The decision to become a director, whether in a new business venture or an established company, is one that demands serious consideration. Individuals must understand whether becoming a director is the best approach to their business ventures and weigh-up the associated risks and benefits in order to make an informed decision.
Recent legislative reforms have significantly amplified the personal financial exposure and risks directors face. In light of this, it is more important than ever for directors to grasp the full extent of their duties and the potential risks associated with such a position.
Unfortunately, most individuals who become a director are unaware of their duties and exposures and often find themselves in serious financial difficulty should the company’s financial situation take a turn for the worst.
This article outlines various scenarios where a director could be personally exposed and the potential consequences to them if their company is placed into liquidation. It also provides a set of tips to help protect individuals seeking to become a director.
You may also like to read our previous article exploring the various considerations individual should consider before becoming a director, their duties and roles. Part 2 of this 4-part series – A Guide for New Directors – know your duties and risks.
Personal Exposure of Directors
Directors need to have a good understanding of their potential exposure to the company’s debt. These scenarios can apply to existing directors, former directors, and shadow directors:
- If a director fails to perform duty:
- they can be investigated, charged or convicted of a serious crime;
- they may need to pay a fine by order of a Court or ASIC;
- they can be personally liable to compensate the company or others for loss or damage suffered;
- they can be disqualified from managing a company.
- Issuance of personal guarantees for loans, leases and hire purchase agreements under the company’s name.
- In the event the company goes into liquidation, a director may find themselves with a claim against them personally for any debts the company incurred whilst insolvent i.e. debts that continued to accumulate when the company could not pay its debts, resulting in an insolvent trading claim.
- An individual may be personally liable for unpaid company tax liabilities in the form of a Director Penalty Notices (DPNs) issued by the ATO.
- Fines and prosecution by ASIC for breach of duties.
- Taxation penalty for loans to directors that are not supported by a valid loan agreement (Division 7A).
- Company is forced into liquidation by a creditor or voluntarily by the directors when debts can no longer be paid. This can impact credit ratings of directors and may also lead to the loss of various licenses issued by government agencies.
- Excessive drawings from the company account will create a loan account and liability against the director and will be pursued by the liquidator if the company goes into liquidation.
- Obligations to the ATO.
- Actions by the ATO by not registering workers correctly as employees or paying ‘cash’ or undeclared monies to workers.
- Director of a corporate trustee incurring liabilities on behalf of the trust that it cannot pay back and is not indemnified from the trust.
Signs your company is Insolvent
As mentioned above, a director has a duty not to trade insolvently. There are many scenarios where a company director may continue to trade after a company can no longer pay its debts. One such scenario is where a director believes optimistically that the company can trade its way out of its growing debt problem. Another scenario is when a director is simply not aware to the extent of the company’s debt problems and continues trading and incurring losses.
Directors can find themselves receiving a demand for payment from a liquidator for insolvent trading in these situations. Such an action for insolvent trading could be catastrophic to directors.
Definition of insolvency
It is important to understand the statutory definition of insolvency and identify the signs that your company is insolvent.
Section 95A of the Corporations Act states that – ‘a person is solvent if, and only if, the person is able to pay all the person’s debts as and when they become due and payable’.
Case law has identified some of the signs of insolvency, being:
- continuing losses
- overdue taxes
- high bank overdraft
- inability to borrow further funds
- suppliers changing supply terms to cash on delivery (COD)
- dishonoured, postdated or rounded cheque amounts
- special arrangements with selected creditors
- inability to produce timely and accurate financial information
- enforcement action taken by creditors
- Failure to comply with a statutory demand.
Courts often apply a ‘cashflow’ test in favour of a ‘balance sheet’ test when assessing insolvency.
Liquidation – impact and risk on directors
A company may be placed in liquidation, either as a choice made by the directors and members of the company or by a creditor applying to the Courts to wind up the company.
Once the company is in liquidation, a qualified liquidator is appointed, and they will have control over the company’s financial affairs. The director’s control is suspended, and they will be legally required to attend all reasonable requests by the liquidator, including providing requested information and attending meetings. Not doing so will be a breach of the Corporations Act and could lead to civil or criminal prosecution. The liquidator will take assets that are, or appear to be, the property of the company.
The liquidator will conduct investigations to identify and recover assets, determine whether the directors have engaged in any uncommercial transactions and if directors have breached their duties or committed an offence, reporting them to ASIC if required.
Directors of the company may be summonsed to attend an examination in Court.
ASIC or a liquidator can commence actions to prosecute directors for breaches of their duties or any offences committed.
The liquidator will consider whether they have a claim against directors or third parties for any transactions that removed money or assets from the company at any time in the previous four years before the date of liquidation, depending on whether a related party was involved in the transactions.
Directors could be criminally prosecuted if their actions are found to be reckless or dishonest by a Court of law.
Personal Exposure – when a company is in liquidation
- Insolvent trading – either because the company continued incurring debt or failed to keep proper financial records.
- Claims by the liquidator for uncommercial transactions, director-related transactions, creditor defeating dispositions, preference claims and other recovery provisions.
- Directors could be forced into bankruptcy as a result of personal exposure and liquidator claims. This exposes personal assets to become available to pay such claims.
- A bankrupt cannot be a director of a company during the bankruptcy.
- Bankruptcy destroys creditworthiness for at least five years.
In summary
Whether embarking on a new business venture or working in an existing company, assuming the role of a director requires careful consideration, especially due to recent legislative changes that have increased personal finance exposure and risks. Additionally, if the company faces liquidation, there are substantial implications such as loss of control, investigations, potential legal actions, and even personal bankruptcy.
Recognising the importance of these risks is essential, and seeking guidance from a knowledgeable and experienced liquidator can be valuable. Their expertise can offer invaluable and practical assistance in navigating these complex situations.
Part 4 of this 4-part series will outline “How a director can prevent or reduce personal exposure.”
If you are considering becoming a director or you are a director of a company experiencing difficulties and are concerned you may be personally exposed, please contact our liquidator and trustee in bankruptcy Anthony Bagala at dVT Group on (02) 9633 3333 or by email mail@dvtgroup.com.au.
dVT Group is a business advisory firm that specialises in business strategy, turnaround, forensic investigations, and insolvency (both corporate and personal).
