A director’s personal finances are not tied to their company, so it may be easy to think that directors are not liable for the debts of their insolvent company.
However, there are several ways a director of a company facing insolvency can be made personally liable for its debts:
- Unreasonable director-related transactions;
- Insolvent trading;
- Claims of loss of employee entitlements;
- Unpaid taxation and superannuation contributions; and
- Personal guarantees
Through these scenarios a director can find themselves personally liable, which can potentially result in a company liquidation extending into personal bankruptcy.
Regardless of whether or not directors have taken due care and remedial action to resolve financial problems of the company, there are various liabilities that may initially be company debts but ultimately result in personal liability.
For claims to be made by creditors under personal guarantees they do not require a company to be in liquidation. When a personal guarantee is in place they are a secured creditor, secured by personal guarantee. The creditor may exercise any provision that falls within the guarantee initially agreed upon by both parties.
Unreasonable director related transactions
These claims are made by the liquidator during liquidation and are made when a company gives a director, their close associate or their nominee an unreasonable benefit. These include 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.
If there is no benefit to the company, it could be unreasonable. For example, sale of shares for less than market value.
According to the Corporations Act 2001 (Cth), “… if it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction having regard to the benefits (if any) and detriment to the company entering into the transaction and also the benefits to the other party to the transaction.”
The director can be liable for any loss the company suffers by entering into the transaction.
Insolvent trading claims are made by either liquidators or creditors and are made when it is believed that a company has continued to trade despite being insolvent. The director, if found guilty of insolvent trading, then becomes personally liable for any shortfalls to creditors that the liquidation of the company does not cover.
Directors may be personally liable for insolvent trading by the company if:
- A person is a director at the time a company incurs a debt;
- The company is insolvent at the time of incurring the debt or becomes insolvent because of incurring the debt;
- At the time the debt was incurred, there were reasonable grounds to suspect that the company was insolvent;
- The director was aware such grounds for suspicion existed; and
- A reasonable person in a similar position would have been so aware.
Loss of employee entitlements
Employees are a priority creditor, as termination of their employment will terminate their source of income in most cases. A director may be held liable if the company enters into an agreement or transaction that reduces the assets available to pay employee entitlements. The agreement must be entered into with the intention of either:
- Preventing the recovery of employee entitlements; and
- Significantly reducing the amount of employee entitlements that can be recovered.
A director can be liable for any loss the company suffers by entering into the transaction.
Unpaid Taxation/Superannuation debts
Any unpaid taxation or superannuation debts are liabilities and may potentially penetrate all protection structured around the directors (e.g. discretionary trusts, etc).
If a company can pay its debts when and as they fall due then they are solvent, and if not they are by definition insolvent. It is the responsibility of the director to have full awareness of their financial position and to have clear knowledge and reasonable grounds to suspect whether or not the company is trading whilst insolvent.
If a company is found to be trading whilst insolvent, the director/s will be held personally liable for the shortfalls of debt that the company is unable to pay. This liability usually falls upon the director; however, if there are parties carrying out directive duties without being officially appointed as a director, liability also rests with them. These are called “De Facto Directors” or “Shadow Directors”.