Section 588v Of The Corporations Law (“CL”)
Division 5 of Part 5.7B of the CL deals with the liability of a holding company for insolvent trading by a subsidiary. This Division is an explicit legislative departure from the principles of limited liability and provides a means for shareholders to be made liable for the debts of a company.
A holding company contravenes section 588V of the CL if, at the time its subsidiary incurs a debt:
a) the subsidiary is insolvent or becomes insolvent through incurring the debt or other debts at that time; and
b) there are reasonable grounds for suspecting that the subsidiary is insolvent or would become insolvent; and
the holding company, or one or more of its directors, is or becomes aware that there are such grounds for suspicion; or having regard to the nature and extent of the holding company’s control over the subsidiary’s affairs and to any other relevant circumstances, it is reasonable to expect that:
a) a holding company in the circumstances of the holding company would be so aware; or
b) one or more of such a holding company’s directors would be so aware.
Actual knowledge by the holding company of the insolvency is clearly the best evidence of a contravention. But the legislative test of reasonable grounds (an objective test) for suspecting insolvency is very wide. Again actual knowledge of these ‘reasonable grounds’ by the holding company or any of its directors is sufficient. Alternatively, the relationship between the holding company and the subsidiary is to be examined to determine whether it is reasonable to expect such knowledge to be possessed by the holding company or any of its directors. The law is not examining the degree of control over the operations by the holding company, but rather is considering the knowledge base of the holding company and presumes the ability of the holding company to control the subsidiary!
Where a holding company contravenes section 588V of the CL and:
a) the creditor to whom the debt is owed suffers loss or damage in relation to the debt because of the subsidiary’s insolvency; and
b) the debt is wholly or partly unsecured when the loss or damage was suffered; and
c) the subsidiary is being wound up,
the liquidator of the subsidiary may recover from the holding company as a debt due an amount equal to the amount of the loss and damage. The proceedings must be brought within six months of the commencement of the winding up. The liquidator would commence proceedings in respect of all loss and damage suffered by the relevant creditors. Unlike the position where creditors may pursue individual directors for a contravention of section 588G of the CL, under sections 588R and 588T of the CL, particular creditors may not commence proceedings directly against the holding company.
Only debts may be recovered
One of the most significant aspects of these provisions is that only ‘debts’ may be recovered and the provisions do not extend to other liabilities such as damages for breach of contract or perhaps more significantly, the damages due to the victims of torts. Recent cases have indicated that liabilities under guarantees may be caught, but a general right to damages is arguably not caught. Another uncertainty is whether a secured creditor who is effectively unsecured because the value of the security is insufficient to cover the outstanding indebtedness falls within the ambit of this provision because the secured creditor was ‘partly unsecured’ when the loss or damage was suffered (which presumably was when the company went into liquidation).
It is a defence to an action brought by a liquidator under section 588W of the CL if:
a) at the time the debt was incurred, the holding company and its relevant directors (that is the directors aware that there are reasonable grounds for suspecting insolvency) had reasonable grounds to expect, and did expect, that the subsidiary was and would be solvent at that time;
b) at the time the debt was incurred, the holding company and its relevant directors (that is the directors aware that there are reasonable grounds for suspecting insolvency):
(i) had reasonable grounds to believe, and did believe;
a) that a competent and reliable person was responsible for providing to the holding company adequate information about whether the subsidiary was solvent; and
b) 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 subsidiary was and would remain solvent at that time;
c) the holding company is only liable because of the awareness of a director and that director did not take part in the management of the holding company because of illness or some other good reason; or
d) the holding company took reasonable steps to prevent the subsidiary from incurring the debt.
The implications for corporate governance are that if the holding company does not wish to be liable for the debts of its insolvent subsidiary it must pursue a number of strategies. The first strategy is one of ‘informational poverty’, that is ensuring the holding company knows as little as possible about the activities and financial position of its subsidiary. Because the touchstone of liability is actual knowledge or presumed knowledge arising from the relationship between the holding company and the subsidiary, the holding company must effectively not receive regular updates on the financial position of the subsidiary, share common officers or employees and not control (or arguably be in a position to control) the subsidiary’s affairs. This strategy is unlikely to be either practical (particularly in the context of a requirement to prepare consolidated accounts) or desirable. This is because the reasons for creating a separate subsidiary, as we have discussed, usually involve the active management and control of the subsidiary’s affairs.
The alternative strategy is to ensure that while the holding company is aware of the financial position and prospects of the subsidiary (or is presumed to be so aware) one of the defences applies so that the holding company is not liable notwithstanding that knowledge. The most practical defence is to ensure that a reliable and competent person is providing financial information that indicates the subsidiary is solvent. This defence incorporates both sub-sections 588X(2) and (3) of the CL. It is very difficult to consider upon what other basis the holding company and its directors could reasonably consider the subsidiary was solvent.
Another approach is for the holding company to take reasonable steps to prevent the subsidiary from incurring the debt and so seek to rely upon section 588X(5) of the CL. There are a number of concerns about this defence. The first is the supposed separation between the duties and responsibilities of the board of directors and shareholders, so that the board is responsible for the management of the affairs of the subsidiary How does this principle of corporate governance sit with the requirements of this defence? Does it affect what is reasonable for a holding company to do to prevent the incurring of the liability? How is the holding company to actually prevent the incurring of the liability? Does it require the holding company to replace the board of directors? It is not clear that setting up authorities and restraints which seek to impose limits upon the activities of subsidiaries in incurring debts when insolvent would be adequate for the defence. The defence in its terms refers to ‘the debt’ singular, rather than preventing insolvency and suggests the actual contemplation of a debt which it is sought to prevent from being incurred. In any event, action could only be taken if the holding company was aware that the relevant debt was about to be incurred and that insolvency was an issue for the subsidiary. The required knowledge about the incurring of the debt is a significant assumption. The more the detail of this provision is considered, the more it becomes apparent that it is conceptually very difficult to avoid liability in the ‘controlled subsidiary’ situation, which is most likely where the subsidiary is a wholly-owned subsidiary.