Everything you Need to Know (Updated 2023)

In circumstances where a company is or may be insolvent, the question can arise as to whether the directors of the company can be held personally liable for company debts. The answers to this question are not straightforward and depend on circumstances, this guide goes through a few common situations.

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    Overview: The General Rules of Liability

    The General Rule of Liability is that any debts incurred by a company are the company’s debt and are not automatically the director’s personal debts. It is only under specific circumstances that a company’s debt also becomes the personal debt of the director. This is called becoming personally liable.

    Doesn’t Limited Liability Mean A Director Can’t Be Held Liable?

    No. Limited Liability means a company’s shareholders (sometimes the same as directors but not always) can only be held liable for company debts to the extent that their shares remain unpaid. More often than not, company shares are fully paid, and shareholders cannot be held liable for company debts at all.

    Director’s Duties When Facing Insolvency

    There are a lot of legal provisions that a director needs to consider in a situation where their company is possibly insolvent. We have provided below some of the relevant sections of the Corporations Act and other director’s duties that are developed through case law, Corporations Act  and the Tax Act. But this is a very complicated area so after you’ve had a read of the information below, we strongly recommend that you call us for specific advice.

    Mentioned below are some of the more important sections of the Corporations Act, Tax Act and general case law:

    • Section 95 (A) (1) Insolvency Definition
      The section defines insolvency as simply the inability to pay debts as and when they fall due.  However, the reality is much more complicated than that.  There is a mountain of case law on the topic and no director can be expected to be on top of all of that.  We suggest you have a look at our page Is my company insolvent? where we summarise the case law into a series of easy questions.
    • Section 588G Insolvent Trading
      A director may incur civil and criminal liability for debts incurred during trading when there are reasonable grounds for suspecting that the company is, or may become, insolvent. We have explained this concept in more detail at Insolvent Trading.
    • Section 588V Holding Company liability for subsidiary debts
      If a subsidiary incurs a debt when there are reasonable grounds for the directors of the holding company to suspect that the company is insolvent, then the holding company may be liable for a compensation claim made by the liquidator of the subsidiary.
    • Section 60 Definition of director
      An adviser to a company may be defined as a director. Whilst it is the duty of a director to prevent a company from trading whilst insolvent, the definition of director may be extended to advisers. Anyone who instructs or directs the directors on a day-to-day basis may be defined as being actively involved in the direction of the corporation and may incur personal liability for the company’s debts. This possibly may extend to bankers if they are actively involved in rehabilitating a company. Care should be taken by lenders and advisors not to involve themselves in director’s decisions.
    • Duty of care
      It is now a generally accepted principle that where a company is insolvent, its directors have a duty not to prejudice the interests of  the company’s creditors. This may well apply to transactions involving banks obtaining security in respect of a past debt or obtaining a guarantee from a technically insolvent company.
    • Section 588FJ – Floating Charges
      This section seeks to prevent companies from creating a charge to secure past debt in the dying days of its business. With certain exceptions, including if new funds are advanced to a company, this section provides that a floating charge created in the six months prior to winding up is void as against a liquidator. It is of utmost importance that floating charges are registered in accordance with the Corporations Act.
    • Section 588E – Inadequate Books and Records
      Companies are required to keep accounting and other records in accordance with section 286 of the Corporations Act. If the company is wound up and it is found that the company didn’t keep proper records, it is then deemed to be insolvent throughout the period it did not keep proper records.
    • Section 588FA – Unfair Preferences
      Payment of accounts outside normal trading terms may be recovered as an unfair preference by a future liquidator if the liquidator can show that the creditor had a suspicion that the company was insolvent. It is not uncommon for a director to ensure that those creditors paid before liquidation are those where the directors have provided a personal guarantee. In such a case, the directors need to be aware that the repayment could be “clawed back” by the liquidator leaving the director again exposed under the personal guarantee. The director can also become personally liable to the liquidator for the value of benefit he or she obtains as a result of the creditor being given the preferential payment.
    • Income Tax Assessment Act Schedule 1 Director Penalty Notices
      That section allows the Commissioner of Taxation to issue notices on directors of the company whereby they will automatically become personally liable for any unremitted deductions by the company, without any formal court hearing. The serving of such a notice will force the directors of the company to remit those deductions; or have the company placed into voluntary administration; or have the company placed into liquidation.

    Trading While Insolvent

    Insolvent trading is the law under the Corporations Act section 588G that says that if a company is insolvent and a director allows the company to incur a new debt, then the director can be personally liable for the new debts incurred. The law makes directors responsible for ensuring that their company does not trade while insolvent.

    See our guide on the topic for more information:

    Director’s Personal Guarantees

    A personal guarantee is a specific agreement between a director, or some other guarantor, and a particular creditor. The usual provision is simply that if the company that incurred the debt cannot or does not pay the liability then the creditor can seek payment from the guarantor personally. So personal guarantees are sometimes requested by suppliers as part of their standard Credit Agreement and by Banks when providing any form of finance.

    Liabilities for Loans and Drawings

    Often a company’s financial accounts will show “directors’ loans”. That is an amount owing by a director to the company. So, it is an asset of the company that is recoverable by a company or the company’s liquidator.

    The history will be that:

    • the company has been making profits in the past and the accountants advise that tax can be saved by paying directors a small salary with the balance of drawings being put to a “loan account”, then the company strikes troubled times; or
    • a director has simply been drawing funds from the company, effectively being a salary, but the bookkeeper has been coding that as “Drawings” or “Directors Loans” in the accounts; or
    • it is a genuine loan from a company to the director.

    If the company enters any form of insolvency administration, such as liquidation or voluntary administration, then a liquidator will require the amount to be repaid to the company. Options available include the following:

    • Repay the debt you personally owe to the company.
    • Offset any loans the directors have made into the company (this is called set off).
    • Take your full salary but reduce the cash you take out of the business to gradually offset the account. So, pay yourself $5,000 per month but take $1,000 only with the balance being set against the loan account. Remember the company will need to pay PAYG on the full $5,000.
    • Discuss the matter with your external accountant.
    • Use a Voluntary Administration to come to an arrangement where all parties are better off.

    Company Credit Cards

    A sometimes-overlooked personal liability for a director and their staff is in regard to company credit cards. Most credit cards are issued to individuals and, as a result, even if that credit card is usually paid by the company, the credit card company will look to the individual to pay the amount due under the credit card. Further, even where a credit card is issued to a company, standard terms and conditions are that the holder of the credit card is personally liable for the debts as well as the company.

    Unfortunately, there is no “magic pill” to solve this problem. The best prevention is to ensure that the credit card is paid off regularly by the company so that the balance is usually low.

    Liabilities for Tax Debt & Superannuation Guarantees

    Company directors are not automatically personally liable for all company tax, but there are certain circumstances where the ATO can chase a director with a Director Penalty Notice.

    A Director Penalty Notice (DPN) is a Notice that the Australian Tax Office (ATO) can send a director that can make that director personally liable for three types of tax debts of a company – Pay As You Go (PAYG), Superannuation Guarantee Charge (SGC) liabilities and Goods and services tax (GST).

    See our guide on the topic for more information:

    Personal Liability for Unfair Preference Payments

    In the liquidation process, the liquidator examines the company’s recent transactions to see if one creditor has been paid in preference to others. If a preference is detected, the liquidator can claw that payment back. If that creditor held a personal guarantee from the director, the liquidator could seek repayment from the director.

    Phoenix Companies & Sale of Assets at Undervalue

    A Phoenix Company is a company that “rises from the ashes” of a failed company. The most common scenario is when:

    • A new company, which we call “NewCo”, begins trading as an identical business from the same location, with a similar trading name as another company, which we call “OldCo”.
    • The assets of OldCo are transferred to NewCo and no consideration is paid for those assets.
    • OldCo probably enters liquidation and leaves a number of creditors unpaid.

    The situation as described is a bad thing for two main reasons. Firstly, there is the financial loss suffered by the creditors of the OldCo when they go unpaid. Secondly, the situation is grossly unfair for the competitors of the Phoenix Company – if a company is not paying its tax debts or trade creditors then its cost base is lowered, usually to such an extent that a competitor can’t match its pricing.

    Whilst we can all agree that the Phoenix Company described above is a bad thing, there are situations that contain some of the elements described above but then vary in crucial aspects that may make it more difficult to describe the situation as a Phoenix. For example, what if the situation was as described above except that when assets are transferred a full market price was paid from NewCo to OldCo. In that situation the position is much less clear.

    Directors can be prosecuted under several areas of the corporation’s act for undertaking such activity. Sale of Assets at Undervalue is a key one. A Liquidator will investigate the removal of assets from a company in liquidation and determine if fair value was received by the company for the assets. If not, the director can be held personally liable for the shortfall. Criminal penalties are also possible for serious offences.

    Liability Timeframes

    Here’s a guide to when the most common forms of personal liability might crop up for company directors:

    Personal Guarantees

    While each guarantee is different, personal guarantees are generally continuing guarantees and have no time limit stated in the guarantee. In practice, they’ll be limited to 6 years by Law.

    A creditor can only pursue a director under a personal guarantee when the principal contract is in default. Liquidation may accelerate this process. A creditor is not obliged to await the outcome of the company’s liquidation to pursue a guarantee – they can pursue the debt immediately through enforcing the personal guarantee given by the director, regardless of any proposed distribution from the liquidation.

    On the other hand, in circumstances where the company is placed into voluntary administration, the creditor cannot exercise or seek to enforce a personal guarantee given by the company’s directors or spouse, de-facto or relative of a director whilst the company remains in voluntary administration. Once the voluntary administration is complete, the creditor has the right to pursue any guarantees that it obtained from the director of the company or any related party as the case may be.

    Ceasing to act as a director of a company does not terminate a guarantee. You will need to either pay the amount due under the guarantee or negotiate with the creditor to have the guarantee terminated.

    On practical level, not all creditors will pursue a director under a personal guarantee even where the company has defaulted. Many creditors will use the guarantee as a negotiating tool but will be reluctant to actually take a legal action against a director. For example, large retail landlords will not pursue a director under a personal guarantee provided the director was cooperative in exit from the premises.

    Trading Whilst Insolvent

    Insolvent trading works like this:

    When a company enters liquidation, it provides its books and records to the liquidator. The liquidator goes through those records and decides a date where the company first became insolvent. If the records show any debts incurred after that date, the directors can be held personally liable for those debts.

    This decision is made once the liquidation has progressed a little, you are unlikely to receive a demand for insolvent trading debt in the first month of the liquidation, but it can happen at any stage. You do not know if you are in the clear, until you see the liquidator has lodged their final return for the liquidation.

    Loans and Drawings

    Like Insolvent Trading, a demand to repay a loan from the company or drawings arises from the investigation phase of the liquidation where the liquidator looks through all collected books and records. A director’s loan or drawings stand out a little more than insolvent trading, so you may receive a demand to repay a loan or drawings at any stage once the liquidator has looked at company records. Again, you can’t be sure you are in the clear until you see the liquidators final return has been lodged.

    Company Credit Cards

    Credit Cards nearly always carry a personal guarantee. Even if they are in the company name, whomever signed up usually provides the guarantee. Banks are probably a little more likely to wait to see the outcome of a liquidation (but don’t have to – see personal guarantees above) before enforcing a guarantee.

    Company Tax Debts & Director Penalty Notices

    Company Directors can become personally liable for company tax debts through the Australian Tax Office’s (ATO) Director Penalty Notice (DPN) regime.

    Under a DPN, the ATO can make a director personally liable for unpaid Pay As you Go withholding, Superannuation and GST.

    The timeframes for when and how they can send a DPN depends on how current tax (and super) reporting has been over the company’s lifespan.

    The rule is if a debt was not reported or reported more than 3 months late you can be pursued at any stage, even if you put the company into liquidation.

    If the debt was properly reported but remains unpaid, then the ATO must issue a Director Penalty Notice that gives 21 days’ notice of pending liability. If the debt is settled or the company placed into liquidation or administration before the 21 days expire, the director avoids liability.

    Amendments affect the reporting date by the way, if a debt was reported on time, but that return was amended outside the 3-month grace window, it is considered to have been reported late.

    Not many people know you must report unpaid Superannuation to the ATO. If a company cannot pay Superannuation when it is due, they must submit a Superannuation Guarantee Charge Statement to the ATO within 3 months of the due payment date. Failure to do this will cause the ATO to classify the debt as unreported and allow them to enforce personal liability at any time as described above.

    Other Topics

    What is Safe Harbour Protection?

    Under Safe Harbour protection, directors are not personally liable for debts incurred after the date of insolvency (S588G Insolvent Trading) if they can show they were incurred in connection with a course of action reasonably likely to lead to a better outcome for the company and its creditors as a whole, rather than proceeding to immediate administration or liquidation. So, the Safe Harbour operates to carve directors out from the civil insolvent trading provisions of section 588G (2).

    What about Directors and Officers (D&O) Insurance?

    Directors and Officers (D&O) Insurance may indemnify directors for some losses but read your policy carefully, some policies do not cover any event arising from Insolvency.

    What does a Director Penalty Notice do?

    A Director Penalty Notice (DPN) is a Notice that the Australian Tax Office (ATO) can send a director that can make that director personally liable for three types of tax debts of a company – Pay As You Go (PAYG), Superannuation Guarantee Charge (SGC) liabilities and Goods and services tax (GST).

    What does a Statutory Demand do?

    A Creditors Statutory Demand for Payment is a formal demand for payment sent by a creditor who either already has or intends to enforce their claim in court. A Stat Demand gives the recipient a 21 period to satisfy the sender that the debt has been or will be paid. If the creditor remains unsatisfied after 21 days, they are then clear to apply to court to have a liquidator appointed to the company.

    What Can You Do About Personal Liability?

    For information on avoiding personal liability in your particular circumstances, give us a call for a free consultation.

    Options for Putting a Company into Liquidation When There is a Dispute

    It’s not uncommon for us to receive a call from a Director in a dispute with their business partner. The caller wants to commence a liquidation but isn’t sure if they can.

    We tell them the cheapest and easiest way to get a company into liquidation is if all directors and shareholders agree, and sign the liquidation documents.

    If not all parties agree, it depends who the dissenter is. If a majority of Directors agree and all shareholders – no problem. If some shareholders don’t agree, it becomes complicated.

    Option 1 is to call a General Meeting of the company and put the liquidation to a vote.

    To call a general meeting written notice must be sent to all shareholders giving 21 days notice of the meeting.

    At the meeting a Special Resolution to put the company into liquidation must be passed. A special resolution requires 75% of the shareholding (calculated by the number of shares each individual holds) that cast a vote in the meeting (so not 75% of the total shareholding, just 75% of those who vote on the day. For example if only one shareholder votes – they carry 100% no matter how many shares they actually hold) to vote in favour.

    This is the cheapest option, but often the 21 day delay is not attractive.

    Option 2 is to put the company into Voluntary Administration.

    If a majority of the directors of the company agree, the company can be placed into Voluntary Administration straight away. This option does not require the agreement of the shareholders.

    If a deal to creditors is not proposed in the Voluntary Administration period (usually 30 days) the company automatically progresses to Liquidation.

    This is a faster, but more expensive option. Voluntary Administration for a small company that is no longer trading costs about twice the price of a standard liquidation. But if it is the difference between becoming personally liable for company tax debt or not, it can be preferable.

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