In 1944, Otto Kahn-Freund published the following reflections on the state of British

corporations law:

[O]wing to the ease with which companies can be formed in this country, and owing to
the rigidity with which the courts applied the corporate entity concept ever since the
calamitous decision in Salomon v Salomon & Co Ltd [1897] AC 22, a single trader or a
group of traders are almost tempted by the law to conduct their business in the form of
a limited company, even where no particular business risk is involved, and where no
outside capital is required. . . This state of affairs would not necessarily call for reform,
if it were not for the fact that the courts have failed to give that protection to the
business creditors which should be the corollary of the privilege of limited liability…
The flexibility of the law governing this topic contrasts completely with the failure of the
courts to mitigate, through the mechanism of the law of agency, the rigidities of the
‘folklore’ of corporate entity in favor of the legitimate interests of the company’s
creditors. As it is, the company has often become a means of evading liabilities and of
concealing the real interests behind the business.

Modern Law Review, April 1944, pp 54-55.

2. In the light of one of the theoretical models of the corporation you have studied
in the course:

(a) Give a succinct account of the Australian law in sections 588V-X of the
Corporations Act, including relevant case law through which the sections
have been interpreted;
(b) Consider how well you think sections 588V-X in action address the criticisms
made of limited liability by Kahn-Freund?

The central complaint of Kahn-Freud is that modern corporations law does not give

adequate protection to creditors. The protection of shareholders and the folklore of

limited liability has been the paramount consideration – at the expense of the interests

of creditors. Section 588V directly attacks limited liability. To use a cliché; 588V-X

pierces the corporate veil in favour of the creditor. This essay will first summarise the

powers and defences available in 588V-X. 588V-X is part of a relatively recent

legislative instrument. In approaching relevant case law, it will be imperative to take a

broad approach. This essay will look at case law regarding 588G – the corresponding

section to prevent insolvent trading in non-group companies. This section uses almost

identical language to 588V, and has had much more judicial scrutiny than 588V-X.

Following an analysis of relevant case law and a summary of powers, this essay will

look at justifications for limited liability, focusing on Bainbridge’s director primacy

model of a corporation. Next, this essay will reconcile the justification of 588V-X

with the arguments in favour of limited liability. The legislature has recognised Kahn-

Freud’s concerns, and has armed creditors, liquidators and the courts with an

appropriately sized scalpel with which to pierce the corporate veil.

Section 588V-X provides an exemption to the general rule of limited liability. 588V

prevents a holding company from hiding behind limited liability when a subsidiary

company incurred a debt at a time when it was insolvent or there were reasonable

grounds for suspecting insolvency. A debt must be “something recoverable by action

for debt ...[something] which is ascertained or can be ascertained.”1 It cannot be an

obligation to pay unliquidated damages.2 Pay-roll tax can be a debt.3 Insolvency must

be more than a “temporary lack of liquidity” it must be “an endemic shortage of

working capital whereby liquidity can only be restored by successful outcome of

business ventures in which the existing working capital has been deployed.”4

There are of course qualifications, which limit the scope of the action. 588V only

takes effect if the company was insolvent or became insolvent when taking on the

debt.5 In addition it must be found that there were reasonable grounds for suspecting

insolvency,6 and either the company (or directors) was aware of grounds for

suspecting insolvency;7 or having regard to the holding company’s control over the

subsidiary it is reasonable to expect that they would be aware.8 Reasonable grounds to

suspect insolvency is tested on “objectively reasonable grounds which must be judged

1
Hussein v Good (1990) 1 ACSR 710, 718.
2
Hawkins v Bank of China (1992) 7 ACSR 349, 356-357.
3
Commissioner of State Taxation (WA) v Pollock (1993) 12 ACSR 217, 230.
4
Hymix Concrete Pty Ltd v Garrity (1977) 2 ACLR 559, 566.
5
Corporations Act 2001 (Cth) s 588V(1)(b).
6
Ibid s 588V(1)(c).
7
Ibid s 588V(1)(d)(i)
8
Ibid s 588V(1)(d)(ii)
by the standard appropriate to a director of ordinary competence.”9 Questions of

knowledge are factual, “liability is, therefore, not contingent on elements personal to

the respondent.”10 Section 588W prescribes that the liquidators may only recover

money in relation to the debt incurred.11 The creditor must have suffered a loss as a

result of the company’s insolvency,12 the debt must be unsecured,13 and the company

must be being wound up.14

Section X provides some defences. The directors and holding company will not be

liable if they had reasonable grounds to “expect”, and did expect, that the company

was solvent and would remain solvent despite accepting the debt.15 The term “expect”

requires “a higher degree of certainty more than ‘mere hope or possibility’”.16 It is

also a defence to believe that a competent and reliable person was responsible for

providing adequate information regarding the company’s solvency.17 The court held

that directors could not rely on business consultants, but rather the defence was

established for large companies where competent accountants advised the board.18

There is also a defence for a director who is aware of solvency problems or had

reasonable ground for suspecting problems, but, because of illness or “some other

good reason” that director did not take part in the management of the company at the

time the debt was incurred.19 Finally, it is a defence if the holding company took all

reasonable steps to prevent the company from incurring the debt.20 The Executive of

9
Group Four Industries Pty Ltd v Brosnan (1991) 56 SARS 234, 238.
10
Metropolitan Fire Systems Pty Ltd v Miller (1997) 37 ACSR 589, 76.
11
Corporations Act 2001 (Cth) s 588W(1)(a).
12
Ibid, s 588W(1)(b).
13
Ibid, s 588W(1)(c).
14
Ibid, s 588W(1)(d).
15
Ibid, s 588X(2).
16
Tourprint International Pty Ltd (in liq) v Bott (1999) 32 ACSR 201, 67.
17
Ibid, s 588X(3)(a).
18
Manpac Industries Pty Ltd v Cecattini [2002] NSWSC 330 [54].
19
Ibid, s 588X(4).
20
Ibid, s 588X(5).
the day suggested that “a court might require unequivocal action” if seeking to rely on

this type of defence.21 As final note on defences, an empirical study on insolvent

trading cases from that a defence like those listed above was argued 63.1% of the

time, however was only successful in 10.8% of those cases.22 This evidence suggests

the courts have held defendants to a relatively high standard.

This section only applies to legally defined holding companies. The Act only

recognises a holding/subsidiary relationship when one entity: controls the

composition of the board;23 or has half the votes of a general meeting;24 or has half the

share capital of the other entity.25 It has been held that “de-facto control, in the

absence of any such legally enforceable power, does not suffice to establish the

relationship of holding company and subsidiary.”26 However, Redmond argues that a

wider more fluid standard is used with “the practical influence” as the primary

concern.27 Ramsey notes a new definition has come into vogue, based on “the capacity

to dominate decision making, directly or indirectly.”28 Redmond argues a degree of

ambiguity “promotes interpretative freedom to secure policy goals”.29 In other words

the courts are free to group companies together if it is just to do so.

21
Corporate Law Reform Bill 1992, Public Exposure Draft and Explanatory Paper (1992) para 1240.
22
Paul James, Ian Ramsey and Polat Siva, ‘Insolvent Trading – An Empirical Study’ (Research Report,
Clayton Utz and Centre for Corporate Law and Securities Regulation, the University of Melbourne,
2004) 33, 34.
23
Corporations Act 2001 (Cth) s 46(a)(i)
24
Ibid, s 46(a)(ii).
25
Ibid, s 46(a)(iii).
26
Mount Edon Gold Mines (Aust) Ltd v Burmine Ltd (1994) 12 ACSR 727, 748.
27
Paul Redmond, Companies and Securities Law: Commentary and Materials (Thomas Reuters, 5th ed,
2009) 167.
28
Ian Ramsey, ‘Holding Company Liability for the Debts of an Insolvent Subsidiary: A Law and
Economics Perspective’ (1994) 17(2) University of New South Wales Law Journal 520, 544.
29
Redmond, above n 10, 168.
In direct contrast to Kahn-Freud many scholars hail the limited liability regime for its

positive effect on investment and its appropriate positioning of the burden of risk – on

creditors. Anderson argues,

[T]he difficulties for shareholders with unlimited liability regime exceed the

difficulties for creditors with a limited liability regime.”30

Shareholders, she argues, would risk losing their personal assets, and would therefore

need to monitor the company’s actions. This reduces a shareholders’ capacity to limit

risk through diversification of stocks, and places upward pressure on the required

return.31 Creditors, on the other hand, have a better opportunity to shield from risk.

Ramsey notes two contractual self-protections mechanisms available to creditors.

They can either alter the interest rate, and/or restrict the company from incurring debts

of similar or higher priorities.32 In addition to these contractual options which

creditors may exercise, another factor which assists creditors is that shareholders and

managers are unlikely to take action that will harm their reputation.33

However, incurring a debt while insolvent creates a special set of circumstances.

While legislative safeguards relating to insolvent trading have existed since the

1970s,34 it is important to analyse why insolvent trading is frowned upon. Street CJ

has held:

Where a company is insolvent the interests of the creditors intrude...It is in a

practical sense their [the creditors] assets and not the shareholders’ assets that,

30
Helen Anderson, ‘Piercing the veil on Corporate Groups in Australia: The Case for Reform’ (2009)
33 Melbourne University Law Review 333, 338.
31
Ibid, 338
32
Although 588V-X will only assist the unsecured creditor. Ramsey, above n 10, 523.
33
Ibid, 524.
34
James, Ian and Siva, above n 22, 4.
 through the medium of the company, are under the management of the

directors.35

What Street CJ is saying is that when a company is insolvent the shareholders’ assets

have already been expunged. Taking on a debt in these circumstances means the

directors are no longer gambling with the shareholders’ money, but rather they are

using the creditors to play for the “bonanza payoff that will prevent insolvency.”36

The legislature is trying to stop companies from exacerbating the problem, making it

worse by taking on more unsecured debt. As such it is appropriate to pierce the

corporate veil when insolvent trading is established. We now need to turn to the

holding company, and establish why it is important to pierce the corporate veil to hold

parent companies liable for insolvent trading.

As already stated there is a concern that unlimited liability would give rise to the need

for shareholders to closely monitor a company’s actions. Helen Anderson argues,

Unlimited liability would make shareholders unwilling to invest and diversify

their investments because of the need to monitor the company and fellow

investors.37

The notion that shareholders do not monitor companies they invest in and have very

remote influence on the board is a notion explored in detail by Stephen Bainbridge

and the director primacy model of a corporation.

The director primacy model of a corporation places decision making authority at the

core of the company – with the board. The shareholder is peripheral, generally

powerless to engage in the management of the company. Bainbridge argues that it is

35
Kinsela v Rulless Kinsela Pty Ltd (1986) 4 NSWLR 722, 730.
36
Ibid, 14.
37
Anderson, above 17, 338.
too costly and difficult to have consensus decision making by shareholders.

Consensus decision making works in partnerships. Partnerships are generally small,

the practicality of consensus decision making is possible. Partners share equally in the

gains and losses of the company, they have an equality of interests, and an equality of

interest is manifested in an equality of decision making power – consensus decision

making works in a partnership. On the other side of the coin is the director primacy

model – authority based decision making. The advantages include efficient and cheap

decision making; and the potential for specialisation of labour. The result is that

shareholders are at the periphery of the company’s management structure. The

shareholders’ rights to control the company are minimal and usually limited to some

sort of mild accountability and electoral measures.38 Centralised decision making

makes shareholders apathetic and aware that it is “easier to switch than fight.”39

Ownership and management are clearly separate.

It is easy to see how limited liability fits into the director primacy framework.

Companies accept that consensus decision making is inefficient, and shareholder

power is reduced. Parallel to director primacy is limited liability. When a company

engages in insolvent trading, those with limited decision making power have limited

liability. And this is fair enough. But why should a holding company, not receive the

benefits of limited liability? The answer is because a holding company is not an

ordinary shareholder. As Helen Anderson argues, there is economic integration

between parent and subsidiary, “the parent company will be involved in important

decision-making for the subsidiary.”40 A holding company is a very influential

38
See, Stephen Bainbridge ‘Director Primacy’ (Law-Economics Research Paper No 10-06, University
of California Los Angles, 2010).
39
Ibid, 109. NB: Pinpoint references for this source will refer to the page numbers in the University of
New South Wales, Faculty of Law, Business Associations 1 Supplementary Materials (Vol 1) Session
2, 2010.
40
Anderson, above n 13, 353.
shareholder, one with immense power. As the maxim goes; with power comes

responsibility or in this case, with power comes liability.

Helen Anderson lists other differences between shareholders and holding companies.

This sharp analysis backs up the call from Kahn-Freud to protect the creditor not the

parent company. Firstly, unlimited liability would rely on recovery from multiple

shareholders where “the cost of taking action against them may exceed the benefit”.41

On the other hand a parent company is a single target for the liquidators, and unlikely

to be an impecunious defendant. Secondly, unlike shareholders, the parent companies

reap the full rewards of the subsidiaries risk taking. In conclusion, holding companies

are influential on the decision making process, they are easy to litigate against, and

they are more like directors than shareholders. The legislature has long established

that directors should not hide behind the veil if found to have taken on debts while

insolvent.42

The justification for 588V-X lies with the analysis of access to effect the decision to

trade while insolvent. The shareholder, has little or no decision making power with

respect to taking on a debt. Bainbridge told us that it is inefficient for shareholders to

be involved in decision making. Anderson told us that if shareholders had to monitor

the management of the company, it would limit their ability to reduce risk by

diversifying their portfolios. The holding company, on the other hand, is involved in

the decision making processes, and does monitor the management of subsidiaries.

588V-X recognises this and imposes liability for insolvent trading. However, the

section only imposes liability when the power to effect the decision to trade while

41
Ibid, 352.
42
Ibid, 353.
insolvent existed – this is a matter of fact. The holding company must have been

aware or it is reasonable to expect that they would have been aware that the subsidiary

was insolvent. The section appropriately provides defences including when directors

or holding companies did all that they could to stop the subsidiary from taking on the

debt. Without these qualifications on the section, it would arm the courts with too

large a scalpel and undermine the core of limited liability. The section provides

liquidators, and courts with a handy mechanism to protect unsecured creditors. It

takes on Kahn-Freud’s criticism of limited liability. However, 588V-X appropriately,

only punishes only those who had the capacity to effect decisions to take on debts

while insolvent.
 Bibliography

A. Articles/ Books/ Reports

1. Anderson, Helen, ‘Piercing the veil on Corporate Groups in Australia: The

Case for Reform’ (2009) 33 Melbourne University Law Review 333.

2. Bainbridge, Stephen, ‘Director Primacy’ (Law-Economics Research Paper No

10-06, University of California Los Angles, 2010).

3. Ramsey, Ian, ‘Holding Company Liability for the Debts of an Insolvent

Subsidiary: A Law and Economics Perspective’ (1994) 17(2) University of
New South Wales Law Journal 520.

4. Redmond, Paul, Companies and Securities Law: Commentary and Materials

(Thomas Reuters, 5th ed, 2009).

5. James, Paul, Ian Ramsey and Polat Siva, ‘Insolvent Trading – An Empirical
Study’ (Research Report, Clayton Utz and Centre for Corporate Law and
Securities Regulation, The University of Melbourne, 2004).

B. Cases

1. Commissioner of State Taxation (WA) v Pollock (1993) 12 ACSR 217.

2. Group Four Industries Pty Ltd v Brosnan (1991) 56 SARS 234.

3. Hawkins v Bank of China (1992) 7 ACSR 349.

4. Hussein v Good (1990) 1 ACSR 710.

5. Hymix Concrete Pty Ltd v Garrity (1977) 2 ACLR 559.

6. Kinsela v Rulless Kinsela Pty Ltd (1986) 4 NSWLR 722.

7. Manpac Industries Pty Ltd v Cecattini [2002] NSWSC 330.

8. Metropolitan Fire Systems Pty Ltd v Miller (1997) 37 ACSR 589.

9. Mount Edon Gold Mines (Aust) Ltd v Burmine Ltd (1994) 12 ACSR 727.

10. Tourprint International Pty Ltd (in liq) v Bott (1999) 32 ACSR 201.

C. Legislation

1. Corporations Act 2001 (Cth).

D. Other

1. Corporate Law Reform Bill 1992, Public Exposure Draft and Explanatory
Paper (1992).