There are several areas of liability that directors must be aware of in the event of an insolvency appointment.
Can directors be liable for company debts?
Yes, the areas of potential liability are:
- insolvent trading compensation claims
- unreasonable director-related transactions
- loss of employee entitlement claims
- PAYG taxation debts and superannuation contributions
- personal guarantees.
What are the differences between these liabilities?
The three main differences between these areas of liability are:
- who has the right to make a claim
- whether or not a company must be in liquidation
- how the liability arises.
In liquidation, under the Corporations Act 2001:
- Insolvent trading claims can be made by liquidators, or creditors (section 588M and 588R respectively).
- Unreasonable director-related transactions by liquidators, under section 588FDA.
- Employee entitlement claims by liquidators, or creditors (section 596AC and 596AF respectively).
Not in external administration:
- PAYG taxation debts and superannuation claims are made by the Australian Taxation Office, under the provisions of the Income Taxation Assessment Act 1997 (ITAA) through the directors penalty notice (DPN) regime.
- Personal guarantees can be exercised by creditors holding guarantees, under their agreement document.
Who is a director?
Under section 9 of the Corporations Act directors can be appointed directors, de facto directors, shadow directors, and those acting as directors. Therefore, a person does not have to be formally appointed as a company director to be liable for claims in liquidations.
When is a director liable for insolvent trading?
Insolvent trading occurs when a company incurs a debt that it cannot and does not pay, at a time when a director knew, or should have known, that the company was insolvent. Directors have a duty to prevent insolvent trading under section 588G of the Corporations Act. And a director becomes liable to pay an amount of compensation equal to the amount of the debt.
How much can be recovered?
A claim can be made for compensation for losses resulting from insolvent trading. The amount claimable is equal to that of the debt incurred when the company was insolvent, as long as the debt remained unpaid at the time of liquidation.
How is a director made liable?
A liquidator can make a demand upon a director to compensate the liquidator for the amount of the insolvent trading claim; however, in reality, the liquidator must prove the elements of the claim. The liability will not be enforceable until such time as the court makes an order against the director.
Section 588H of the Corporations Act sets out the available defences. Directors will not be liable if they can establish one of the following:
- They had reasonable grounds to expect that the company was solvent.
- They did not participate in management of the company, due to illness or some other good reason.
- They took all reasonable steps to prevent the company from incurring the debt.
What are 'all reasonable steps'?
A court may consider the following matters when deciding whether a director took ‘all reasonable steps’:
- ‘any action the person took with a view to appoint an administrator of the company; and
- when that action was taken; and
- the result of that action.’
The appointment of a voluntary administrator or a liquidator will mitigate a director’s exposure to an insolvent trading claim; but, it may not eliminate a claim for debts incurred prior to the appointment.
How long do liquidators have to taken an insolvent trading action?
Liquidators have six years from the liquidation’s beginning to commence an action for insolvent trading. Proceedings must be initiated by applying to the court within that six-year period—merely issuing a demand for payment is not sufficient.
Unreasonable director-related transactionsWhat is a director related transaction?
A director-related transaction includes:
- payments of money made by a company
- conveyances, transfers, or other dispositions of company property
- securities issued by the company
- incurred obligations to make such transactions.
- a company director
- a close associate of a company director
- a ‘nominee’ acting on behalf of, or for the benefit of, a director or their close associate.
When is a director liable?
Directors will be liable to compensate a company for loss if they cause the company to enter into a director-related transaction that would have resulted in an ‘unreasonable’ benefit.
Who is a close associate?
Under section 9 of the Corporations Act a close associate is:
- a relative or de facto spouse of a director, or
- a relative of a spouse or of a de facto spouse, of the director.
A relative is a spouse, parent or remoter lineal ancestor, child or remoter issue, or brother or sister of the person.
What makes a transaction unreasonable?
A transaction is unreasonable if a reasonable person in the same circumstances as the company would not have entered into the transaction after considering:
- any benefits that the company may have obtained
- any detriment the company may have suffered
- any benefits that other parties to the transaction may have obtained
- any other relevant matters.
If a reasonable person who would not personally benefit from the transaction would not have entered into that transaction, the transaction is likely to be ‘unreasonable’.
How is a director made liable?
A liquidator can make a demand upon a director to compensate the liquidator for the amount of the unreasonable transaction; however, in reality, the liquidator must prove the elements of the claim. The liability will not be enforceable until such time as the court makes an order against the director. The Corporations Act outlines the relief available, but the type of compensation is dependent on the transaction.
What is the effect when a court ordered the transaction?
If a court ordered the transaction, and it meets the criteria for an unreasonable director-related transaction, the director will be liable under section 588FDA of the Corporations Act, which states:
(3) A transaction may be an unreasonable director-related transaction under subsection (1):
(a) whether or not a creditor of the company is a party to the transaction; and
(b) even if the transaction is given effect to, or is required to be given effect to, because of an order of an Australian court or a direction by an agency.
How much can be recovered?
A liquidator may claim the amount of loss suffered by the company as a result of the director entering into the transaction. A director or close associate may be liable for more than the mere loss if any extra consideration is deemed reasonable when compared with the benefit received from the transaction. That is, if an asset was sold for undervalue to a director, the director would have to pay the extra consideration deemed reasonable for that asset.
What timeframe applies?
The transaction must also have occurred, or action was taken for the purposes of giving effect to the transaction, during the four years before the winding up commenced.
Loss of employee entitlement claims.
When is a director liable?
Liquidators and employees have a right to claim against a director if a company entered into a transaction that reduced the amount of assets available to pay priority employee entitlements in a liquidation. These transactions are known as agreements or transactions to avoid employee entitlements.
What amounts to a contravention of the Corporations Act?
Section 596AB of the Corporations Act states that:
A person must not enter into a relevant agreement or a transaction with the intention of, or with intentions that include the intention of:
(a) preventing the recovery of the entitlements of employees of a company; or
(b) significantly reducing the amount of the entitlements of employees of a company that can be recovered.
Directors contravene the Corporations Act if they intentionally cause a company to enter into one of these agreements or transactions. A contravention of section 596AB activates section 596AC and gives the liquidator the right to make a recovery claim.
How does a director become liable for the claim?
Directors become liable to either a liquidator or, in some circumstances, an employee, if:
- the director contravenes section 596AB of the Corporations Act
- the company is being wound up
- company employees suffer loss or damage because of:
(b) action taken to give effect to an agreement or transaction involved in the contravention.
How much can be recovered?
An amount equal to the loss caused by entering the transaction may be claimed. The loss is limited to the total of the priority employees’ entitlements that cannot be paid due to the reduced available assets caused by the transaction, or agreement.
How are recovered monies distributed?
Under the Corporations Act employees and other parties who would have been entitled to priority claims under section 560 are given priority.
Can directors be liable for a company's tax debts?
Yes. Directors are personally liable if a company fails to remit PAYG withholding tax or superannuation contributions by their due dates; however, personal liability can be avoided in certain circumstances. Directors may also be liable if the ATO needs to refund monies to a liquidator under the unfair preference provisions in section 588FGA of the Corporations Act.
How does liability operate when preferences are recovered from the ATO?
Under section 588FGA of the Corporations Act directors are liable to the ATO for payments originally made by a company to the ATO, then set aside as preferential and refunded to the liquidator. That is, if a liquidator forces the ATO to return money, directors become liable to the ATO for that amount, as well as any costs the ATO is ordered to pay to the liquidator. Liability extends to anyone who was a director at the time of the original payment to the ATO, not simply at the time the company was wound up.
Does an insolvent administration disrupt a personal guarantee agreement?
No. A personal guarantee is a separate third-party agreement between a director (the guarantor) and a creditor, where the guarantor agrees to pay company debts, usually in full, when they have not been paid. The validity of personal guarantees is not disrupted by the actions of liquidators or administrators. Generally, a creditor does not need to take any specific action to make a guarantor liable. However, a personal guarantee cannot be exercised while a company is under voluntary administration. Once that period ends, the guarantee can be exercised immediately.
No action is required by a creditor to make the guarantor liable under a personal guarantee agreement.
What are the implications if a guarantor pays a creditor?
If a guarantor pays a creditor in full, the guarantor has the right to ‘stand in the shoes of the creditor’ under a right of subrogation. This replaces the creditor with the guarantor and means the guarantor has the same rights against the company as the creditor. The creditor must have been paid in full for any right of subrogation to exist, as this right does not exist partially.
When do directors usually enter into personal guarantees?
Commonly, directors sign personal guarantees, with suppliers when they enter into a credit agreement, with guarantees found in the terms and conditions. Sometimes, guarantees are found in a separate document. Guarantees usually form part of any finance facilities with banks and other financial institutions.
Does a company have to be in liquidation for a claim to be made?
No. Because a personal guarantee is a separate agreement between a director and a creditor, the company does not need to be in liquidation, or even insolvent, for the guarantee to be exercised.