Rising interest rates and insolvency
From November 2023 to December 2024, the cash rate was 4.35%, the highest it has been for over a decade.1 Although this has eased slightly to 4.10% in February 2025, the higher rates over the last few years have meant higher borrowing costs for existing debts and that it has become more challenging to find new lines of credit. Higher interest rates can strain cashflow, resulting in short and long-term reduction in revenue and profitability. Unsurprisingly, the number of companies entering external administration increased by 39 percent in the 2023-24 financial year, with the construction industry and food and accommodation services sector being amongst the most impacted.
While the cash rate is one of many factors that influence a company’s business, it is crucial directors are aware of their obligations and liabilities, and seek advice early if they suspect their business may be struggling.
Insolvent trading and personal liability
A company will be insolvent if it cannot pay all its debts as and when they become due and payable. Under section 588G of the Corporations Act 2001 (Cth) (Act), directors have a duty to prevent insolvent trading by prohibiting the company from incurring debts when the company is insolvent, or in circumstances where incurring debt would make it insolvent.
Directors have statutory defences to this breach, including that the director had reasonable grounds to believe the company was solvent at the time it incurred the debt and believed that a competent and reliable person was responsible for providing adequate information that the company was solvent and that the person was fulfilling that responsibility. A director will also have a defence if they did not take part in the management at the time the debt was incurred because of illness or some other good reason.
A director who has breached this duty:
- may be guilty of a criminal offence and a pecuniary order of up to $660,000, imprisonment for up to five years and disqualification;
- may receive a civil penalty of up to $1.65 million or three times the benefit obtained and detriment avoided, whichever is greater; or
- compensation payments for amounts lost by creditors.
Ignorance is not an excuse. Directors are required to take positive steps to inform themselves of the solvency of their company. Officers should actively monitor the company’s solvency and look for early warning signs of financial distress (such as ongoing cash shortfalls, overdue taxes or unpaid creditor demands). If there are grounds to suspect a company may risk approaching insolvency, directors should immediately take steps to address the risk and prevent the company from incurring further debts. Knowing what options are available and seeking professional advice is a key step in navigating this risk.
Restructuring and alternative next steps
The safe habour protections
When facing financial distress or actual insolvency, there are numerous options for directors. The best course will depend on the company’s different circumstances, such as its size and prospects for turnaround. The more typical options usually include informal workouts under the safe harbour principles, voluntary administration or the small business restructuring process for those companies that qualify. Each option carries its own benefits and considerations.
Section 588GA of the Act may provide directors with ‘safe harbour protection’ from personal liability for insolvent trading. The safe harbour protection may apply if the debt is incurred directly or indirectly in connection with developing a course of action that is reasonably likely to lead to a better outcome for the company.
In determining whether a course of action is likely to lead to a better outcome for the company, regard may be had to whether the director:
- is properly informing itself of the company’s financial position;
- is taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay its debts;
- is taking appropriate steps to ensure the company is keeping appropriate financial records;
- or its company is obtaining advice from a qualified entity who was given sufficient information to give advice; or
- is developing or implementing a plan for restructuring the company.
For a director to be excused from liability for insolvent trading, it must ensure the company has paid the entitlements of its employees that are payable and given returns, notices, statements, applications or other documents as required by taxation laws. If these requirements are met, directors may be able to mitigate their exposure to liability. This safe harbour protection does not, however, apply to all debts. It only applies to debts which are incurred directly or indirectly with developing and taking a course of action. Accordingly, directors should ensure they are able to establish a nexus between the course of action and the debt.
Voluntary administration
Directors of a company may resolve to appoint an administrator in circumstances where they consider the company is insolvent or likely to become insolvent. The administrator will assume control of the company’s business with a focus on business continuity by way of sale or restructure. Alternatively, if this is not possible the administrator may enter into a Deed of Company Arrangement (DoCA) in order to provide a better return to the company’s creditors than what would otherwise have been achieved through liquidation.
The decision as to whether the company should be wound up, returned to its directors or made the subject of a DoCA is left in the hands of the creditors, who vote after considering the administrator’s report and recommendation. If the creditors vote in favour of the DoCA, secured creditors who voted in favour will be bound by its terms, along with all unsecured creditors regardless of their vote.
Directors may be motivated to initiate voluntary administration as it is a relevant consideration when determining whether a director has taken all reasonable steps to prevent debt or disposition, and may negate a directors potential liability for insolvent trading.
Small business restructuring
Part 5.3B of the Act sets out the restructuring process which is intended to allow eligible companies to formulate a restructure plan with the directors remaining in control, under the guidance of a qualified small business restructuring practitioner (‘SBRP’).
To be eligible to appoint a SBRP:
- a company’s total liabilities must not exceed $1 million;
- the company’s directors must not be or have been a director of any other company that was restructured or the subject of a simplified liquidation process in the seven years preceding the restructure; and
- a company must not have undergone a restructure or been the subject of a simplified liquidation process in the preceding seven years.
With the SBRP’s assistance, the directors have 20 business days to develop the restructuring plan, which will typically provide creditors with some payment funded through continued trading or external finance. Once the plan has been circulated, creditors will have fifteen business days to vote to accept or reject the proposed plan.
It is important to note that a company cannot propose a restructuring plan unless all employee outstanding entitlements have been paid and the company has given all documents and notices as required by taxation laws.
Relevantly, while a company is engaged in this process, a third party cannot readily begin or continue claims, enforce security interests, or proceed with winding up applications against the company.
If a plan is accepted by creditors and their obligations under the plan are fulfilled, the plan will terminate and the company will be released for all admissible debts and claims.
Key takeaways
It is important that boards be proactive in monitoring the financial health of their company, particularly in a climate of rising costs and tighter credit. The earlier that actual and potential risks are identified, the earlier the directors can manage and fulsomely consider their restructuring strategies for business survival, per se mitigating exposure to personal liability.
Please contact our Corporate and Commercial team for further guidance.
This article may provide CPD/CLE/CIP points through your relevant industry organisation.
The material contained in this publication is in the nature of general comment only, and neither purports nor is intended to be advice on any particular matter. No reader should act on the basis of any matter contained in this publication without considering, and if necessary, taking appropriate professional advice upon their own particular circumstances.
