Directors and the duty to prevent insolvent trading

Every director of a company that is heading into financial trouble faces a personal legal duty that sits above the ordinary worry about whether the business will survive. The Corporations Act 2001 (Cth) (the Act) requires you, in effect, to stop your company from taking on new debts once it is insolvent or close to it. The duty is not a vague statement of good practice. Breaching it can make you personally liable to repay money the company owed, on top of fines and possible disqualification from managing companies.

This obligation, the duty to prevent insolvent trading under s 588G of the Act, is one of the few areas of corporate law where the corporate veil is genuinely set aside. If your company later goes into liquidation, a liquidator can pursue you personally for the debts that were incurred while the company was insolvent. The stakes are high enough that directors should understand exactly who the duty attaches to, what triggers it, what the defences are, and what steps to take the moment solvency becomes doubtful.

Who the duty applies to

The duty in s 588G of the Act applies to a director of the company. That is a broader category than the people formally appointed at a general meeting. Under the definition in s 9 of the Act, a director includes a person who acts in the position of director, even if never formally appointed (a de facto director), and a person whose instructions the directors are accustomed to follow (a shadow director). If you genuinely call the shots, the law is likely to treat you as a director for this purpose. It does not matter whether you have any formal title, receive a salary, or appear on the company's records with ASIC.

The duty attaches to each director individually and it cannot be delegated away. Delegating bookkeeping or account management to a finance manager, an accountant, or a shareholder does not shift the personal obligation; it only affects whether a defence of reasonable reliance is available.

When the duty is triggered

The duty is not engaged every time a company spends money. Section 588G applies only when three conditions are met at the same moment a debt is incurred:

• The company is insolvent or becomes so because of the debt: The Act's definition is in s 95A: a company is solvent if it is able to pay all its debts as and when they become due and payable, and insolvent if it is not. This is a cash-flow test about debts that have fallen due, not simply a question of whether assets exceed liabilities on a balance sheet.
• There are reasonable grounds for suspecting insolvency: The duty bites where, at the time the debt was incurred, a reasonable person in the director's position, in the company's circumstances, would have suspected that the company was insolvent or would become so by taking on the debt.
• The company incurs a debt while the duty is engaged: If the company goes on to become insolvent because of a particular debt, the debt is treated as incurred at the time the company was still solvent but heading over the edge.

The test for what counts as incurring a debt is broad. Section 588G(1A) treats a range of transactions as incurring debts, including paying a dividend, buying back shares, and entering into an uncommercial transaction. The practical trigger for the duty is often the point where the company can no longer pay its suppliers, employees, and tax obligations as they fall due, yet keeps trading and accumulating new liabilities.

The core duty: stop the company incurring debts while insolvent

The substance of the duty is simple to state: by failing to prevent the company from incurring the debt, you contravene s 588G if you were aware there were reasonable grounds to suspect insolvency, or if a reasonable person in your position would have been aware.

The obligation is judged on both what you actually knew and what you should have known. You cannot avoid liability by keeping yourself deliberately uninformed about the company's deteriorating position. The standard is an objective one viewed through the lens of the company's actual circumstances, so a director of a small cash-strapped business is expected to notice the same warning signs that a careful director of that kind of business would notice.

In practice this means monitoring the company's cash position, ensuring financial records are kept up to date, and acting on warning signs before debts pile up. The duty is not to guarantee solvency. It is to avoid incurring additional debts once the position is, or reasonably should have been, apparent.

The duty of reasonable reliance

A related but distinct obligation is that the director must not simply accept whatever they are told. The Act and the case law expect a director to engage with the company's financial information. Where responsibility for financial reporting has been properly delegated to a competent and reliable person, the director must still act on what that person provides rather than ignore it. The point is that "I did not look at the numbers" is rarely a complete answer.

Consequences of getting it wrong

The consequences of a breach are designed to make directors take the duty seriously, because the losses fall on creditors who cannot recover from an insolvent company.

• Personal liability to compensate: Under s 588M of the Act, once the company is being wound up, its liquidator may recover from a director, as a debt due to the company, an amount equal to the loss or damage an unsecured creditor suffered because of the insolvent trading. This is the mechanism that turns the breach into a personal obligation to effectively reimburse the company for the debts it incurred while insolvent.
• Civil penalties: A contravention of s 588G(2) is a civil penalty provision under Part 9.4B of the Act. ASIC can seek a declaration of contravention and a pecuniary penalty paid to the Commonwealth. Under s 1317G of the Act, the maximum civil penalty for an individual is the greater of 5,000 penalty units or three times the benefit obtained and detriment avoided. With the penalty unit at $364 from 1 July 2026, that cap is around $1.82 million.
• Criminal consequences in serious cases: Where a director suspected the company was insolvent and their failure to act was dishonest, the contravention can amount to an offence under s 588G(3), which carries its own penalties.
• Disqualification: The court can disqualify a director from managing corporations under sections such as 206C. Losing the right to manage companies can end a person's ability to run any business.

Defences available to a director

Section 588H of the Act sets out defences a director can raise to defeat an insolvent trading claim. Each requires the director to prove the relevant facts (the onus shifts to the director once the liquidator establishes the contravention).

• Reasonable grounds to expect solvency: It is a defence that at the relevant time you had reasonable grounds to expect, and did expect, that the company was solvent and would remain so. The word "expect" sets a slightly higher standard than a mere hope or belief, so this defence requires a reasonable foundation in the company's actual position.
• Reasonable reliance on a competent person: You can defend the claim if you had reasonable grounds to believe that a competent and reliable person was responsible for providing you adequate information about whether the company was solvent, that they were fulfilling that role, and that you expected, on the basis of that information, that the company was solvent.
• Illness or good reason for not participating: A director who did not take part in management at the relevant time because of illness or for some other good reason can rely on this defence.
• All reasonable steps: It is a defence if you took all reasonable steps to prevent the company from incurring the particular debt. In weighing this, a court looks at any action you took to appoint an administrator or restructuring practitioner, when you took it, and what came of it.

The safe harbour

The most important protection, in practice, is the safe harbour in s 588GA of the Act. It recognises that a director who is trying to rescue a struggling company should not be punished merely because the attempt ultimately fails.

The safe harbour operates by removing the s 588G(2) civil liability where, after you start to suspect the company may be or become insolvent, you begin developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator. The protection covers debts incurred in connection with that course of action, or in the ordinary course of the company's business, during the period while the course of action remains reasonably likely to lead to a better outcome.

To stay within the safe harbour, directors are expected to take practical steps, including properly informing themselves of the company's financial position, preventing misconduct by officers and employees, keeping appropriate financial records, obtaining advice from a suitably qualified adviser who is given sufficient information, and developing or implementing a plan to restructure the company.

There are important limits. The safe harbour does not apply if the company is failing to pay employee entitlements or to lodge required tax documents, and the failure amounts to less than substantial compliance, or is one of two or more such failures in the preceding 12 months. The onus is on the director to point to evidence supporting the safe harbour. Separate safe harbours in s 588GAAB and s 588GAAC give related protection to companies under restructuring and those looking to appoint a restructuring practitioner.

A practical compliance checklist

If you are a director and solvency becomes doubtful, the following steps reduce your personal exposure:

• Check the cash position now: Reconcile what the company owes and what is due in the short term, not just what the balance sheet shows in equity.
• Stop taking on new debt once insolvency is suspected: Every new credit facility, supplier order on credit, or deferred tax arrangement is a potential insolvent trading claim.
• Pay employee entitlements and lodge tax documents: These are excluded from the safe harbour and are a frequent point of failure.
• Keep minutes and records: Document the financial information you reviewed and the decisions you made.
• Get qualified advice early: A turnaround adviser or insolvency practitioner who sees the full financial picture can help you structure a defensible course of action.
• Consider whether a formal administration or restructuring is the better outcome: Appointing an administrator can itself cut off liability and may be the realistic option when a rescue plan is not reasonably likely to succeed.

When you should get professional help

Insolvent trading is an area where the difference between a mistake and a defence often turns on evidence gathered at the time, and where the onus is on the director to prove a defence. A lawyer can help you assess whether the company is technically insolvent, whether a safe harbour course of action is available and being properly documented, and what the exposure is if a liquidator later pursues a claim. If a claim has already been made, a lawyer can advise on which defences apply and how to run them, and on engaging with ASIC if it has become involved. Obtaining early advice both strengthens any defence and can itself be part of the reasonable steps that keep the safe harbour available.

The decision a director actually faces

The real judgment call is not whether the duty exists, it is the moment you choose between continuing to trade in the hope of a turnaround and keeping the company's obligations under control or stepping back so it stops incurring debts it cannot pay. The law does not punish a director for making a genuine rescue attempt that fails, and the safe harbour exists precisely to protect that. What it does punish is the director who keeps spending while aware, or reasonably expected to be aware, that the company cannot pay, and who has not taken the documented steps that a careful director would take. If you suspect trouble, put the company's cash position on the table now, stop it taking on new debt, and get advice before the next order is placed. Waiting is where the personal liability accumulates.