company's insolvency (section 588K). The amount of
compensation will be equal to the loss or damage and it may be ordered
whether the Court imposes a penalty.

The time limit for criminal proceedings is five years from the act or
omission constituting the offence unless the Minister extends the period
(section 1316).


When ordered by a Court after a liquidator applies:

A person may be liable to pay compensation in the circumstances set out in
section 588M when proceedings are commenced by the company's liquidator.
Under this provision:

where a director has contravened section 588G; and

the creditor to whom the debt is owed has suffered loss or damage in
relation to the debt because of the company's insolvency; and

the debt was wholly or partly unsecured when the loss or damage was
suffered; and

the company is being wound up;

then whether or not the director has been convicted of an offence in
relation to the contravention or whether or not a civil penalty order has
been made against the director, the liquidator may recover from the
director an amount equal to the amount of the loss or damage, as a debt due
to the company. Proceedings under this section may only be begun within
six years after the beginning of the winding up.


When ordered by a Court on application of the creditor:

In addition to liquidators having rights against directors in these
circumstances, creditors may also be able to claim compensation. The Act
provides that creditors of companies that are being wound up, may, with the
consent of the liquidator, begin proceedings in relation to the incurring
by the company of a debt that is owed to the creditor (section 588R). Such
creditors may give to the company's liquidator written notice within six
months of winding up indicating that they intend to bring proceedings under
section 588M in relation to a specified debt and requesting the
liquidator's consent (section 588S). Where consent by the liquidator has
not been given within three months of a request from a creditor, the
creditor may apply to the Court for leave to commence the action under
section 588M (section 588T).

However a creditor of a company that is being wound up cannot begin
proceedings under section 588M if:

a) the liquidator has applied to the Court in relation to the debt being
a voidable transaction under section 588FF; or


b) the liquidator has commenced proceedings under section 588M; or


c) the liquidator has intervened in an application for a civil penalty
order against a person in relation to the incurring of the debt in
relation to a contravention of section 588G. (section 588U).

It should be noted that there cannot be double recovery by both a creditor
and the liquidator (section 588N).

Compensation ordered by the Court in all these circumstances is not
available to pay secured debts unless all the unsecured debts have been
paid in full (section 588Y(1)).


HOLDING COMPANY LIABILITY

Liability is also imposed upon holding companies for insolvent trading
committed by subsidiaries[74]. Where a holding company permits one of its
subsidiaries to trade while insolvent, then the subsidiary's liquidator may
recover from the holding company amounts equal to the amount of loss or
damage suffered by the unsecured creditors of the subsidiary.

Under Division 5 of Part 5.7B of the Corporations Act, a company
contravenes section 588V if:

the company is a holding company at the time when the subsidiary
incurs a debt; and

the subsidiary is insolvent at that time, or the subsidiary becomes
insolvent by incurring that debt or by incurring at that time debts
including that debt; and

there are reasonable grounds at the time for suspecting that the
subsidiary is insolvent or will become insolvent; and

that either the holding company or one or more of its directors were
aware of these grounds or, having regard to the nature and extent of
the corporation's control over the subsidiaries affairs, it is
reasonable to expect that a corporation in the holding company's
circumstances would have been aware of those grounds or that one or
more of the holding company's directors would have been aware of those
grounds; and


that time is at or after the commencement of this Part, that is 23
June 1993.

The test involves an assessment both of whether reasonable grounds exist
and whether the holding company or one of its directors should have been
aware of those grounds. A corporation which contravenes the section is not
guilty of an offence but civil penalties can be imposed (section 588V(2).

A liquidator of a subsidiary can take proceedings against the holding
company to recover for the benefit of the unsecured creditors of the
subsidiary, loss or damage suffered. The limitation period for these
proceedings is six years (section 588W(2)).


Holding company defences

A holding company does have defences to an action commenced under section
588V. These defences are contained in section 588X of the Corporations Act
and provide:

a) if it is proved that when the debt was incurred the holding company
and each relevant director had reasonable grounds to expect, and did
expect, that the company was solvent at the time and would remain
solvent even if it incurred that debt and any other debts that it
incurred at that time, then a defence will have been made out (section
588X(2)).


b) it is a defence if it is proved that, at the time when the debt was
incurred, the holding company, and each relevant director:

had reasonable grounds to believe, and did believe:

that a competent and reliable person was responsible for
providing to the holding company adequate information about
whether the subsidiary was solvent; and

that the person was fulfilling that responsibility; and

expected, on the basis of the information provided to the
holding company by the person, that the company was solvent
at the time and would remain solvent even if it incurred
that debt and any other debts that it incurred at that time
(section 588X(3)).

c) if it is proved that, because of illness or for some other good
reason, a particular relevant director did not take part in the
management of the holding company at the time when the company
incurred the debt, the fact that the director was aware is to be
disregarded (section 588X(4)).

d) it is a defence if it is proved that the holding company took all
reasonable steps to prevent the subsidiary from incurring the debt
(section 588X(5)).



d) Section 461(k)

A company may be wound up by the court if it considers it to be "just and
equitable" to do so. In Ebrahimi v Westbourne Galleries Ltd [1973] AC
360, two men conducted a carpet laying business in partnership. Both
equally participated in management and profits. Sometime later they formed
a company carrying on in much the same fashion. No dividends were paid and
all profits were distributed as directors remuneration. Both men held 500
shares each and were the only two directors.

Later one of the men's sons came into the business and the two men
transferred 100 shares each to the son. The son eventually became a
director and he and his father voted the other man (Ebrahimi) off the
board of directors. Ebrahimi thereupon petitioned the court either to wind
the company up on the "just and equitable" ground or to order that the
father and son be made to buy out his interest. The House of Lords took
the former approach. It was argued by Ebrahimi that the "veil of
incorporation" should be lifted to see the real relationship between the
parties.

The Court stated that a winding up would be ordered if one or more of the
following elements was present. First, showing that the company was formed
on the basis of a personal relationship, of mutual confidence, and this
relationship had broken down. Secondly proving that there existed an
understanding that the aggrieved shareholder would participate in the
management and profits and that this arrangement was broken. Thirdly, that
a restriction on the transfer of shares was present so that a shareholder
could not simply sell out.

In this case there had been a pre-existing partnership which had lasted
thirteen years. Ebrahimi had started out as a partner, and expected to
continue to participate in management profits. As this was thwarted it was
just and equitable to have the company wound up.


-----------------------
[1] "Constitution" is defined in sec 9.

[2] Now sections 16 and 17 of the Insurance Contracts Act 1984 (Cth)
require only that the claimant suffer a "pecuniary or financial loss"
through the destruction of, or damage to, the insured property. So
long as this interest exists as at the date of the loss, the claimant
is not barred from claiming on the policy by reason only of not having
a legal or equitable interest in the property. It thus seems that if
the circumstances of Macaura's case were repeated today, the claimant
would be successful.

[3] See also NRMA v Parker (1986) 4 ACLC 609.

[4] [1895] 2 Ch 323.

[5] [1897] AC 22 at 51.

[6] [1897] AC 22 at 40.

[7] [1897] AC 22 at 45.

[8] 18 & 19 Vict. c133. This Act was repealed soon after and later
incorporated in the Joint Stock Companies Act 1856.

[9] Farrar, J.H., Company Law, Butterworths 1985 ed. London, at 18.

[10] Farrar, J.H., Company Law, Butterworths 1985 ed. London, at 18.

[11] Such limiting clauses were held to be ineffective from 1854.

[12] Gower LCB, Gower's Principles of Modern Company Law 4th ed. 1979,
Stevens & Sons London at 36.

[13] Gower LCB, Gower's Principles of Modern Company Law 4th ed.
1979, Stevens & Sons London at 48.

[14] [1897] AC 22.

[15] In Qintex Australia finance Ltd v Schroders Australia Ltd (1991) 9
ACLC 109, Rogers CJ suggested that the whole issue of the
separateness of the corporate legal entity be re-examined in the light
of the so-called tension between the realities of commercial life and
the applicable law. Although his Honour in the case at hand had to
determine which company in the Qintex group of companies should be
able to claim the benefit of the contract entered into, a number of
more general remarks were made concerning the separate legal entity
doctrine. According to his Honour, (at p 111) it may be desirable
"for Parliament to consider whether this distinction between the law
and commercial practice should be maintained. This is especially the
case today when the many corporate collapses of conglomerates occasion
many disputes."

[16] Easterbrook FH and Fischel DR., Limited Liability and the
Corporation, (1985) Uni of Chicago Law Review 7 at 89.

[17] Farrar JH., Company Law, 1985 ed, Butterworths, London at 57. This
categorisation was accepted by Young J, in Pioneer Concrete Services
Ltd v Yelnah Pty Ltd (1987) 5 ACLC 467 at 474.

[18] [1933] 1 Ch D 935 at 956.

[19] [1953] 1 WLR 483 at p 486.

[20] (1987) 5 ACLC 467 at 476.

[21] (1987) 5 ACLC 467 at 477.

[22] (1987) 5 ACLC 467 at 476.

[23] Indeed Lord Denning described the case as the "three in one". Three
companies in one or alternatively as the "one in three". One group of
three companies. See [1976] 1 WLR 852 at 857.

[24] For a discussion on this point see Re Securitbank Ltd [1978] 1 NZLR
97 at 133 and Industrial Equity Ltd v Blackburn (1977) 137 CLR 567.

[25] [1976] 1 WLR 852 at 860.

[26] The decision in DHN was approved in Amalgamated Investment & Property
Co Ltd (in liq) v Texas Commerce International Bank Ltd [1983] QB 84.
However the case was distinguished in Woolfson v Strathclyde Regional
Council (1978) 38 P & CR 521. Lord Keith of Kinkel at 526 expressed
doubt as to whether the decision in DHN correctly applied the
principle that it is appropriate to pierce the corporate veil only
where special circumstances exist indicating that it is a mere facade
concealing the true facts.

[27] [1976] 1 WLR 852 at 861.

[28] (1951-52) 25 ALJR 225 at 228.

[29] [1923] AC 723 at 740-741.

[30] (1991) 9 ACLC 109 at 111.

[31] (1989) 7 ACLC 841 at 863. This was also the view of Lord Goff in DHN
Food distributors v Tower Hamlets London Borough Council [1976] 1 WLR
852.

[32] Courtney, W., "Failed Pre-registration Contracts and the Statutory
Remedy", (2007) 25 C & SLJ 226.
[33] It should be noted that sections 592(6) and 593(2) of the
Corporations Act also deals with conduct known as fraudulent trading.
These provisions have not been replaced and this means that these
parts of sections 592 and 593 are still operative in regards to
fraudulent trading notwithstanding that the debts were incurred after
the 23 June 1993. However with regards to insolvent trading, a
preliminary issue of ascertaining the date the debt was incurred must
be made. If debts were incurred after 23 June 1993 in these
circumstances sections 588G-588Z will apply. For debts incurred prior
to this date in similar circumstances, sections 592(1)-(5),(7),(8),
593(1) and (4)-(8) apply.

[34] (1990) 8 ACLC 390 at 397.
[35] (1992) 10 ACLC 588 at 595. Kirby P also agreed at 599 with this
conclusion.
[36] Reed International Books Australia v King (1993) 11 ACLC 935 at 938.
[37] (1980) CLC 34,428 at p 34,430.
[38] See 3M Australia Pty Ltd v Watt & Anor; NEC Home Electronics
Australia Pty Ltd v White & Anor (1984) 2 ACLC 621.
[39] See Jelin Pty Ltd v Johnstone & Anor (1987) 5 ACLC 463.
[40] See BL Lange & Co v Bird (1991) 9 ACLC 1015.
[41] See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC 287.
[42] State Government Insurance Corp v. Pollock (1993) 11 ACLC 839.
[43] See Ross McConnel Kitchen & Co. Pty Ltd (in liq) v Ross & Ors (1985)
5 ACLC 326 at 329.
[44] Shapowloff v Dunn (1981) ACLC 33,127.
[45] Deputy Commissioner for Corporate Affairs v Abbott & anor (1980) CLC
34,428 and DeRossi v Hamilton (1982) 7 ACLR 40 and Flavel v Day (1985)
3 ACLC 320.
[46] Southern Highlands Building Co. Pty Ltd (in liq) and the Companies
Act (1979) ACLC 32,074.
[47] Metal Component Industries Pty Ltd (in liq) v Clark & Anor (1980)
ACLR 862.
[48] (1987) 5 ACLC 463 at 465.
[49] See Castrisios v McManus; McManus v Castrisios (1991) 9 ACLC 287 at
296.
[50] (1992) 10 ACLC 588 at 595.
[51](1992) 10 ACLC 588 at 598.
[52](1986) 4 ACLC 393.
[53](1986) 4 ACLC 393 at 396.
[54] Pollard SM., "Fear and Loathing in the Boardroom: Directors Confront
New Insolvent Trading Provisions" (1994) 22 ABLR 392.
[55] Although Palmer J's decision in that case was overturned on appeal,
it was done so on grounds not impacting on the statements quoted.
[56] This was confirmed on appeal: see Lewis (as liquidator of Doran
Constructions Pty Ltd) v Doran (2005) 219 ALR 555; 54 ACSR 410.
Special leave to appeal was refused by the High Court. The case was
also approved in Reynolds v Neumedix Biotechnology Pty Ltd [2006] QSC
302.
[57] See Report number 45, volume 1 (1988), [290].
[58] A number of cases have reiterated this view in relation to
predecessor legislation. See Shapowloff v Dunn (1981) ACLC 33,127 at
33,133 - 33,134; Pioneer Concrete Pty Ltd v Ellston (1985) 10 ACLR 289
at 301; 3M Australia Pty Ltd v Kemish (1986) 4 ACLC 185 at 187 and
191; Statewide Tobacco Services Ltd v Morley (1990) 8 ACLC 827 at 831;
Commonwealth Bank of Australia v Friedrich & Ors (1991) 9 ACLC 946 at
953; State Government Insurance Corp v Pollock (1993) 11 ACLC 839 at
846; Rema Industries & Services Pty Ltd v Coad (1992) 10 ACLC 530 at
536-537; Carrier Air Conditioning Pty Ltd v Kurda (1992) 10 ACLC 773
at 775.
[59] Deputy Commissioner for Corporate Affairs v Caratti (1980) ACLC
34,155 at 34,158.
[60] Southern Highlands Building Co. Pty Ltd (in liq) and the Companies
Act (1979) CLC 32,074.
[61] The other two issues in contention were first, whether at the time
when the debts were incurred Eise did not have reasonable cause to
expect that the company would not be able to pay all its debts as and
when they became due and secondly, whether Eise could obtain relief
under section 535(1) (now section 1318 Corporations Act)?
[62] (1991) 9 ACLC 946 at 954.
[63] (1991) 9 ACLC 946 at p 955.
[64] (1986) 4 ACLC 739.
[65] (1988) 6 ACLC 725 at 732.
[66] (1990) 8 ACLC 827 at 837.
[67] Ormiston J distinguished Metal Manufactures on this point because in
that case Mr Lewis was the managing director and there was no evidence
that Mrs Lewis appointed or participated in the appointment of him.
[68] (1992) 10 ACLC 1233 at 1241.
[69] (1991) 9 ACLC 1181.
[70] On appeal, the only question raised was the application of the first
defence.
[71] (1986) 4 ACLC 739 at 749.
[72] Australian Law Reform Commission, General insolvency Inquiry (1988),
Vol 1, [307].
[73] Finding a person guilty of an offence will occur, if and only if, the
court convicts the person or where the court finds the offence proven
but does not proceed to convict (section 73A).

[74] Liability of a holding company for the insolvent trading of a
subsidiary is set out in section 588V of the Corporations Act.
Recovery of compensation is contained in sections 588W, 588Y and 588Z.


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1