How to avoid the pitfalls of insolvency and liquidation

How to avoid the pitfalls of insolvency and liquidation

You are in business to succeed but sometimes circumstances lead you down paths that you never imagined traversing.  Managing a business to achieve the best results is often difficult when events beyond your control occur.  However, it pays to understand what can occur if you find your business is heading for negative territory.  A company structure provides a certain level of protection for its shareholders BUT if you are also a director of the company you need to take care to protect your personal liability for a companies debts.

Personal guarantees

Although it may appear straightforward, the implications of a personal guarantee are frequently overlooked by directors. To clarify, a personal guarantee is a commitment made by a director to be responsible for the company’s debts. This commitment is often included in a credit application signed by a director with a creditor. If a director has signed a personal guarantee, that director will then become liable for any debts unpaid by the company. This can amount to a large amount in the event of a liquidation.

In the event of a company’s liquidation, creditors with personal guarantees in place are particularly proactive in proactive in pursuing payment from the director.

One common challenge directors face is a lack of awareness about which of their creditors hold these personal guarantees. It is our suggestion that directors should maintain a register of creditors who hold personal guarantees. It is also our recommendation that the director seek to put a ‘cap’ on any personal guarantees that they sign rather than leaving it as unlimited.

Charging clauses – often found in personal guarantees

Many personal guarantees include a “charging” clause, a critical component that gives a creditor the ability to secure a claim against any real property owned by the director, or any other signatory to the personal guarantee. This clause effectively gives the creditor the status of a “secured creditor”, providing them with security over any real property owned by the director.

In practical terms, this means that if the personal guarantee is called up and not paid, the creditor has the right to lodge a caveat against the director’s real property. Should it become necessary, the creditor can then commence legal proceedings to enforce this caveat. Such actions could lead to the appointment of a statutory trustee, who would be authorised to sell the property. The proceeds from this sale would first be used to settle debts with any creditors who hold a mortgage over the property. Then, any creditors with caveats with any remaining funds will then be paid to the owners of the property.

Given the potential impact, charging clauses are a formidable tool in the hands of creditors and something directors much fully understand and carefully manage. It is our advice that any director should seek proper legal advice before signing any personal guarantees to ensure that they understand whether there is a charging clause included. It may be that the director is better off finding a different supplier that doesn’t have a personal guarantee with a charging clause.

Directors loan accounts

There has been a notable rise in the use of director loan accounts. This has been for two reasons:

  1. Directors choose to draw minimal salaries or none at all, opting instead to withdraw funds from the company through a director’s loan account. The benefit being that there is no PAYG (Pay as you go) or superannuation paid under this approach.
  2. During the COVID period, the directors withdrew significant sums for personal use, whether it be to renovate the house, purchase a caravan, boat etc.

Regardless as to why, this approach carries significant risk in the event of liquidation. One of the first actions a liquidator will undertake is to identify and demand payment of any director loan accounts. These loan accounts are often of a significant amount which places a heavy financial burden on the director to settle the debts.

It is our recommendation that directors should not pay their salaries through a loan account, but rather through a proper payroll salary, which includes paying the PAYG and superannuation. While it will cost a little more to do this, it ensures minimal risk should the company be wound up. The superannuation is a benefit received by the director in any case.

Secondly, it is our view that any director should not take money out of the company for personal expenses by way of a loan account. If the company has surplus funds, these should be paid out in the normal process of a dividend declaration to shareholders.

Director penalty notices (DPNs)

A DPN enables the ATO to directly recover unpaid company PAYG, Superannuation and GST from directors. It’s crucial for directors to be aware of the risks associated with DPNs, particularly if they have outstanding tax lodgments. Directors may find themselves automatically liable for a significant portion of these unpaid taxes and superannuation.

Receiving a DPN is a serious matter that requires immediate action. Directors should seek professional advice as soon as they are notified of a DPN. Ignoring a DPN will only exacerbate the situation, leading to potentially more severe financial consequences. Proactive engagement is essential to managing and resolving these obligations effectively.

Insolvent trading

Liquidators have the power to pursue directors for insolvent trading claims.  Essentially, a liquidator’s role involves conducting thorough investigations to identify the precise moment a company became insolvent. The liquidator then quantifies the total amount of debt that the company accumulated after this date of insolvency. This amount represents the financial liability that liquidators can demand from the directors for insolvent trading.

This process underscores the importance of careful financial management and timely action to prevent or address insolvency.

Queensland Building and Construction Commission (QBCC) licensing

In Queensland, directors of companies that hold a QBCC license face significant consequences if their company enters voluntary administration or liquidation. The QBCC views such events as “insolvent events” and as a result any director, or even former director within the last 12 months who held a QBCC license at the time of the company’s insolvency is labeled as an “excluded individual”. This designation comes with a three-year prohibition on holding a QBCC license.

The consequences then escalate if the director is involved with a second company that also goes into administration or liquidation. In such cases, the director faces a lifetime ban from holding a QBCC license.

These measures are intended to uphold the integrity of the building industry, but they also significantly impact the director’s professional figure, severely restricting their ability to earn an income in the construction industry.

QBCC Deed of Covenant

Directors of companies that hold a QBCC license are often required to sign a “deed of covenant”. This agreement is meant to ensure that a company meets the QBCC’s stringent financial requirements. By signing this deed, directors commit to covering any financial shortfalls.

In the event that a company enters liquidation, the deed of covenant grants the liquidator the ability to make a demand on the director for the amount as defined in the deed of covenant. Furthermore, if the demand remains unsatisfied, the liquidator can then take more drastic action by lodging a caveat over any real property owned by the director. This then provides the liquidator with the power to receive a priority from any sale proceeds should the property be sold, or even provide them with the power to take action to sell the property.

The use of a deed of covenant underscores the serious financial responsibilities and potential risks that directors undertake when managing a company that holds a QBCC license. Directors need to ensure that they are seeking proper advice both legally and financially if considering signing a deed of covenant.

Section 588FGA liability for ATO preferences

One critical aspect often overlooked by directors and their advisors during the process of a winding up of a company is the liability associated with ‘preferential payments’ made to the ATO. When a company is in liquidation and the liquidator identifies that preferential payments were made to the ATO, they are obligated to take steps to recover these funds.

Under Section 588FGA of the Corporations Act 2001, if a liquidator successfully secures a court order to reclaim such payments, the responsibility for the PAYG component of these payments shifts to the directors. This means that if a liquidator recovers any preferential payments from the ATO, the ATO is then entitled to pursue the directors personally for the PAYG portion of these recovered funds.

This liability is a significant risk for directors during the liquidation process, emphasizing the importance of seeking proper advice at all relevant times.

Section 588FDA actions

Section 588FDA of the Corporations Act 2001 empowers liquidators to take action against directors for what are deemed “unreasonable director-related transactions”. This provision is designed to scrutinise financial dealings that may not align with the best interests of a company in distress.

To assess whether a transaction qualifies as unreasonable, liquidators must confirm several criteria:

  1. Transaction initiation – The transaction must involve the company making a payment, transferring property, issuing securities, or incurred an obligations to do any of these things.
  2. Recipient of the transaction – The beneficiary of the transaction must be a director, a person closely associated with a director, or someone acting on behalf of the director or their close associate
  3. Reasonableness of the transaction – The transaction should be such that a reasonable person, given the company’s financial position, would not have agreed to it considering both the benefits and drawbacks to the company.

These criteria give liquidators a broad mandate to investigate any transactions that may disproportionately benefit directors of their close associates at the expense of the company, often including family members.

Liquidators closely monitor these transactions, ready to take corrective action if they find any that do not meet the required standards of fairness and reasonableness.

It is our recommendation that directors to not partake in such transactions, as these will be found. Often it is the case that any such transactions that involve family members – in which case the liquidator will take legal action against that family member.

Conclusion

The potential pitfalls for directors of companies facing liquidation are numerous and can have profound negative impacts. It’s crucial for directors to consult with reputable and knowledgeable advisors to navigate these treacherous waters. Misleading advice, such as the notion that liquidation will magically erase all problems, is not only unethical but also patently false. Directors must be discerning in their choice of advisors to ensure that they are receiving honest and effective guidance to mitigate the significant risks associated with liquidation. If the unqualified advice is to undertake a transaction that seems “too good to be true” – it likely is. Take the time and get the right advice.

Recent Posts

How to scale your business with minimal effort

How to scale your business with minimal effort

When you’re ready to take your business to the next level, you might start thinking about “scali

Read More
Decoding Division 7A – how to avoid unexpected tax consequences.

Decoding Division 7A – how to avoid unexpected tax consequences.

Borrowing money from a private company might appear straightforward but it's crucial to consider the

Read More
The Power of Financial Models

The Power of Financial Models

Financial models are invaluable tools designed to help you understand and project the financial heal

Read More

Partners

Stay Connected

Sign up with your email address to receive news and updates