When can directors be liable for company debts?

A company is an association incorporated under the Corporations Act 2001 (Cth) (“Act”). The effect of incorporation gives the company a separate entity, distinct from its directors and shareholders. It can enter into contracts, sue and be sued in its own right.

The Australian Investment and Securities Commission (ASIC) is the Government body authorised to administer the Act and may investigate and impose civil and criminal penalties for breaches under the Act.

As the company is a separate legal entity, generally its directors are not personally liable for the company’s actions. However, increasingly, creditors of companies that have limited assets and ASIC are pursuing recovery personally from company directors who may have breached their duties under the Act.

In certain circumstances, directors can be held personally liable for losses of the company. Some of these circumstances include:

  • Insolvent trading;
  • Personal guarantees;
  • Breaching directors’ duties;
  • Taxation debts and superannuation contributions; and
  • Phoenix activity.

Insolvent trading

The Act prohibits a company from trading whilst it is insolvent.

Because a company is a separate legal entity, directors and shareholders are generally protected from being personally liable for the company’s debts. This protection however may be abused when directors allow companies to continue trading and incurring debt despite warnings of potential insolvency.

To circumvent unscrupulous or reckless trading, the Act provides that directors who allow a company to trade whilst insolvent will be in breach of both civil and criminal provisions of the Act and may be liable for its debts.

There are however certain defences available and directors may not be liable if:

  • they had reasonable grounds to expect the company was solvent at the time the debt was incurred and would remain solvent after that time; or
  • at the time the debt was incurred they did not participate in management due to illness or some other good reason; or
  • they took all reasonable steps to prevent the company from incurring the debt.

Arguably, the threat of confronting personal liability for insolvent trading could cause directors who are facing transient cashflow issues to succumb to the early appointment of an administrator, despite good prospects of survival. To find an appropriate balance between encouraging enterprise and protecting the community, additional protections for directors have been introduced in section 588GA(1) of the Act – colloquially known as the safe harbour provisions.

What are safe harbour provisions?

The safe harbour provisions are available to directors who take positive steps that are reasonably likely to result in a better outcome for the company than administration or liquidation. Directors will not be liable for insolvent trading if:

  • after suspecting the company is in threat of insolvency, the directors begin to develop a course of action that could be reasonably likely to lead to a better outcome for the company than immediate administration or liquidation; and
  • the debts were incurred directly or indirectly in connection with this course of action and during a specified time period.

Factors that may establish that a course of action would likely lead to a better outcome include:

  • whether the director properly informed himself / herself of the company’s financial position;
  • whether the director prepared a plan to improve the financial viability of the company such as a restructure;
  • whether the director retained a suitably qualified person to advise on the restructuring;
  • the taking of appropriate steps to prevent any misconduct within the company that could adversely affect its ability to pay its debts.

Directors generally cannot rely on the safe harbour provisions in circumstances where the company has failed to meet its obligations for employee entitlements as they fall due or failed to comply with its reporting and filing requirements under taxation laws.

Personal guarantees or indemnities

A personal guarantee or indemnity is a separate agreement between a director and a creditor (such as a landlord or supplier) where the director of a company agrees to become liable for the company’s debt to that creditor in the event that the company does not (or cannot) pay the debt. This could include a director providing security over personal assets such as the director’s home.

Director’s personal guarantees and  are very common but can be financially devastating to the director if the company fails. We strongly suggest that any director asked to sign a personal guarantee or indemnity should obtain legal advice before signing the contract.

Breaching directors’ duties

Under the Act, directors have certain duties that must be complied with. The key duties of directors are to:

  • act in good faith and in the best interests of the company;
  • exercise their powers for the purposes for which they were conferred;
  • act with reasonable care and diligence;
  • avoid conflicts of interest; and
  • not improperly use company information or their position to gain an advantage for themselves or someone else or to cause detriment to the company.

Where a breach of any of these duties is committed and the company suffers a loss, directors can be personally liable. In these circumstances, civil and criminal penalties under the Act may also apply.

Taxation debts and superannuation contributions (Director Penalty Notices)

Directors can be held personally responsible for companies complying with Pay As You Go withholding (PAYGW) and Superannuation Guarantee Charge (SGC) obligations.

Where these obligations are not met by a company, a director can become personally liable for the company’s unpaid PAYGW and SGC obligations through the Director Penalty Notice (DPN) scheme.

In summary, there are two kinds of DPN:

  • A non-lockdown DPN, which applies where the company has properly reported it’s PAYGW and SGC obligations but has not paid them. The amount of the DPN will be the unpaid amount of the PAYGW and SGC; and
  • A lockdown DPN, which applies where the company has not complied with its BAS or IAS reporting obligations within three months of the due date. Because the company has not self-reported, the amount of a lockdown DPN is based on an ATO estimate of the company’s PAYGW & SGC liability.

A non-lockdown DPN may be “remitted” (i.e., cancelled) in any one of three ways:

  • paying the debt;
  • appointing an administrator; or
  • beginning to wind up the company.

A lockdown DPN automatically applies at the end of the day on which the ATO gives written notice of the estimated liability to the director(s). A lockdown DPN can only be remitted by the company or directors paying the amount of the estimate.

Phoenix activity

The Australian Tax Office decribes illegal phoenix activity as:

“Illegal phoenix activity is when a new company is created to continue the business of a company that has been deliberately liquidated to avoid paying its debts, including taxes, creditors and employee entitlements.”

Illegal phoenix activity can result in civil and criminal penalties for directors, it can also result in a term of imprisonment.

Conclusion

Company directors hold a position of power and trust. The risk of personal liability is real but manageable and should not deter you from pursuing business and employment opportunities.

The best way to meet the obligations of being a director is to become familiar with your duties and to understand the legal obligations and the situations which could give rise to personal liability, be involved in the affairs and operations of the company and to obtain professional advice and assistance when needed.

If you or someone you know wants more information or needs help or advice, please contact us.