Quantifying Compensation for Insolvent Trading - The Latest from the WA Court of Appeal
In a decision of importance for liquidators and litigation funders, the Western Australian Court of Appeal in Perrine v Carrello has further explained the important issue of how to determine the amount of compensation recoverable by liquidators where insolvent trading has occurred. Together with the NSW Supreme Court’s decision of earlier this year in Re Swan Services Pty Limited (in liq) (see our update here), the Court of Appeal has clarified the extent to which liquidators can seek compensation for unsecured debts from liable directors. The decision also deals with the tricky issue of insolvent trading in the context of "pay if you can" arrangements with suppliers and creditors.
Key point – when the debt was incurred
The key points for liquidators and litigation funders arising from Perrine are:
- A liquidator recovering compensation under section 588M, Corporations Act, for a director's breach of his or her duty to prevent insolvent trading (set out in section 588G) is obliged to bring into account other recoveries by affected creditors in respect of their unpaid debts. Those other recoveries might include dividends paid to creditors as a result of unfair preference recoveries by the liquidator. This is consistent with the earlier NSW decision, Re Swan Services.
- Importantly, a liquidator may, in the right circumstances, include in the amount of compensation recoverable from the defaulting director amounts invoiced even where the debtor company and unsecured creditor had a flexible repayment arrangement.
- In a commercial setting, Perrine highlights the need for directors and their advisors, in a situation of managing a company in financial distress, to carefully consider "pay if you can" and "pay when you can" arrangements in supply terms - having those arrangements properly documented may be very significant in the event that the company cannot be rescued and is instead placed into liquidation.
- Finally, Perrine is also a reminder of the importance for liquidators and their funders of being across this issue - including the details (like "pay if you can" terms) of individual creditor claims that will comprise a claim for compensation.
For those interested, further detail follows below.
The appellants were directors and (indirectly, through controlled entities) shareholders of the subject company.
The company relied on infrastructure provided by a separate entity ("PA"), including its office (the relevant invoices were for rent under a monthly lease) and staff. The company paid for PA’s services at commercial rates. In a “flexible arrangement”, PA did not press the company for repayments. Before it became insolvent, the company had unpaid invoices due to PA totalling $1.35m.
Proceedings at trial
At trial, the company’s liquidator successfully claimed the appellants had failed to prevent insolvent trading by the company. The relevant insolvent trading debt was the amount of $1.35m due to PA. The directors were ordered under section 588M to compensate the liquidator for that amount.
Issue on appeal
On appeal, the directors argued that they were not properly liable to pay that compensation because the nominal amounts on the invoices issued by PA to the company did not represent debts of the company. They claimed that the primary judge wrongly equated 'loss or damage in relation to the debt because of the company's insolvency' (as contemplated by section 588M) with 'debt' - because of the "pay if you can" arrangement in place with PA, PA did not suffer the requisite loss or damage when the company failed to pay its invoices.
The appeal failed, for reasons that follow.
Quantifying the amount of compensation - key principle
Significantly, the Court of Appeal noted the need to distinguish between the sum of the debts the subject of the allegation of breach of the duty to prevent insolvent trading, and the amount of compensation recoverable in respect of that breach.
This conclusion is consistent with the NSW position, as explained in Re Swan Services - in broad terms, it requires that other recoveries (such as unfair preference claw-backs) should be off-set against the relevant debts, before reaching a conclusion on the amount of compensation payable by a defaulting director.
Effect of "pay if you can" payment terms
The Court of Appeal concluded that the trial judge’s findings that demands for payment would not be made by PA until such time as they could be satisfied by the company were “expressed in very general terms” and “far removed from” the appellants’ assertion that the arrangement between the company and PA only gave rise to “due and payable” debts when the company's cash flow permitted payments to be made. Rather, the Court of Appeal found that the parties’ agreed constraint on demands being made was an arrangement not to enforce PA’s right to payment, rather than an agreement not to make a demand.
This was so even in light of other findings by the primary judge, including that:
- the relationship between the company and PA was “multifaceted”;
- PA showed forbearance to the company regarding its payment of invoices in an arrangement “designed to facilitate” the continuing supply of services and funding by the company to enable it to continue operating and to benefit PA; and
- the minutes of the company’s board recorded that demands would not be made by PA to the detriment of the company’s cash flow.
This difficult outcome for the company's directors highlights the need for great care by directors and their advisors - especially in times of financial distress for a company - when deploying "pay if you can" and "pay when you can" arrangements in supply terms for the company. It is crucial that those arrangements are precisely documented and then properly managed, to reflect the intent of the distressed company in continuing to trade (and incur debt) - from a director's perspective, the focus must be on avoiding debts becoming due and payable (rather than simple arrangements to not enforce payment of debts that have become due and payable).