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A limited liability company is an attractive business structure for business owners and directors as the company is a separate legal entity from its shareholders and directors. This structure provides shareholders and directors with protection over their personal assets because if someone sues the company, they sue the company as a legal entity and not the directors or shareholders. However, there are some occasions where directors and shareholders can be held personally liable for the debts of the company during insolvency. Shareholders, on the other hand, will usually only be liable up to the value of any amount unpaid on the shares they hold, which is usually zero. This article will explain what insolvency is and what liabilities shareholders and directors may have during this time.

What is Insolvency?

Solvency is defined as a company’s ability to pay its debts as and when they fall due. A company which is unable to pay its debts as 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

As a director, one of your directors’ duties is to ensure that the company does not trade while insolvent or if you suspect that the company may be insolvent. If you allow the company to trade while insolvent, you may be in breach of your directors’ duties. If you are in breach of your directors’ duties, you will be legally responsible for the company’s debts during this time. You can be held personally liable if they have not taken adequate steps to prevent the company from incurring further debts while insolvent.

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.

The consequences of breaching directors’ duties can include:

  • civil penalties of up to $200,000;
  • 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 $220,000 or imprisonment of up to five years if dishonesty is involved.

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

As a director, you should keep yourself informed about your company’s financial affairs and its solvency. 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.

Key Takeaways

Insolvency occurs where 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 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, contact LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.

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