Directors’ and Shareholders’ Liabilities During Insolvency

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Table of Contents

• What is Insolvency?
• Liabilities of Directors
• Defences to Insolvent Trading
• What You Need to Do as a Director
• Liabilities of Shareholders
• Key Takeaways

A limited liability company is an attractive business structure for business owners and directors as it protects shareholders and directors over their personal assets. Generally, the company’s debts are the company’s. If the company is sued, they sue the company as a legal entity and not the directors or shareholders in their personal capacities. A director is not sued in their personal capacity, and a shareholder’s shareholding entity is not sued in that capacity. However, there are some occasions where directors and shareholders can be personally liable for the debts of the company during insolvency. Generally, shareholders of a private company limited by shares will only be liable up to the value of any amount unpaid on the shares they hold. If the shareholder has fully paid the amount they agreed to pay for their shares, this liability is usually zero. This article will explain what insolvency is and what liabilities shareholders and directors may have during this time.

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What is Insolvency?

Solvency is a company’s ability to pay its debts as and when they fall due. A company that is unable to pay its debts as and when they fall due is insolvent. As a director, it is important to stay informed about your business operations at all times and monitor your company’s solvency.

A few warning signs that your company is or is soon to be insolvent include when your company is:

• experiencing cash flow difficulties;
• unable to pay creditors or suppliers, with outstanding payments of over 90 days;
• defaulting on interest or loan payments;
• unable to pay taxes when they are due; or
• unable to obtain finance.

Liabilities of Directors

Directors are generally not liable for their company’s debts. As the company is a separate legal entity, the company’s debts are generally those of that company. 

As a director, one of your most important directors’ duties is to ensure that the company does not trade while insolvent. If you allow the company to trade while insolvent, you will be in breach of your directors’ duties. Consequences of trading while insolvent may make you legally responsible for the company’s debts during this period of insolvent trading. 

The consequences of breaching directors’ duties can include:

• civil penalties of up to the greater of 5,000 penalty units or three times the benefit obtained or detriment avoided;
• paying compensation for amounts lost by creditors (e.g. Sally may have to personally pay Bob’s building company for the work the company engaged it to do). These proceedings can also lead to personal bankruptcy which disqualifies a director from managing a company; or
• criminal charges which can lead to a fine of up to 2,000 penalty units or imprisonment of up to five years, or both.

Example

Generally, if you have not taken a course of action reasonably likely to lead to a better outcome for the company, you may be personally liable for the company’s debts during the period of insolvent trading. 

For example, Sally is the director of a retail clothing company, and she enters into a contract with Bob’s building company to carry out building works on some of her stores. During this time, Sally suspected that she would be unable to pay Bob for the work as she was unable to pay off other debts with the bank. She was also unable to obtain finance. In this instance, Sally has breached her directors’ duties by continuing to trade (by entering into a contract with Bob) while her company was insolvent or soon to be insolvent.

Tax and Super Obligations

Directors of a company are also responsible for ensuring that the company is complying with its tax and super obligations. This includes reporting these obligations and ensuring they are being paid on time. If your company does not pay certain liabilities by the due date, the Australian Taxation Office (ATO) is able to go after the director in their personal capacity for these outstanding obligations. This applies to current and former directors.

If the ATO issues a director penalty notice (DPN), this serves as a notice and allows the ATO to recover the company’s unpaid amounts. The DPN outlines the unpaid amounts. 

Director Guarantees

Another process that may give rise to personal liability as a director is when the company takes out a loan with a bank, trade creditor or anyone else providing finance or credit. It is extremely common for the lender to ask for a “director guarantee”, which means you are personally guaranteeing the company’s loan. 

For example, the lender may ask you as a director to give a mortgage over your house to secure the company’s repayment of a loan. If the company does not repay the loan it owes, the bank may enforce its right to recover the loan by taking possession or selling your home.

Illegal Phoenixing

This situation refers to one where a new company, for little or no value, continues the business of an existing company that has been liquidated or otherwise abandoned to avoid paying outstanding debts. These debts include taxes, sums owed to creditors and employee entitlements.

This happens because a company is a separate legal entity. If the company has employees, those employees have signed contracts with Company A and therefore can sue Company A. If Company A is abandoned because it owes debts to various parties, and Company B is created, runs the exact same business as Company A and where Company B has not paid at least market value to acquire the business, this is illegal phoenixing activity.

Engaging in illegal phoenixing can involve a breach of your directors’ duties. This includes failing to prevent creditor-defeating dispositions, fraudulent concealment or removal of assets and fraud by directors. Penalties include large fines and up to 15 years’ imprisonment for company directors.

Defences to Insolvent Trading

As a director, you may be exempt from failing to prevent insolvent trading if you are able to show that:

• you had reasonable grounds to believe the company was solvent and would remain solvent;
• you relied upon information supplied by a reliable and competent person regarding the company’s solvency;
• during the time that the debt was incurred you were not involved in the business management due to illness or another good reason; or
• you took all reasonable steps to prevent the debt from being incurred. Reasonable steps include developing a course of action to turn the company around towards a better outcome.

What You Need to Do as a Director

In order to place yourself in the best position to avoid trading while insolvent, a director should be constantly monitoring the company’s financial position for any indication that it may be insolvent. Ensure that you stay informed on an ongoing basis. If you are relying solely on financial statements at the end of each financial year, this will likely not be considered sufficient.

You should immediately act on the first signs of financial difficulties that present themselves. If you believe that your company is heading toward insolvency, you should:

• not incur further debts; and
• seek professional advice from a qualified insolvency practitioner.

Liabilities of Shareholders

Shareholders, as the owners of the company, enjoy certain rights in the company, including the right to:

• receive dividends;
• receive company reports;
• attend shareholder meetings; and
• vote on key issues.

Shareholders are generally not liable (or legally responsible) for company debts. As a shareholder, you are only legally responsible for any amount unpaid on your shares. You will need to pay this amount if the company asks you to do so, which may happen during insolvency. Therefore, you have limited liability, capped to the amount unpaid on your shares. Shares are usually issued fully paid, so in most cases, you will not have any additional liability.

For example, suppose you have agreed to pay $100 in consideration for receiving 100 ordinary shares. If you have paid the consideration to the company, your liability as a shareholder is zero.

Similar to directors, where the company takes out a loan with a bank, trade creditor or anyone else providing finance or credit, the lender may ask for a “shareholder guarantee.” This means you, as a shareholder, are personally guaranteeing the company’s loan. 

Key Takeaways

Insolvency occurs when a company is unable to repay its debts as and when they fall due. Shareholders will not be liable for the company’s debts during insolvency except for the amount that is unpaid on their shares. However, this is generally zero because most people will pay for their shares in full and upfront. 

As a director, you must adhere to your duties set out under the law. One of these duties is ensuring that the company does not trade while it is insolvent. If you breach this duty, you may be personally liable for the debts the company incurs during that time. 

If you have any questions about your personal liability as a director or shareholder of a company, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.