If you’re not an officially appointed company director, you may be operating as a shadow director, or de facto director. You need to be aware of your legal obligations, especially if there’s a question of insolvency or fraud.
On 10 January 2020, Justice Brian Devereaux of the District Court of Queensland sentenced former shadow director of Kleenmaid, Andrew Eric Young, to nine years’ imprisonment after being found guilty of 19 offences of fraud and insolvent trading.
Background – Kleenmaid shadow director case
Kleenmaid was an Australian based manufacturer which sold kitchen appliances to electrical retailers. Kleenmaid operated across five states in Australia, with over 20 retail outlets, five of which were owned by Kleenmaid and the others were franchises. In 2008 Kleenmaid was listed in Business Review Weekly’s Top 500 Australian Companies and sold products to major retailers including Harvey Norman and Clive Peeters.
On 9 April 2009 Kleenmaid went into voluntary administration with debts of over $100 million. A Report to Creditors was shortly published indicating that Kleenmaid may have been trading while insolvent since 2007.
In 2015 former director of Kleenmaid, Gary Collyer Armstrong, pleaded guilty and was sentenced to seven years’ imprisonment for fraud and insolvent trading. Shortly after, in 2016, another former director of Kleenmaid was also convicted of fraud and insolvent trading and was sentenced to nine years’ imprisonment.
What is insolvent trading?
Under Section 95A of the Corporations Act 2001 (Cth) (Act), a company is considered solvent if, and only if, the company can pay all its debts as and when they fall due. The Act goes on to state the obvious: if a company is not solvent, it is insolvent.
The Court applies several principles in determining the solvency of a company, and fundamentally this will be a question of fact to be determined by considering the company’s financial position as a whole.
The primary test applied by the Court to determine solvency is classically described as the ‘cash-flow test’; although the Court may take the balance sheet position of the company into account. Under the cash-flow test, broadly, if a company is unable to liquidate its assets quickly to satisfy its debts, the company may be deemed insolvent.
Under Section 588G of the Act, a person who is a director (including shadow and de facto directors) of a company when the company incurs a debt, and that company is insolvent (or becomes insolvent by incurring that debt), and there are reasonable grounds for suspecting that the company is insolvent at that time, then by failing to prevent the company from incurring that debt, the director may be found to have contravened Section 588G(2) of the Act if:
- The person was aware at that time that there were such grounds for suspecting insolvency; or
- a reasonable person in a like position in a company in the company’s circumstances would have been so aware.
There are defences available to insolvent trading. These include:
- Coming within the Act’s safe harbour regime, which includes where, at the time the person starts to suspect insolvency, the person starts to develop a course of action which is likely to lead to a better outcome for the company. This is a highly nuanced defence and would need careful consideration;
- There were reasonable grounds to expect the company was solvent;
- A competent and reliable person provided information to support the company was solvent;
- Because of illness or for some other good reason, the director did not take part in the management of the company; and
- The director took all reasonable steps to prevent the company from incurring the debt.
What is a Shadow Director?
In this latest conviction in the Kleenmaid saga, someone who was not validly appointed a director was found criminally liable as a ‘shadow director’ – he was treated as if he had been appointed a director.
It is not only persons who are formally appointed directors who may fall within the definition of “director”. Under Section 9 of the Act, a director includes persons who are acting in the position of a director or persons on whose instructions or wishes the directors of the company or body are accustomed to act in accordance with, even though they are not formally appointed a director of the company.
In this case, Mr Andrew Eric Young was a shadow director and was giving instructions in relation to the affairs of Kleenmaid. Being deemed a shadow or de facto director carries with it responsibilities and the risk of personal civil and criminal liability.
Director penalties for insolvent trading
A director (including a shadow or de facto director) found liable for contravening the insolvent trading provisions of the Act may face civil penalties, including a fine of up to $200,000. If dishonesty is found to be a factor in insolvent trading, such as it was found in this Kleenmaid case, the director may face up to five years’ imprisonment or a fine of up to $220,000 (or both) for each count. There is, of course, also director disqualification to consider.
If a director (including a shadow or de facto director) finds itself in a position where he or she suspects the company is insolvent, it is important to obtain prompt advice from an accountant, lawyer or insolvency practitioner.
If a company is experiencing financial problems, even if borderline, it is important to continually and consistently monitor the finances of the company to ensure it is not unable to pay its debts.
Some signs (which are non-exhaustive) of insolvency include financial loss, a clear inability to pay bills and paying creditors outside of the agreed terms. If a company is experiencing these signs, and the directors are worried about its financial stability, or suspect insolvency, it is important to act quickly in getting professional advice.
The Kleenmaid case also highlights the need to carefully consider one’s position if one is exercising influence in a company and may be deemed a shadow or de facto director.
Being deemed a director can give rise to liability as if that person was appointed a director. If you are concerned, you should check that your company has directors’ and officers’ insurance and that insurance includes, and at the very least does not exclude, coverage for shadow directors and de facto directors.