Andrew Yeo outlines six common liability traps that often ensnare company directors.
There are many pieces of legislation in Australia where a director has some degree of personal liability. The past decades have seen an increase in the prevalence of such legislation affecting directors’ liability. We have also seen the courts continuing to tighten the reins on company directors. Legislators need to tread a fine, but important, line regarding the personal liability debate.
The starting point is the long history of limited liability afforded to company directors. The case for such a protection is that by sheltering company directors from the ravages of personal liability for a company’s debts, directors may be more inclined to enter into (potentially risky) entrepreneurial activities and that by encouraging these activities, our economy as a whole thrives. The case against is that even free market economies need some protection for their participants. That is the balance and the debate that confronts us.
The true problems for company directors usually fall into a handful of liability traps such as personal guarantees, director penalty notices (DPNs), indemnity provisions to the Australian Taxation Office (ATO), insolvent trading, director loan accounts and the blurring of lines between a director’s and a company’s finances. The most common cause of personal liability is self-inflicted in the form of personal guarantees.
There are few companies I have wound up as liquidator where no personal guarantees have been given. Inevitably the bank finance is guaranteed (and often also secured) and almost always the landlord will have a guarantee.
While the ability of companies to now validly have only one director has substantially reduced, the effect of such guarantees (often one spouse holding the family assets and the other assuming the liability risks of being a company director) is still the most prevalent cause of financial downfall for a company director.
The second liability trap concerns DPNs from the ATO. Since June 1993, the ATO has had the power to issue DPNs to company directors which, if not actioned, render them liable to a penalty equivalent to the amount of certain taxes that remain unpaid. While the DPN provisions have always applied to amounts withheld from employee wages but not remitted to the ATO, the provisions have recently been expanded to include unpaid superannuation guarantee charge liabilities for the company.
Recent amendments also mean that where amounts have been unreported and unpaid for over three months, the ability of a director to avoid personal liability by placing the company into administration or liquidation has been removed. In my experience, these amendments, while only coming into effect on 29 June last year, have already significantly affected the personal liability position of many directors.
The third trap concerns indemnity provisions to the ATO. A little-known indemnity provision, section 588FG of the Corporations Act 2001, provides that if a liquidator is successful in recovering an amount from the ATO by way of an unfair preference, then the company director automatically indemnifies the ATO against certain components of the amounts repaid by the ATO. As a liquidator, I often see directors suffering personal liability and becoming insolvent because of this provision.
The fourth liability trap is insolvent trading. A company becomes insolvent if and when it is unable to pay its debts as and when they fall due. The test is a cash-flow one, not one simply based on the company’s balance sheet. A director who allows his or her company to incur liabilities after the time at which it has become insolvent may become personally liable for the company’s debts incurred after that point.
While the costs of pursuing and defending such actions often mean litigation is resolved before it gets to court, insolvent trading remains a significant liability concern for company directors.
The fifth concern is loan accounts that develop between the company and a director where the director owes the company money. This often results from drawings the director has made for the company or to live on, but which have not been deducted as PAYG withholding tax because of tight cash flow. The amounts drawn are recorded as a loan, with the loans being recoverable by a liquidator in the event of insolvency, a common occurrence leading to liability issues for company directors.
The final liability trap is the failure to distinguish between the company’s finances and the director’s personal finances. While most people would not ordinarily regard this as a "liability risk", there is the need for a director to monitor a company’s performance, to act accordingly and to distinguish between a company’s assets and personal assets.
In more than 20 years in the insolvency industry, I have seen too regularly a business owner refusing to accept that a business venture is a "lemon" and then proceed to plough all of his or her, and family’s, resources into a venture in an effort to turn it around. While entrepreneurs by their very nature are optimists, the optimism cannot be overshadowed by good business sense and the taking of appropriate advice.
So where are we heading? The short answer is that there is no liability respite on the horizon for directors. Indeed, most would predict an even rougher road ahead. Despite that, most company directors, being the entrepreneurs they are, expect little change in their willingness to take up the challenge.
Andrew Yeo is a partner at Pitcher Partners, an official liquidator of the Supreme Court of Victoria and registered trustee in bankruptcy.
Already a member?
Login to view this content