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10 Personal Liability Risks For Company Directors Facing Insolvency

10 Personal Liability Risks for Company Directors Facing Insolvency

If your business is struggling, deciding what to do isn’t easy, especially if you have a small to medium business and are emotionally, as well as financially, invested.

When in this situation, voluntary liquidation can seem like the sensible, or even the only, option. However, whether you choose to liquidate or not, there are certain circumstances where you, as director, could be unprotected by the company and held personally liable for its debts.

To help you make the best decision for yourself, and your company, here’s a run-down of the main personal risks you could be faced with, and their potential impact.

1. Personal guarantees

As a director, you’re required to sign personal guarantees in a number of situations. This usually includes when opening a trade credit account, securing bank loans and finance, or signing a premises lease.

Unfortunately, if you do decide to liquidate this means you could end up being held personally liable for these company debts you’ve guaranteed. This is because liquidation often results in little or no return to creditors.

As company debts can be disproportionately large compared to your personal assets, this can land you in financial strife. Worst case, you could face losing your family home and bankruptcy. However, there are various options to avoid bankruptcy for personal debts.

2. Director Penalty Notices (DPNs)

If your company has unpaid PAYG or super debts, the Australian Taxation Office (ATO) can issue you with a DPN making you personally liable.

Lodged your BAS, IAS and quarterly SGC returns on time? You could receive a ‘21-day’ DPN. In this instance, placing your company into liquidation or voluntary administration within 21 days of notice would protect you from personal liability.

Failed to lodge on time, or within three months of the due dates? The ATO can issue you with a ‘Lockdown’ DPN making you personally liable for your company’s unpaid debts, even if your company has already entered into liquidation, a deed of company arrangement or been deregistered.

Watch our video for further information on DPNs.

3. Directors’ drawings and loan accounts

If you’re getting paid from your company via drawings – something accountants advise for tax reasons – you’ll often find the residual amounts on the balance sheet as a directors’ loans.

Accounting entries can then be used to repay these loans by applying all or part of shareholder dividends from the accumulated profits of your company.  However, if you don’t have sufficient profits because your company’s struggling, the loan account can’t be zeroed out or reduced.

As director, you would be liable for the loan account balance and in a situation where you would have to pay back these drawings to a liquidator. To check whether you have a director loan, often referred to as a Division 7A loan,  look at your company balance sheet or talk to your accountant.

4. Insolvent trading

If your company continues to incur debts while facing insolvency, an insolvent trading claim can be brought against you personally for your company’s outstanding debts.

To prevent this from happening, you need to act quickly if you suspect your company is insolvent. Typical warning signs of insolvency include rising super and ATO debt, inability to pay suppliers on time, or a personal situation such as divorce or illness.

It’s important to note that recent legislation has introduced new ‘safe harbour’ protections. This is intended to protect directors who continue to trade when insolvent for as long as they’re taking reasonable and genuine steps to turn things around.

5. Breaches of director’s duties

As director, not only is it your duty to avoid insolvent trading, you also have other ethical and legal obligations towards your company and creditors.

These include exercising reasonable care and diligence, acting in good faith and for a proper purpose and not using your position for personal advantage.

If you breach these duties, you can be liable for the amount of damage caused to your company as a result. To avoid this, beware of practices such as illegal phoenix activity, selling assets for less than fair value, or paying funds to related companies.

6. Uncommercial transactions and preference payments

If you decide to engage in an uncommercial transaction or preference claim while your company is insolvent, these actions can also come back to bite you and the entities involved.

Uncommercial transactions are when a company enters into a financial agreement, or transfer of property, that provides no benefit, or is actually to its detriment. For example, when assets are sold or transferred for less than fair value. A liquidator can claim the value of the benefit received from the recipient of the property or benefit.

Unfair preference payments are payments made to certain creditors in the six months before liquidation in favour of others. Examples for this include making large payments to the ATO, or repaying director or related-party loan accounts. A liquidator can recover these payments from the creditor directly.

7. Illegal phoenix activity

Phoenix activity generally refers to the transfer of a business and assets from one company, with debts it cannot pay, to another company with the same directors, or an associate of the directors.

This type of activity is increasingly common and in some instances, where done legally, can lead to the best outcome for the company and its creditors. While it’s not a specific offence in itself, it becomes illegal where the transfer is not for fair value and on commercial terms. In this instance, a number of claims can be made against the company that received the business or assets, and you as director.

If you are considering restructuring in this way, you should seek advice from a reputable professional, get an independent valuation and make efforts to pay the purchase price on reasonable terms.

9. ATO preference recoveries

While this point has already been covered briefly under uncommercial transactions and preference claims, ATO preference payments are a common occurrence worthy of their own explanation.

The reason they’re common is that the ATO is often the last to get paid, but they have more powers to recover payment. Once they start recovery, they receive large payments to halt action, which drains cash flow and can cause a company to cease trading.

As already explained, payments made to the ATO within six months of liquidation can be recovered by a liquidator as unfair preference payments. However, under section 588FGA of the Corporations Act, the ATO can seek to recover from the director personally any amounts it repays the liquidator.

So worst case, if you’re using your own personal funds to pay ATO debt, you may end up having to pay it again if it’s later recovered in liquidation.

9. Building licence loss

 If you’re a director of a building company you may lose your licence to trade. For example, if you hold a Queensland building licence, you can become an excluded individual for three years if your company goes into liquidation.

In addition, you can also lose your licence if your company goes into administration, or you personally enter bankruptcy, a debt agreement or a personal insolvency agreement.

This could have significant repercussions, including your company not being able to carry out building work, and you being unable to hold a senior position in a QBCC-licensed company.

10. Unfair dismissal

Although less common, under the Fair Work Act, directors can be held personally liable for unfair dismissal claims successfully pursued against their company.

While it’s often necessary for desperate measures such as staff cutbacks to be made if your company’s struggling, it’s important to try to make rational rather than emotional decisions, and seek specialist legal advice to ensure you follow the law.

While only a few such claims have been made to date, this section of the law is being used by the Fair Work Ombudsman more and more.  This has resulted in the company, the director, or them jointly being held responsible for paying penalties and compensation to employees.

Deciding whether or not to put your company into voluntary liquidation is a tough call. Throw in the various situations in which you could be held personally liable and it’s tougher still. However, by knowing the risks you can make better decisions for your company and prepare yourself personally.

Still struggling to make the right decision for your business? As well as speaking to your accountant and lawyer, contact Revive Financial today for timely business debt and insolvency advice.

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